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Over the last few days we have written on both Cisco (CSCO) and Ericsson (ERICY) in an attempt to make real the complexity theory of asset pricing (CTAP) we have been developing over the last several quarters (years really). One of the central tenets about CTAP to understand is that markets are non-linear, that they naturally progress and egress, and that that action comes about as the result of the manner in which asset prices are created; largely based on irrational notions of 'value' rather than on any sense of utilitarian economic decision making. We have referred to the works and papers of Tversky, Kahneman, Shiller, Lowenstein, etc. on behavioral economics to illustrate why linear economic theories (like efficient market hypothesis) are flawed. Human beings largely do not make rational economic choices, as these theorists argue. The implications of that statement are manifold.

The most important implication to us is the one we were trying to make with our CSCO and ERICY examples: fundamentals do not lead stock prices. Which is to say that knowing the fundamentals perfectly ahead of time is in no way a guarantor of being able to predict the stock price. There is no causal relationship (in a leading indicator sense that is) between earnings and a stock's price. Just as there is no causal relationship between say oil prices and stock prices, or between interest rates and stock prices or even between S&P 500 earnings and SPX prices. We showed charts at our Crested Butte retreat this past summer proving these very points. But yet the myth persists that there is in fact some sort of relationship: that if we just knew what SPX earnings were going to be next year, we would be able to know what stock prices are going to do. Or if we knew the price of oil a year from now we would be able to determine if that were good or bad for stocks. Both are plain wrong, as any close examination of the actual record of these data sets prove.

Our theory suggests that knowing the full price record of a particular security - because it is a more coincident indicator of the present behavioral environment in which the fundamentals are being reported - is far more important to predicting asset price changes than knowing what the earnings, cash flow, or revenue numbers are actually going to be. How many times in your own experience have you seen a stock gap up on 'bad' earnings? How many times have you seen a stock gap down on 'good' earnings. If you've spent any amount of time in the markets, you have seen this happen an untold number of times. Perhaps as many times as you have witnessed stocks react well to good news and poorly to bad news?

Because human beings largely make irrational economic decisions when faced with an environment in which there is an information deficiency and in a group (social) setting (precisely the dynamics of the stock market), they do not respond in the way that you would think they 'should'. How many times have you asked yourself the following: "Bad news is bad, right? Why isn't the stock going down?" The reason simply is that irrationality plays a critical (and in fact essential) role in the price discovery mechanism for all assets.

We said with both our CSCO and ERICY examples that, if we turned out to be 'right', it would prove nothing. And indeed these two examples do not. But we said that if you performed this task enough times that you might become convinced that there is no long term leading correlation between fundamentals and stock prices. So we encourage you to explore complexity theory as it pertains to asset markets. We think you'll find that all the old assumptions - all those things you think you know about why asset markets do what they do - are wrong.

In the spirit of illustrating the benefits of this theory in an altogether different way, let's take a look at Dell (DELL) for the same fundamental 'insight' via the actual price record of the stock. They report tonight as, just as before, I sure don't have any fundamental insight into DELL's business. (In fact I defy anyone on the sell-side to claim they actually do, but that is an aside).

Here's the interesting thing, from a chart perspective on DELL. There are two acceptable ways to interpret the short term and longer term indicators here. One (bearish) says that the bounce off the February 2004 lows (and thus the bounce off the 2003 lows) is complete and a very bearish downtrend just started on December 15th that should take DELL well below the August 04 lows and in time to new lows beneath the 2003 lows. The other (bullish) interpretation is that the bounce off the Feb 2004 lows 'needs' one more new peak in the $43-45 area to complete the entire bounce off the 2003 lows. At this stage, prices are really in no-man's land between these two scenarios. The current and recent price action does not in fact lend us meaningful insight into whether DELL's earnings news tonight will be perceived as markedly positive or markedly negative. It could be a terrible number, both in perception and reality. If so, we could 'see' how the price action suggests a rapid decline to the November and August 2004 lows (a 20% move down). On the other hand, the number too could be an upside surprise, insofar as the price is suggestive of a 'need' for a move to a new annual high (a 4-8% move up). Our analysis of price - of the underlying behavioral tendencies of the buyers and sellers of this security - is inconclusive on this point.

And that is in fact a useful insight unto itself. Why? Because keeping capital on the sidelines when good risk/reward setups do NOT present themselves is just as important as knowing when to deploy it in earnest. It is thus a far better decision to do nothing than to simply guess (or worse, thinking that you have a significant insight into what the fundamentals are as well as the reaction investors will have to them and take action on that basis). So in this case, our complexity theory and the tools we use to exploit it is providing us some useful guidance: do nothing. If the news is 'terrible' there is potential for more than 20% downside and you can sell weakness. If the news is great, you might get another 4-8% out of it on the upside and can play accordingly (it should be a choppy advance to that $43-45 level rather than a straight shot). Either way, since the security price itself (which, again, is the best indicator of the fundamentals) lends no particular insight, the best thing now is to simply wait for the news and the crowd's reaction to it. It could be telling one way or another.
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