That wasn’t just a willy nilly call. There were good reasons for believing that the stocks would rally a bit and they did after successfully finding support in the 1,260′s. The S&P is in the low 1300′s right now and also kissing the 50-day moving average. It’s as good an out point as you can ask for if your time horizon is short.
Commodities still seem to be looking for a bottom. This is exactly what we warned about a couple of months ago when we started writing about the end of QE2. Turns out, those warnings had merit. I got a lot of hate mail for the suggestion that commodities would go down alongside the conclusion of QE2. But it goes to show that markets don’t move in the same direction all the time. Longer-term, the trend in commodities may still be higher, but I believe that the theory that QE2 was artificially overextending commodity prices is legit.
If pressed, I’d probably guess that crude oil heads back around where it was before QE2. On a technical basis, it seems to want to trade between $70 and $90 per barrel and most of the energy analysts I listen to seem to say the same sort of thing. For whatever it’s worth, refiners can’t really make money with oil below $70 and OPEC doesn’t want prices too far above $90. It’s a topic for an entirely different newsletter, but the whole crude oil problem is very long-term in nature. This is not a situation that will be resolving itself in the next several years.
It might be a little too early to make this call, but we may have been right about interest rates too. Maaaybe.
Rates have rocketed higher this week but the jury is still out on whether that’ll be a move that has legs. I still think it will, but I’ve been wrong about enough stuff in the past not to get too locked into that forecast.
My basic argument is that there are just too many other investments that are more attractive than loaning your money to the U.S. government for 10 years and getting only 3.1% in return. That’s on a nominal basis, too! After inflation, it’s an investment with basically zero return and a fair amount of risk.
Seriously, ask yourself the question: what’s the lowest interest rate you’d accept to lend the government money for the next decade? 4%? 5%? 10%
More Greek Drama
Most of the news headlines I’ve seen this week have been basically of the “market rallies on hope for Greece” sort.
If you’ve been reading this newsletter for any length of time there’s probably one thing you know above all others: there is no hope for Greece.
Sorry. I don’t say that to be mean. It doesn’t make me a hater or a perma-bear. It just means that there is basically one outcome for the Greeks. The details of that outcome are obviously difficult to know — maybe the current government works out a restructuring deal, maybe Papandreou gets the boot and the new government gives the EU the finger, or maybe something happens that nobody sees coming – but none of that matters. Regardless of how it plays out, the final outcome will be one that destabilizes the market.
There are two ways to look at this and two super-important things to understand.
The first is that you need to ask yourself how your portfolio is going to tolerate a destabilization event like that. I can hear what you’re saying. You’re saying, “so what, I’ll be able to re-position myself before that actually happens!” You might think you’ll be able to get out in time but I have news for you: you won’t. Timing on stuff like this is impossible to predict and The Draconian’s Draconian Law of Market Timing is that extremely inconvenient events will happen exactly when you are not expecting them and always when it’s least convenient for you.
Have the evacuation plan in place before the building catches fire.
The second super-important thing to understand is that you need to be prepared to go into the market and buy when this happens. This is every bit as easy to preach and difficult to practice as that first principle. Your gut will be telling you, “ugh, the world is falling apart, maybe I’ll just hang out and see what happens.”
Have a purchase plan at the ready. Make a list of companies you’d like to own for the next year or so. If you know that destabilization events make you nervous, adopt a strategy that takes that into consideration. Scale into these things slowly. Do some dollar cost averaging. Whatever. Just find something that works for you and roll with it. The point is that you should use what the market gives you.
The reason why I’m suggesting that the next big correction will be one worth buying on is because of what we talked about last week. Right now, the market is telling you that default of some form might be inevitable but that it will not translate into a full-blown banking crisis. On top of that, none of the leading economic indicators suggest that anything worse than a growth slowdown is up ahead.
So this two-tailed strategy that we’ve outlined here should work as long as the current environment persists. Pullbacks should be purchased.
Keep your eye on all these indicators. If Greece finally does hit something of an inflection point and credit spreads blow out to record wide levels, then this whole plan may go out the window. If these leading economic indicators start to hint that a recession might be in store some time in 2012 you’ll need to quickly move to Plan B.
It’s a fluid world. Stay flexible.
Lessons on flexibility
I play this game called Puerto Rico. In the oddball community of board game aficionados like myself it’s regarded as one of the best games, if not the best game, of the modern world.
I think this is a game that every investor should play. Serious investors might even want to spend some time to get seriously good at it. It’s an economic game where players develop a population of workers to produce and sell different types goods. But the economic theme is not why investors should play it. The game has some strange and unique mechanics which are incredibly relevant for anyone with a portfolio to manage.
The most peculiar thing that new players will notice is that there is no luck element. In Puerto Rico there are no mechanisms of randomness like rolling dice or drawing a hand of cards. On each turn players can choose between one of several actions which directly impacts both them and their opponents.
We talk about luck and randomness all the time in the market, but in truth, this stuff isn’t actually random. Any professional investor who’s been around for a while will tell you that it’s not a coin toss as to whether the market goes up or down on a given day. It’s not a roll of the dice to determine whether a company goes out of business or a country defaults on its debt. Even something like a terrorist strike doesn’t work in a true, mathematically random sense. It’s all driven by human behavior which works in an essentially unknowable way.
This makes life rather difficult. Believe it or not, random environments are easier to deal with than non-random ones with unknowable probabilities.
One of the major problems in the world of investing is that economists assumed that financial outcomes were normally distributed. We all thought we could nail down probabilities of things like whether a borrower would default on their home loan or whether a bucket of CDO’s would go bad. Then we built fantastic economic models based on these assumptions.
Investors thought they were playing a game like Craps where the odds are known and the distribution of outcomes adhered to an easy-to-model Gaussian pattern. It turned out, they weren’t. The market rolled snake eyes like a dozen times in a row. Everybody was baffled that something which could only happen once in a million years was not only happening right now, but also happened a decade prior and also a couple decades before that.
The dice weren’t betraying us. We were just playing the wrong game.
The market doesn’t play a game like Craps. The market plays a game like Puerto Rico. There isn’t any true luck or mathematical randomness, just illusions of it. The game is based entirely on the actions of humans. Sometimes it’s easy to predict other players’ behavior. But every once in a while they’ll throw you for a loop. It can have catastrophic consequences, too. You might think that investors will rationally follow principles of long-term value, but then they’ll panic and drag the whole market down with them.
Getting good at Puerto Rico is all about effectively adapting to your opponents moves. Sometimes you’ll think you can guess which way the player on your right will zig based on his board’s configuration, but then he’ll zag and do something completely unexpected. Unlike a lot of games — and exactly like the stock market — you have to react to the move your opponent does make rather than the move he should make.
Sometimes your opponent does stupid, irrational, or intentionally vindictive things. If you aren’t able to calmly adjust and head off in a different direction, you’ll fall behind.
The way you win at Puerto Rico is to stay flexible. After you play a number of games you begin to learn all the different ways in which it is possible to win. There are probably four or five broad strategies that work very well and one in particular that is quite popular with many players. But the next thing you’ll notice in Puerto Rico is that none of those are guaranteed winners in each game. There is no strategy like betting the Pass Line and taking full odds that’s guaranteed to get you the best results in any game with any mix of players.
In Puerto Rico you’ll start off playing one strategy only to realize that it’s doomed because of what your opponents are doing. If you’re playing against really skilled opponents, they’ll see what strategy you’re using and intentionally try to derail it. In those situations, you can certainly try to keep forcing your initial strategy. You can hold out hope that it’ll work out in the end. But it doesn’t. It’s a recipe for failure.
It works the same way when it comes to investing in the market. You can play the buy-and-hold strategy or always follow a strict mix of asset allocation, but there are times when that stuff is guaranteed to disappoint. You have to adjust or accept defeat.
It’s not all fun and games
I like to play games. Games are probably one of my favorite things in the whole world.
I play board games, card games, word games, dice games, computer games, solitaire games, social games, mind games, war games, brain games, sports games, role-playing games, casino games, and games you can play in the middle of summer on your back lawn after a pitcher of sangria.
I like games because they give me a chance to interact socially in an environment where the etiquette & expectations are clearly defined. That’s much more comfortable for us introverts than something like a cocktail party. But I also like games also give my brain an opportunity to indulge in exercises of strategy.
When I was a youth, winning was the only thing that mattered. Today that attitude seems silly. Winning has little to do with it. The goal is to always get better, to become a stronger player.
Investing is one big game. Or at least that’s how I see it.
It’s one with infinite complexity, too. And I play it the way I play most games. I start with small bets until I feel familiar enough with the rules. I learn everything I can about the different ways to win. I watch my opponents carefully and learn from them. I learn about them. I try to not only anticipate their moves and make the right counters, but I try and predict the moves they’ll use to counter my counters. After a while I settle down with a handful of strategies that I find particularly appealing or happen to have a knack for.
For me, a lot of those investment strategies were value strategies and contrarian strategies. They were what felt right to me and they were what I was good at. This is why we spend so much time on here talking about things that are cheap and things that everybody else hates. Nobody reads this newsletter for tips on how to day-trade momentum stocks.
As an investor, you have to do the same thing. You have to play all the games and explore all the strategies to find stuff that feels right and gets you satisfactory results. Sometimes it’s work and sometimes it’s fun.
This weekend is the 4th of July. My favorite holiday of the year. All your friends and family will be over for the BBQ and sangria.
What better opportunity to dust off your favorite game?
- If you happened to buy the market when it was looking scary a couple weeks ago, now might be a time to close out that trade if your horizon is short.
- Keep your eyes on interest rates over the next couple of weeks. The higher they go, the less attractive stuff like the stock market will look to investors. In this world of negative real rates, this is the #1 most important mandatory-to-understand dynamic. It’s all relative.
- You can learn a lot by playing games if your mind is open to it. Many of these lessons translate to the world of investing.
SEMANTIC NOTE: It occurred to me that the above discussion of randomness might seem strange. I totally understand how the market can seem random — like a drunkard’s walk down the alley — to most people. But when I talk about true, mathematically random environments, I’m speaking of a game like craps where there are a known set of outcomes and known probabilities associated with those outcomes. The market’s action may satisfy one definition of “random,” but it fails to satisfy our technical definition. Sorry, I minored in computer programming and took a lot of weird math classes in college so I get fussy about the semantics of things like randomness.