To know a thing well, know its limits. Only when pushed beyond its tolerances will true nature be seen.
- Dune, The Amtal Rule
I feel like there’s something about this quote that speaks directly to us in the world of finance. The market tests us on a daily basis and pushes us towards extremes with disturbing regularity. Every once in a while we are pushed beyond what we can tolerate. And that is where the real learning begins.
Think of the all the intimate, longstanding relationships in your life. Your spouse. Your kids or your parents. Your best friend. Your coworkers, fellow soldiers, or teammates. Think about the ten or twenty individuals you’d take with you to the proverbial desert island, the people you’d want to have with you in your foxhole when the artillery is raining all around.
My guess is that you’ve seen most or all of these individuals when they have been pushed to their limits or beyond. You’ve seen their true nature. Or rather, you’ve seen their true nature and admired what you saw. You got a glimpse behind the curtain and concluded decisively that your life was better with these individuals as a part of it.
I can think of dozens of people I’ve known, who, when pushed to their personal limits exhibited behavior that made me uncomfortable, afraid, or disappointed. It sounds terrible, but I discarded many of these individuals from my life where I had the option to do so. It wasn’t a hostile or even an active separation. It just happened. My life went one direction and theirs went another and we each allowed it to go that way without interruption. Perhaps this is what we really mean when we use the expression “we grew apart.” We discover each others’ true nature and make a subconscious decision.
Think about how many old girlfriends, bosses, or golf buddies you’ve abandoned for the exact same reasons.
Peeling away the layers of artifice
So much of what we see in the world is veneer. We see it at the department store, with the people all around us, and in the investments from which we are supposed to choose. We wonder and ask, Behind those layers of artifice, is it crap or quality?
My job, in a nutshell, is to answer that question. I sift through investments and try to figure out which are legit and worth adding to my portfolio. I do it in private. I do it in front of thounsands of you. This newsletter is little more than a public exhibition, a show in which you get to watch me sort the good stuff into one pile and the garbage into another. (The price of admission, of course, is that you have to endure my bad jokes and awkward obsession with science fiction and fantasy baseball. TANSTAAFL, my friends!)
Before I can issue a judgment, I have to get to know the asset. When I’m getting to know something, I want to learn its true nature, and to do that you have to push it to extremes. In the lab or in the real world. You do the best you can and you open your mind to any lessons that may be revealed.
I do stress testing, of course. Some of it involves fancy math and complicated spreadsheets. But some of it is as simple as checking how an investment performed between Q3 2008 and Q1 2009. There are a lot of things you can do, most of which involve imagining a scenario and building a hypothetical model for it however you can. Unfortunately, a lot more of this process is vague and qualitative than some of you quants and stats people may be comfortable with.
The really critical thing to understand is that this isn’t risk management. I’m just trying to get a sense of what the asset is all about. Where are its weaknesses? What are its strengths? How do the characteristics I thought I knew about the asset change under duress?
It’s all part of the art of finance. That’s why I quoted Dune and not Feynmann.
The Fiscal Cliff
You can see where I’m going with this. Consider the U.S. economy. At present, it’s slathered with layer upon layer of veneer and stimulus. We’re hopped up on tax credits, continually-extended welfare benefits, and artificially low interest rates. A lot of this stuff will disappear next year and some people are starting to freak out. Even the Congressional Budget Office said that the disposal of all this economic veneer — about $500 billion worth — is likely to tip us into recession.
The CBO is probably right. Does everybody remember the most important equation in macroeconomics?
GDP = C + I + G + NX
A nation’s GDP is the sum of Consumption, Investment, Government Spending, and Net Exports.
This isn’t rocket science. If you reduce government spending by $500 billion then GDP goes down.
$500 billion represents a little over 3% of nominal GDP, which is interesting because we’re probably looking at something between 3-5% nominal GDP for next year. So, yeah, this could very well send the U.S. into recession. Gonna be pretty hard not to. This also serves as a stark reminder that a major portion of the economic growth of the last few years has been due to heroic levels of government spending.
Among the specific items scheduled for expiration at the end of the year are:
- The Bush tax cuts (originally designed to be temporary).
- A temporary 2% reduction of the payroll.
- A temporary extension of unemployment benefits.
I happen to believe that our noble stewards in Congress are going to do something about all of this. They will not sit idly by. I have no doubt that they will point their fingers and claim that those stubborn bastards on the Other Side are threatening to throw the economy into recession! They will call for action and compromise (but on their terms), and woe to the guy who stands in the way of job creation!
It’s an election year, people. There’s far too much opportunity here for political gamesmanship and far too many intriguing strategies to play to sabotage the opposing team. With so much at stake, the incentive to join together and do something of substance is virtually nil. Sorry about that.
Perhaps it isn’t so bad, though. The gridlock and stasis actually has me optimistic that not all of this stimulus disappears. I think a reasonable chunk of it stays in place. However, none of it will be without cost. You can’t make G go up for free.
Are you seeing the problem with temporary measures yet? Temporary measures work great in the lab and in the economic models. Add a little G here when C goes down and -bam!- GDP smooths out. Crisis avoided. In the real world these measures all involve humans. Humans have a tendency to exhibit strange, irrational behavior or move in mysterious ways.
Psychologically, it’s a lot more difficult to take stimulus away once it’s been added. The last few years of policy ought to be proof enough of that. We reap the benefits in the short-run while the costs accrue over the long-run.
This complicates matters further because of how we actually make decisions. We make a lot of our short-run decisions based on our expectations for the long-run. Do you all remember Friedman’s permanent income hypothesis? Our spending today is based on expectations of future income. E.g. if I give you $5 today and tell you it’s a one-time thing, you’re less likely to go out and spend the entire $5 than you would be if I gave you $5 and told you I’d give you another $5 tomorrow, and the next day, and so on. This really matters for the U.S. economy because the Consumption component represents about 70% of that GDP equation.
Personally, I believe nothing would be more beneficial to the U.S. economy over the course of the next decade than establishing new, long-term policies. Washington D.C. should tell everybody, “here are the new rules and this is the way it’s gonna be for the next 20 years.” Simply communicating and installing long-term reform might actually be more important than what the reform even looks like. The vibe that I get from consumers and businesses is that they just want to know what to expect. That’s all. They’ll make do with whatever.
The good news is that we humans are incredibly adaptive creatures. This is our true nature. When pushed to our extremes, we adapt.
I wonder if perhaps the U.S. has forgotten this true nature. You’d think that with a few hundred years of history as rich and eventful as ours, we would all feel more confident about being pushed to our personal limits. Our history suggests we do just fine in those environments. I’d argue that our collective behavior is better in extreme times than normal times.
I honestly can’t figure out why a nation with our wealth, attractive demographics, intellectual capital, entrepreneurial ingenuity, freedom, and militaristic might is so afraid about kicking the habit and sobering up? What’s so terrifying about the business cycle? Why all the band-aids and cosmetic surgery?
What’s underneath the surface is pretty darn awesome. Beautiful, even. The U.S. is — by a long short — the most powerful, safest, and most stable economy in the world. That’d still be true even if we ripped the stimulative band-aid completely off. It’s true whether you believe it or not, whether you’re a Tea Partier looking to “take back your country” or one of those occupiers occupying something somewhere for the sake of the 99%.
The data is pretty difficult to deny.
And if you think we already have been pushed to our limits I completely disagree. We have plenty of capacity for additional sacrifice. Good thing, too, because we’re going to need it eventually.
The U.S. is kind of like the fundamentally good high school kid — he gets good grades, does his homework, and when the pressure is on he does the right thing. But he hangs out with the wrong crowd. For some weird reason, he tries to be something he isn’t and makes bad decisions when the stakes are low and parental guidance is nowhere to be found. Parents, do you know any kids like this?
If you pick that kid up and drop him in with a pack of fremen on Arrakis, he probably does all right. Seriously. Don’t judge him by his cover.
A Sensitive Market
The problem, and the reason why I bring all this stuff up instead of shrugging it all off with a “whatever,” is that the market is a totally different creature. It’s based on perception. It cares a lot about veneer. At times, the market does a pretty good job valuing the asset underneath and figuring out its true nature (witness: Facebook), but it’s every bit as susceptible to being duped by superficial appearance as the humans who comprise it.
The market gets it wrong a lot.
I’ve seen the market under extreme conditions. I feel like I have a relatively good grasp on its true nature. It is a volatile, insecure, and deceptively unstable beast. If it was person, it wouldn’t be a person I’d want to have in my life. Fear and greed are its true nature, and if that’s not enough to make you cautious while standing near it I haven’t a clue what would.
You’re probably asking why I bother with the thing. Why does anybody bother with such a crazy beast? The answer is that you can exploit it.
Way back in the day, back when Mrs. Concord was getting her Masters degree as a PA, she use to get incredibly nervous before big exams. She would honestly, seriously believe that she was going to fail. Because I’m a man who enjoys a little calculated risk, every time she’d get like this I’d offer her a wager. I’d bet that if she failed her test, I’d have to buy her something sparkly. But if she passed she’d have to take me out to a nice dinner. Never once did I have to pay out. I understood her true nature and had total confidence that her preparation was sufficient for the stress of a test. So I got to eat a lot of nice dinners on her dime.
You can do the same thing with the market. It’s hard work because you have to understand its true nature as well that of the assets in question. But if you’re good at it or know some professionals who are you can make a lot of money.
My long, long-term view is that the market is going to make one more epic mistake. I think we’re going to see a decisive and significant cyclical bear market in the next couple of years. I have no idea what will trigger it or when it will happen. But that’s the basic environment and I am continually on the lookout for signs that it’s about to begin or signs that I have the environment wrong. I think I have the context right, but I can’t assume. It’s entirely possible I have the big picture all wrong.
My gut tells me that there’s still a little more juice left in this cyclical bull market. The big rally that began in 2009 isn’t quite done. U.S. companies are doing well enough and the economic environment is good enough to support higher valuations, especially with the entire planet so desperate for yield. Folks gotta make money and stocks have no competition.
If you’re prudent, I think you can still be long here, especially after this little correction. The article I wrote for Seeking Alpha happened to coincide exactly with the local bottom in this correction. (It usually doesn’t work that way; that was pure luck.) Bullish sentiment was at an extreme low and historically that’s been a pretty reliable indicator and so I wrote about it. I thought the S&P would be meaningfully higher at some point in the subsequent 3-9 months. That’s what the data suggested. The market was just being crazy so I offered it a wager.
Ultimately, I’m not worried about the U.S. because of The Amtal Rule. Sure, there are plenty of things I worry about, everything from contagion effects of Spanish debt to reconciling the budget deficit. When it’s all said and done, I think our country is going to be fine. The market is going to be all over the place and when it comes down to it, I want to be making very long-term wagers on the U.S., not against it. There are a variety of investment strategies that work spectacularly well within that context.
It’s frustrating to watch so many people on Wall Street and in Washington D.C. make bad decision after bad decision. But — and I know this sounds crazy — I don’t think the stakes are high enough yet. Eventually they will be and we’ll have to do the right thing. We won’t have a choice.
It’s a rough economy and difficult environment for many. But I don’t think we’re anywhere close to the limit of what we can collectively endure.
Perhaps when we get there, we’ll finally be reminded of our true nature.