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Common Threads

Wednesday, January 16, 2019

Written by Nathan Polackwich, CFA

Categories: PASI Stocks General Markets and Economy

Comments: 0

Jason Zweig, long-time author of The Intelligent Investor column for the Wall Street Journal, once defined his job as writing “the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself. That’s because good advice rarely changes, while markets change constantly.” Looking back, my articles appear similarly bound by a few common threads, mainly relating to the one thing investors can actually control – their decision-making process. This quarter, and in light of the stock market’s recent negative volatility, I thought it worthwhile to weave these common threads together into a (hopefully) coherent story to help PASI clients better weather the stock market’s current rough patch.

Looking back, the key thread in my newsletter articles has been that the stock market is a non-linear, mathematically chaotic system. This is just a fancy way of saying it’s infinitely complex and unpredictable. The market isn’t like a machine you can break down to its component parts to understand exactly how it works. Its trajectory is unknowable because seemingly insignificant changes can have an outsized impact. It’s just like life. Consider how a glance across a smoky bar can lead to marriage and family (as it did in my case), or a chance encounter to a life-long friendship or career opportunity. The financial markets, which are just an aggregation of all this human chaos, are equally capricious.

The stock market’s inherent unpredictability has enormous implications for investors. Perhaps the most important is that it’s hard (and often impossible) to determine why stocks rise or fall. If an infinite number of variables are at play, how can we know which ones are truly affecting stock prices? The answer is we usually don’t.(1) So, people (the news media and investors) construct narratives to explain the stock market’s behavior. Thus, as the old saying goes, “the market drives the news, not the other way around.”

For example, if the stock market drops sharply one morning, the explanatory narrative might be that investors fear a weakening economy. But if the market recovers strongly into the close, a new narrative must emerge – perhaps that investors believe a weaker economy will compel the Federal Reserve to cut interest rates. So which narrative is right? Probably neither. There’s an old story (likely apocryphal) that J.P. Morgan was once asked for his outlook on the stock market. Morgan allegedly quipped, “Young man, I believe the market is going to fluctuate.” What more can any of us really say?

So, if the stock market will fluctuate and we don’t know why, of what value are the news media’s narratives? At best, they’re worthless. At worst, the news might actually have negative value, as it can provoke an ill-advised reaction by investors. Specifically, the stock market’s narratives tend to affect our emotions in precisely the wrong way at exactly the wrong time. When stocks have been rising for years and the economy is roaring, risk feels exceedingly low. Yet paradoxically that’s the moment risk is highest. Why? The news is always best at the top (and worst at the bottom).

I recently encountered a great example of this phenomenon. You might expect that a low unemployment rate would correlate with strong stock market returns and vice versa. Yet, if you look at the data since 1948, when the unemployment rate was less than 4%, stocks returned just 4.7% the following year, on average. Conversely, when the unemployment rate was over 8%, stocks posted an average gain of 22.2%. As Warren Buffett once observed, “You pay a very high price in the stock market for a cheery consensus.”

The above notwithstanding, there is an important qualifier concerning the stock market’s inherent unpredictability – It’s only mathematically chaotic (unpredictable) over shorter time horizons. In The Misbehavior of Markets (2004), the mathematician Benoit Mandelbrot – one of the founders and key proponents of chaos theory – showed that over longer time periods, stock market returns are not mathematically chaotic. In fact, as the table below shows, they are predictable given just one variable – starting valuation.

Exhibit 1: Ten-Year CAPE Ratio vs. Future Returns (1900-2014)


Source: Shiller

Note that the CAPE (Cyclically Adjusted Price to Earnings) ratio above is just the total stock market’s P/E ratio using ten-year average earnings rather than the current year’s earnings in the denominator.(2) The table shows unequivocally that the higher the CAPE ratio (more expensive stocks are relative to their earnings), the worse the stock market tends to perform over the following ten years. As Warren Buffett’s mentor and legendary investor in his own right, Ben Graham, once said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.”

This concept that short-term stock market returns are basically random while long-term returns are predictable and strongly correlated with valuation brings us to another important thread in my newsletter articles – The only investment decisions worth making are those consistent with a long-term view. Many of the investment maxims of history’s greatest investors are really just an acknowledgment of this fundamental truth. For instance, Ben Graham famously wrote,

“Investment is most intelligent when it is most businesses-like.”

Both Ben Graham and Warren Buffett strongly encouraged investors to think of an investment not as a piece of paper, but as an ownership interest in a business. And business owners don’t thoughtlessly trade in and out of their companies based on temporary changes in the economy or business outlook. As Buffett wrote back in 1988,

“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

Buffett’s stipulation that any business he invests in be “outstanding” is, however, critical. As his long-time partner, Charlie Munger, explained,

“A great company keeps working when you’re not. A great company will eventually earn more and more and more while you’re just sitting and doing nothing. And a mediocre company won’t do that. So you’re harnessing a long range force that will help you…These mediocre companies, they by and large are going to cause a lot of agony and very modest profits. If you do fine, you’ve got to sell it and find another one. It’s a lot of work. Whereas you just buy one great company, and if you get the right thing at the right price, you just sit there.”

Focusing on owning great businesses allows us to make fewer and hopefully better decisions. Buffett has often said that he could improve the average investor's ultimate financial welfare by giving them a ticket with only twenty slots in it "so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments." With only twenty decisions available, it wouldn’t be possible (at least for long) to buy and sell stocks in response to short-term news events like quarterly earnings reports or economic data.

Another common thread of my newsletter articles is to think like a fox rather than a hedgehog. This idea comes from the philosopher, Isaiah Berlin, who wrote,

“There is a line among the fragments of the Greek poet Archilochus which says: ‘The fox knows many things, but the hedgehog knows one big thing.’…Taken figuratively, the words can be made to yield a sense in which they mark one of the deepest differences which divide writers and thinkers, and, it may be, human beings in general. For there exists a great chasm between those, on one side, who relate everything to a single, universal, organizing principle in terms of which alone all that they are and say has significance — and, on the other side, those who pursue many ends, often unrelated and even contradictory... Their thought is scattered or diffused, moving on many levels, seizing upon the essence of a vast variety of experiences and objects…The first kind of intellectual and artistic personality belongs to the hedgehogs, the second to the foxes.”

Hedgehogs, as Berlin explained, think one – or just a few – organizing principles direct the current of history. For them, the world is black and white. The Internet or “peak oil” or crypto-currencies will “change everything.” The CIA or “big business” or “deep state” is the puppeteer pulling all the strings. The causes of and solutions to the world’s problems are, to them, simple and glaringly obvious.

Hedgehogs are often extremely intelligent. But their intellect makes them overconfident that they can predict the inherently unpredictable. So, the mark of a hyper-intelligent hedgehog is not good decision-making but rather the ability to construct convincing and complex narratives that are no more likely to be correct than any other. Regardless, armed with their compelling narratives, hedgehogs commonly demonstrate a penchant for high-risk, which they couple with a dangerous inability to admit a mistake. While hedgehogs sometimes enjoy incredible (though usually short-lived) investment success, their failures are often equally spectacular.

Foxes, by contrast, are pragmatists. They see the world for its complexity and nuance, the many shades of gray. They are skeptical that they, or anyone, can predict something as opaque as the future. Thus, foxes tend to take more moderate positions, eschewing risk. Their skepticism concerning the future’s predictability means far less of their egos are wrapped up in the decisions they do make. Consequently, foxes have an amazing superpower when confronted with new and contradictory information – they change their mind!

But, ultimately, the fox has one purpose when it comes to the financial markets – survival. And the formula for survival, as the common threads of my newsletter articles over the years make clear, isn’t all that complicated.

  1. Buy great businesses at reasonable prices.
  2. Stay diversified in case some of those businesses turn out to be not-so-great (sell these when you learn you were wrong).
  3. Buy high quality bonds to further reduce risk in your portfolio (if appropriate for your risk tolerance).
  4. Expect that your great businesses will encounter unpredictable though temporary setbacks including recessions and business-specific issues.
  5. Don’t let those setbacks provoke you to sell your
    great businesses at what are likely discount prices.

While the formula for investment survival is simple, its execution isn’t nearly as easy. Sticking with your investments (or even adding to them!) through the pain of a recession and bear market requires a measure of fortitude that few possess, especially when managing their own money. That’s why we feel that a dispassionate and steady hand on the wheel – helping our clients stay the course with their investments through the market’s ups and downs – is the most important service we provide.

1) Obviously, sometimes we do. If a company defaults on its debt, for instance, and the stock price plunges, it’s clear the two events were related.
2) Profit margins tend to fluctuate greatly over the course of a business cycle so taking the average earnings over the prior ten years helps smooth out those fluctuations giving us a better read on the stock market’s sustainable level of earnings potential.

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