I write this piece this week after being in a very introspective mood. Unfortunately, the dreaded 3rd wave of the Corona virus in my home country of South Africa is underway. This hits close to home and my father-in-law is critically ill in an ICU at the time of writing.
I believe in the power of prayer (or positive thoughts regardless of your leaning or denomination). I’d like to throw it out there to please think of him and the family in this difficult time… praying for a full and speedy recovery!
I had considered skipping out this week’s article. I also almost skipped my weekly Magic Markets podcast recording, but sometimes, the need to feel ‘normal’ like the world isn’t quite spinning off its axis is important.
“This time its different” – cognitive dissonance and mean reversion
In markets there is a dangerous adage of ‘this time is different’. There exists always, a sense of cognitive dissonance. This affects our judgement as humans and investors alike. We tend to view some data as applicable to others but not ourselves. We may also see it as applicable to another time but not now.
While this may hold true in some contexts, it is important to realize that certain fundamental truths tend to hold. For one, I believe in cycles. I believe that humans, markets and in fact all creation exists in cycles. Sometimes, they exist as an interplay of cycles, but are cyclical, nonetheless.
I won’t go into detail on this in this post, but if you are interested, you may check out the works of Howard Marks. He has written about this at length and I tend to share some of his views.
One of the key features of cyclical behavior is the property of mean reversion. Sometimes, the mean is itself part of a macro cycle and as such may also exhibit a trend of its own. As such, when constructing a long term view of markets and planning a strategy, one needs to critically assess where each element is in its own cycle and what may be causing extrapolations or capitulations.
What are the pressure points, risk mitigants and how to position oneself to optimize one’s utility ‘through the cycle’ are all essential elements of how I frame my thinking.
Technological and generational confluence
Let’s bring it back to markets. Markets at this juncture are nothing like normal. I spend my days speaking to investors and CEO’s about how they are seeing things and the one thing which seems to come through loud and clear is that across markets, we find ourselves in a state of dis-function if not dysfunction.
This stems largely from a confluence of factors. The most often touted is the divergence between ‘market fundamentals’ and ‘market performance’, stemming from fiscal and monetary largesse. I will not go into this except to highlight that the indicator I wrote about sometime ago called the ‘Shadow Fed funds rate’ has gone even further negative implying that policy is now the easiest its been since 2015 and trending lower. This is remarkably supportive of risk taking but may extend potential dislocations further.
Over and above this, we are also at a confluence of technological adoption and generational change. The generational change is occurring both in terms of social awareness as well as an awareness of economic power. These factors are hard to ignore when considering elements like the ‘gamification of memefication’ of markets and the seemingly nihilistic rage against the ‘establishment’.
These aspects have manifested in the most interesting if not bizarre ‘trading activity’ in a plethora of financial instruments (stocks, options, crypto, etc) with a seeming disregard for risk tolerance akin to gambling by going ‘all in’ on each hand. It is utterly bewildering and terrifying to behold when applying a rational investing lens.
This high stakes Russian roulette is occurring as millions of retail investors enforce the power of numbers against the ‘old order’ of institutional investors, hedge funds and the like. The problem is that there is no certainty that the retail investors are not being ‘gamed’ too.
This is an era of ‘fake news’ and accusations of nefarious underground social media armies influencing political outcomes. If there is an iota of truth to this, it would be child’s play for an ill-intentioned actor to use the same power of social media and reddit forums to skew the perceptions and actions of millions of relatively less experienced investors or traders.
Let’s step back
I’m no conspiracy theorist. I like numbers. I also believe in the ‘Occam’s Razor’ approach in that we shouldn’t needlessly complicate our analyses, a trap which many (myself included) tend to fall into.
Let’s look at the simplest fact of mapping 12 month rolling returns on the S&P500 over the long term. The chart below illustrates the simplistic mean reversion property we mentioned above.
Equity returns over the long term tend to be around 12% p.a. The data below averages 9% p.a in price plus an average of 2-3% in dividend yields (yes those still exist unless you only invest in new growth/tech stocks).
Sure, in 1985, the risk free rate was a lot higher so in fact, with the US 10 year yield where it is now, the equity return is SUPER generous and arguably is more than compensating for higher risk…
I won’t go into the detail of how the 12 m forward return of the market is related to the PE at the time of buying suffice to say, when investing, the return is largely dependent on the price you pay. DO NOT overpay for assets regardless of how good they may be.
Throwing back to the chart above, equities are still up almost 30% on a rolling 12 months. This after peaking above 50% from pandemic lows. Bear in mind that the last time equities delivered returns of these magnitudes, we almost inevitably were escaping a crisis (GFC, DotCom, Asian Crisis,etc). and that subsequent 12 month returns trailed off and eventually trended sharply negative. Buyer beware!
We’re not in Kansas anymore
Going back to retail investors, when an asset can deliver 10 X annual returns and more (AMC delivered almost 100% in a day last week before coming off) or a cryptocurrency can deliver multiples of returns in a short period of time, the urge of instant gratification (and riches) has seen capital markets devolve into some variant of an online casino or lottery operation.
Let’s unpack the psychology. YOLO options trading or crypto/meme punts mean that millions of retail investors ‘punt’ relatively small amounts of money with the potential to lose it all or make lots of money…. Sounds pretty much like your weekly jackpot/lottery service? Yes in and amongst the masses are remarkably astute and wealthy individual/retail investors.
I’m not saying its right or wrong. What I am saying is that for the overwhelming majority, we shouldn’t call it investing if its more like a punt or gambling. Dorothy on the yellow brick road simply isn’t in Kansas anymore, we’re now off to see the Wizard of Oz!
This is my internal tussle. I am introspective and yearning for some semblance of normalcy. While cognizant that we are on a moving playing field, I think that while returns of certain stocks will continue to be solid, that we are sailing increasingly closer to the wind.
In a world where armies of new investors are barely sensitized to one year of losses, sustained periods of what they may deem to be lackluster returns may prompt even more risky behavior as they seek newer and more ‘innovative’ ways to get their dollars and dopamine hits! Not a healthy market dynamic.
It is in that context that I prefer to be the boring guy, stick to my knitting and realise that even normalcy is ‘mean reverting’. You only achieve it on the way ‘through the mean’ either up or down. And that pretty much the rest of the time, the world will continue to be sub-normal. And that is infact what creates a market and opportunities.