A. The Most Hated Rally

From 2009 till 2016/2017 we had the most hated bull market in history and since March 23rd it has felt pretty similar.

Everyone got prepared for a downturn given the economic data……and then the market turned up.

Three themes come up in discussions now about markets:

1. “This has never happened before……”

2. “The market is ignoring the fundamentals again……”

3. “In 2008 the market didn’t bottom for six months…..”

I was reading this article, which I highly recommend you read in it’s entirety, and I’m going to massively paraphrase & use below.

Let’s discuss each of these.

1. “This Has Never Happened Before……”

In every major market sell-off in history - and every major buying opportunity - there has always been a pervasive sense that 'life as we know it has changed'. Usually, there is a sense of disorientation emanating from a lack of easy past analogies to draw on.

The hindsight observer has the benefit of knowing how things subsequently played out, they therefore have a playbook for how crises of that particular nature work, and are then able to fool themselves into believing they would have been in possession of such a framework at the time, and reacted rationally.

For example, we can now look back and clearly say that the right time to buy was 2009 / 2010 but how many of us really went long then in any real size ?

This is the very definition of hindsight bias - overestimating how much was known/knowable at the time in light of new information that subsequently emerges.

The error is in believing that it is known unknowns, including known risks/headwinds to the economy, that drive major market sell offs/panics.

But markets don't work like that.

Known unknowns do not drive major market panics, because the necessary degree of fear, anxiety, confusion, disorientation and outright panic is unlikely to be sufficiently present. This is because the impact of those known unknowns is already in the price.

It is instead the emergence of unknown unknowns - new and novel risk factors that investors were not previously aware of and had not factored into their expectations/risk appetites, that drive crashes. A crash occurs because it triggers a rapid and synchronous de-risking of portfolios, as people react to the new, unanticipated risk factor, and reposition their portfolios to reflect the increased degree of uncertainty.

Investors get scared, and they decide to increase their cash allocations from (say) 5% to 20%, to 'preserve capital' in the face of the newly-uncertain environment, and 'prepare for future opportunities amidst the coming downturn'. They do this because they believe an abundance of caution to now be warranted given what has become an extremely uncertain/risky outlook, and also because they mistakenly believe that because the economic fallout is likely to last quite some time, that markets will also inevitably continue to go down/remain weak for a long time to come as well.

The problem with this perspective and behavior is that it is classic 'first-level thinking', instead of the more desirable second-level thinking necessary in markets (hat tip Howard Marks). What investors fail to understand is that it is precisely the synchronized move to higher cash allocations and a more defensive positioning mirroring their cautious outlook - which they themselves were very much a part of - that caused the market to crash in the first place.

If everyone increases cash allocations from 5% to 20% at the same time, markets will crash, regardless of the cause……

The thoughtful market observer would ask the question, so what happens next? Most of these investors don't plan to continue to hold 20% cash indefinitely. They are looking to re-deploy it back into equities at a time they perceive to be more opportune. What they really mean when they say that is 'when the outlook is less uncertain and they feel more comfortable', but what they overlook is that sellers will also feel more comfortable at this point; however, the important practical point is that it means they will be future net buyers of equities.

Furthermore, they have already sold as much stock as they want/need to sell in order to feel comfortable with their remaining exposure in the face of what they expect will be considerable economic fallout in the medium term. Given their already very cautious outlook, it is therefore unlikely they will sell a whole lot more in the future.

What has happened at this point is that a previously unknown unknown has now become a known unknown, and consequently is now already factored into investor risk appetite and market positioning, and so it ceases to have much impact on market prices. And this is true regardless of whether the underlying economy is weak or not, because the economy does not drive stocks prices - demand and supply do.

Ergo, all the very bad economic data that keeps coming and yet the market goes up.

At this point, and in contrast to the intuitions most recently-scared investors harbor, a further market crash actually becomes extremely unlikely, and those sitting in cash hoping for more of the same are very likely to have their hopes dashed.

This is why markets almost always bottom well before the real economy, and recover in a manner that confounds most investors. Right when the majority of investors have just finished selling down, raising cash, and positioning themselves cautiously and in preparation for the 'coming downturn' and the 'buying opportunities' sure to emerge therefrom, markets start to rally and the opportunities they had hoped and expected to encounter swiftly disappear.

The buying opportunities are not created by the economic downturn per se, but investors preparing for the economic downturn by raising cash.

What investors are hoping for is markets go back down so they have a second chance to buy stocks as cheap as they were recently trading, but with so many cashed-up investors similarly hoping for a further pull back, such an outcome is inherently self-defeating. There is simply too much cash on the sidelines waiting for an opportunity to buy the second dip for markets to go down enough to retest their lows.

There never has been, and never will be, a law of the universe that dictates that stocks will go down just because the economy remains weak, and the actual truth is that markets almost never go down much - if at all - when investors are already cautiously positioned for a known unknown, and are already holding a lot of cash in preparation for a difficult and uncertain future. 

Every single time there is a recovery from a major economic shock/market sell-off, the same thing happens; people react with the same credulity, and believe the market is ignoring the fundamentals.

Throughout the substantial 2009 market recovery from the GFC lows, there was widespread skepticism about the durability of the rally. Didn't people know that the economy is in a mess and it is going to take years to recover from it? Yes, they did, and that was the whole problem. It was no longer an unknown unknown. The economy contracted throughout 2009 and unemployment continued to rise, and yet stocks continued to rally, not only through 2009, but for the next decade.

2. “The Market Is Ignoring The Fundamentals Again……”

What the market is actually doing is what it always does during market recoveries from crises/crashes - ignoring lagging/co-incident indicators that suggest bad things are happening in the economy that were already widely anticipated to occur during the panic, and instead focusing on the leading indicators which are pointing to an improving medium term trajectory.

Furthermore, even if conditions get every bit as bad as anticipated, but they stabilize at those terrible levels, the degree of uncertainty still declines, as fear of the unknown is replaced with tangible knowledge of how bad things actually will get.

Everyone expected the economy to take a massive hit and unemployment to surge on account of the lockdowns in March. Panic about the absolute carnage that would befall global economies on account of widespread government lockdowns is what drove many asset markets down 40% in the space of 4 weeks, and many individual stocks down by as much as 80%. Sell-offs of this magnitude are extremely rare, and do not happen if investors aren't expecting something approaching Armageddon. It is therefore not surprising news flow confirming that a lot of these things happened in April - notably disastrous US payrolls - has had no additional negative impact on markets.

What has actually been happening over the past six weeks or so of market recovery is that investors have been reacting not to the economic downturn that was already widely expected and priced in, but instead to growing evidence that the duration of the downturn and the breadth of severe impacts may have been meaningfully overestimated.

The reality is that as bad as covid-19 is from a public health point of view, the data is not turning out anywhere near as bad as people initially feared, and anyone who does not believe this has important implications for the likely severity and duration of this covid-19 induced economic downturn is kidding themselves.

Remember, this downturn has not been caused by covid-19 per se, but our policy reaction to covid-19, which has contained some flawed premises. The crisis is entirely man-made, and can be largely undone just as easily by reversing such policies. And as case numbers and deaths have declined, lockdown policies have already started to be relaxed almost everywhere.

During market recoveries from significant sell-offs, markets have never focused on how bad things presently are, but instead trends in the second-derivative and leading indicators, and for good reason.

People forget that stocks are long duration assets. If a stock drops 40% from 20x earnings to 12x earnings in a market crash, the market has just subtracted eight years worth of profits from the valuation. If the company comes out and says, yeah earnings were down 50% in 1Q20, and we think we will operate at a small loss in 2Q, before recovering to 75% of normal profitability in 2H20 based on trends we are already seeing in our revenues and costs, with a full recovery likely during 2021-22, it is not hard to see how investors could start to reconsider whether such a dramatic repricing of the stock was truly justified.

Investors will look through short term earnings pressures and price the impact in a rational manner provided some critical threshold of uncertainty is not breached. When uncertainty is high enough, investors panic and sell and sometimes, no price seems too low.

However, when uncertainty declines back below this critical threshold, investor behavior becomes far more rational, and when that happens, markets are apt to sharply rally from deeply oversold levels. That is exactly what we have started to see in recent weeks/months, as the degree of uncertainty has moderated.

3. “In 2008 The Market Didn’t Bottom For Six Months…..”

A final point worth discussing about recent market experience is the danger of reasoning by analogy. One of the reasons so many investors have been paralyzed by fear during this downturn is that they have no way of thinking other than by analogy, and there are no analogies to draw on with respect to how to invest through a pandemic and government lockdown, so they have defaulted to one of two positions - both flawed.

Either they say that because this event is completely unprecedented, the amount of uncertainty is so high that no reasonable basis for forming any assessment on the outlook exists; or they default to comparing the downturn to the GFC or even the great depression, because - well - um - stocks and the economy went down a lot then too.

There are multiple problems with this approach.

Firstly, an aside on uncertainty: the reality is that the future is always uncertain; it just feels more uncertain to investors at certain times. This is because, as noted, the primary risk in markets is not known unknowns, but unknown unknowns. Six months ago, the outlook felt more certain, but little did we know that covid-19 was about to emerge and wreak havoc with the global economy and financial markets. 

Risk comes from the fact that unknown unknowns exist in the world, and by definition, such unknowns cannot be foreseen. The outlook therefore might feel more or less uncertain to you, but that is an illusion. And even if the outlook for the economy is in fact objectively more uncertain today than it was six months ago, that does not mean the outlook for markets is more uncertain or riskier than normal, because covid-19 is now a known unknown.

The very best opportunities in markets - whether they be at the market, industry, or individual stock level - always exist in situations where there are novel events or changes happening that render past analogies obsolete. It disorients investors and makes them uncomfortable investing. That is how stocks get very cheap.

Great investors are the ones who are original thinkers and are able to reason from first principles without requiring the crutch of analogy. This is something Warren Buffett has obliquely mentioned, when he said he seeks out in successors a very rare trait, which is an ability to think about and anticipate risks that have never happened before. In other words, people that think independently from first principles and don't rely on analogies with the past to form useful judgments.

Being a good investor is fundamentally about the ability to form reasonable judgments in the face of uncertainty and incomplete evidence. 

If you can't do that, you will feel compelled to wait until the uncertainty is resolved and all the evidence is in, but by that stage the opportunity will no longer exist.

Because no pandemic analogy exists, but people feel they need to have one, a lot of investors have defaulted to analogizing the GFC or even the Great Depression. The extent and duration of stock market decline during these periods has often been used as a guide to what we ought to expect this time.

One of the potential consequences of the widespread use of lazy and inappropriate analogies is that people's intuitions on the potential shape and speed of the recovery may be very materially off.

I have seen many people argue that oil demand will not recover until 2022-23. I've seen people argue that there will be radical and permanent changes to peoples lifestyles, including people working from home long into the future instead of at the office; and staying home and using online services for everything instead of going out. And yet recently reopened cruise bookings for August has surged 600%.

While hesitations will persist for a while out of concern for health and safety, it is human nature for risk to be normalized over time, and for people to learn to adapt to the presence of risk.

In my view, this is a government policy/lockdown crisis that is man-made, and therefore can just as easily be reversed as it was engineered. This crisis had a simple cause - the government forced people to stay home, where many people couldn't work and couldn't go out and spend money. When they go back to work, it stands to reason that productivity and consumer spending will rapidly revert to near normal levels, as we are already seeing in China.

Having said all that, I’m not ignoring the real world stress and the countless bankruptcies that have occurred and will. My point is that the GFC or the Great Depression are probably not the best analogues for this moment and we are probably not going to see another 30% sell off from here.

The lows are in (famous last words……)

All of this to say that I think a chart like the below should normalize.

And the chart I am watching closely is this one - which way do you think it will go ?

I’m betting on a move higher.

B. A Few Things Worth Checking Out:

1. No matter what one thinks about Bitcoin, they should read Paul Tudor Jones note to investors for this month. He outlines a novel approach to identify the best performing assets in this era of GMI (Great Monetary Inflation), and ranks Bitcoin on top. Fascinating stuff!

All of this reminded me of his documentary titled “The Trader” from 1987. This basically put him on the map.

2. Great podcast with Adam Robinson on the Northstar Podcast discussing: Searching for Secrets.

Some great quotes:

Look for things that don’t make sense within a domain (an anomaly). When you fixate on anomalies, it opens up a whole new world that no one’s investigating – that’s how you separate yourself from the crowd.

Wait for a pitch you know you can knock out of the park and swing for the fences – this is a key to both investing and life. Apply this broadly – from which people you choose to spend time to the restaurants you choose to visit, wait for the FAT PITCH. This is a key to life, knowing how to wait for the fat pitch opportunities because life pitches you opportunities ALL THE TIME.

When people say: “It makes no sense that…” really what they’re saying is this: “I have a dozen logical reasons why gold should be going higher but it keeps going lower, therefore that makes no sense.” But really, what makes no sense is their model of the world, right? So I know when that happens, that there’s some other very powerful reason why gold keeps going lower that trumps all the “logical reasons.”.....Things that don’t make sense are an algorithm for finding opportunities. Where do we find good ideas? Look where no one looks. When thing’s don’t make sense, get into the trade. 

Things that make sense are often already discounted in the price. The things that make you go hmmm… aren’t, which is why the “no sense” algorithm is quite powerful. Markets are funny like that.

3. Which reminded me of Charlie Munger’s timeless speech - The Psychology of Human Misjudgment.

4. One of Charlie’s favorite ideas is Inversion - know what you don’t want, know what you don’t want to achieve. If you can remove the negatives, then all that remains is the positive. This article does a good job of discussing anti-goals. Many years I wrote down, what I definitely don’t want in life and that is helped me time and time again.

5. Steven Kiel interviews Harris Kupperman as well as Calvin Froedge about the opportunity in tankers.

6. 50 great big ideas summarized into paragraphs by David Perrell.

7. I liked this infographic on the history of pandemics.