A Few Things....Surviving the Storm and Dealing with Uncertainty

March 12 2020

A. Surviving The Storm

“And once the storm is over, you won’t remember how you made it through, how you managed to survive. You won’t even be sure, whether the storm is really over. But one thing is certain. When you come out of the storm, you won’t be the same person who walked in. That’s what this storm’s all about.”

- Haruki Murakami

“Selling out at the bottom & thus failing to participate in the subsequent recovery – is the cardinal sin of investing. The ability to persevere requires consistent adherence to a well-thought-out approach; control over emotion; & a portfolio built to withstand declines.”

- Howard Marks

Does this feel about right ?

It’s amazing how quickly things have changed.

Last week we discussed that the market was trying to price the economic impact, and this week started with the market fairly convinced that we were going to see a full blown recession.

The chart below from Goldman Sachs shows typical declines in prior bear markets, the length of decline and associated recovery.

The median decline is ~32%. The S&P & Nasdaq are now off 24%, though it feels a lot worse, and the US Small Cap Index is down ~30%.

So when do we correctly price in a recession ?

The next step of pricing this recession is figuring out not just how deep, but for how long. Is this one quarter or three ? Or even worse.

The other thing this market is trying to price is the 2nd and 3rd derivative.

Lastly one of the impacts of this being a health & safety related situation is that you have many trading desks under staffed. This means liquidity is POOR. Which coupled with rising volatility is creating very large air pockets in markets, with very large bid-offers.

What now ?

Here are some thoughts:

1. Lower bond yields and oil prices are generally a good thing - both are a stimulant for the global economy, and I think will stimulate economic activity with a six to 12 month lag. Also, lower bond yields should support higher equity valuations, since equities look even more attractive versus fixed income and corporates & households can re-finance their debts at lower rates. This gains could get locked-in in six to 12 months.

2. A lot depends on what the US does. The FED could help further (as it has today). We could see something like “TARP + QE” redux. But there are political risks and frictions here. What if the politicians can’t get anything done ? Who are the adults in the room ? This is what guys like Ian Bremmer and Peter Zeihan have been talking about for a while.

3. Geopolitical risks remain large. Iran being on the ropes due to oil, could lash out. Russia could take advantage of the world being busy to engage in further adventures. Trump could impose massive tariffs on oil imports.

In speaking to people, I haven’t heard much panic, but I have heard stress. That is too be expected. But very clearly this is not 2008 ! This is completely different. 8.8 million people lost their jobs then and companies couldn’t finance their business models anymore. We aren’t there….yet and I don’t think we are going there either.

So does this mean that one of longest expansions in US history is about to end ?

You’ll notice that while it’s been long, it’s also been very shallow (but maybe more debt and QE fueled).

Earlier this week I was thinking about some of the work of Nassim Taleb (Anti-Fragile and Fooled By Randomness) and attended an event where Mervyn King discussed his recent book - Radical Uncertainty.

I think the main ideas (from both) that stayed with me are:

Uncertainty (something that is unquantifiable) and Risk (something that is quantifiable) are not the same thing.

In markets, we’re always dealing with uncertainty. Sometimes that uncertainty is relatively low and the range of plausible outcomes is more narrow than not. And sometimes that range blows out and assessing probabilities with any level of confidence becomes a crapshoot.

Right now the cone of potential of future outcomes has widened significantly. So the market is forced to re-price those assets with much wider tails.

And the reason why you are seeing such wild swings is that not only is the future more uncertain, but given the ergodic nature of investing and financial securities, the cascade effects are even larger.

And since stock markets are simply a pricing function, until the cone of possibilities is tightened, we will continue to swing as those tails cascade wider and wider.

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B. Dealing With Uncertainty

“You know, people talk about this being an uncertain time. You know, all time is uncertain. I mean, it was uncertain back in - in 2007, we just didn't know it was uncertain. It was uncertain on Sep 10, 2001. It was uncertain on Oct 18, 1987, you just didn't know.”

- Warren Buffett

In “The Art of Stock Picking”, Charlie Munger compared stock market investing with the pari-mutuel betting system at the racetrack, where the payoff for each horse winning is determined by how many people bet on it:

….a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet…..Any damn fool can see the horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on.

But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet….

I think our goal in Investing & Life, should be to find the superior propositions. Situations where the odds are generous to one side or the other, whether favorite or underdog. In other words, a mis-pricing.

The market is now pricing a 75-80% probability of a recession - 24% current correction divided by the 31% median correction in a bear market.

What is the correct pricing ? Is it 40%, 50%, 60% ? I don’t know the answer to that.

Where does that leave me ?

1. I’m looking for & making some good bets but not trying to anticipate or predict anything.

2. I’m trying to keep it simple either by operating with enough margin of safety or by having enough anti-fragility in my life that I don’t need to spend time predicting or waiting.

3. Admitting that I probably have no idea what the real risks are.

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C. A Few Things Worth Checking Out

1. Peter Zeihan was on the Invest Like The Best podcast. I love listening to Peter.

2. If you are start-up investor, you need to listen to Mike Maples on the Knowledge Podcast discussing Living in the Future.

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Quotes I’m Thinking About:

“God, give me grace to accept with serenity
the things that cannot be changed,
Courage to change the things
which should be changed,
and the Wisdom to distinguish
the one from the other.”

- Serenity Prayer

“Not taking risks one doesn't understand is often the best form of risk management.”

- Raghuram G. Rajan

“The cost of a thing is the amount of ... life which is required to be exchanged for it, immediately or in the long run.”

- Henry David Thoreau