Among his posts this past week, Kass discussed how to trade what has become a random and inconsistent market.
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Learning to Live With Volatility and Disorder
Originally published on Friday, April 19 at 8:18 a.m. EDT.
One day, the sardines disappear from their traditional habitat off the Monterey, Calif., shores, the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, "You don't understand. These are not eating sardines; they are trading sardines!"
-- Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor
The market that has no memory from day to day has demonstrated an inconsistent and almost random pattern over the past few weeks, and I suspect this will continue to be the investment backdrop over the next several months.
Yesterday I mentioned the role of time frames in my trading -- as an example, one can cover short hedges (as I did recently) while maintaining a negative market view (as I do). In essence, this is not inconsistent with my view, and it is not necessarily a contradiction, as I am gaming the volatility. (Note:Time frames will be the subject of my opener on Monday. I hope it will clarify my tactical approach to trading.)
Last spring I was speaking to the legendary Ira Harris (one of the most influential Wall Streeters over the last 40 years; back in the day, he ran Salomon Brothers' Chicago office), who mentioned that he could not remember a time during his investment career when there was so much uncertainty as there is now.
Ira's fears of uncertainty represent the reality of the times today. Human beings fear that which they do not know -- be it economic, social, political, geopolitical or even environmental (especially of a climate kind).
The market's wild swings over the past two weeks are the most recent reminder of the world's fragility and the general lack of certainty -- it is a world far different than when my Grandma Koufax was investing years ago.
As I tweeted and wrote in my diary yesterday, the only thing I am certain of is the lack of certainty these days!
An important contributing factor to the market's volatility and disorder is the more frequent emergence of black swans.
Last year, Nassim Nicholas Taleb wrote a thoughtful editorial in The Wall Street Journal that underscores that investors must learn to live with general disorder and volatility and the frequency of black swans.
In economic life and history more generally, just about everything of consequence comes from black swans; ordinary events have paltry effects in the long term.... Modernity has been obsessed with comfort and cosmetic stability, but by making ourselves too comfortable and eliminating all volatility from our lives, we do to our bodies and souls what Mr. Greenspan did to the U.S. economy: We make them fragile. We must instead learn to gain from disorder.
-- Nassim Nicholas Taleb, "Learning to Love Volatility," The Wall Street Journal (Nov. 17, 2012)
Random market movements may also may be a function of uncertainty -- uncertainty regarding economic and profit growth but also, I think today, uncertainty of what the appropriate P/E multiple is in a setting of artificiality (and difficulty in estimating the life of policy) in which natural price discovery is being masked by the historic liquidity provided by the world's central bankers.
Volatility and disorder are likely a more constant state in a global economy that is experiencing a new normal that remains on tenterhooks, still experiencing the deleveraging and tail issues stemming from the last down cycle and, as a result, only experiencing a fragile trajectory of growth.
Below are Taleb's five rules for prospering in a world in disorder. It is a good list.
Rule No. 1: "Think of the economy as being more like a cat than a washing machine." Policy aimed at stability and the absence of pronounced cycles is misplaced. As Taleb writes, "The state should be there for emergency-room surgery, not nanny-style maintenance and overmedication of the patient -- and it should get better at the former." Cease bailouts and keep safety nets as long as they encourage entrepreneurs and do not increase dependency.
Rule No. 2: "Favor businesses that benefit from their own mistakes, not those whose mistakes percolate into the system." Certain industries -- such as the restaurant business (when their meals are poor in quality, they have to improve the quality in order to survive) or the airline industry (whose safety measures improve after each disaster) -- are anti-fragile. Success should be an outgrowth of adversity. By contrast, each bank failure hurts the entire system.
Rule No. 3: "Small is beautiful, but it is also efficient." Size often increases fragility. The elephant breaks his leg at the slightest fall, but the mouse is unharmed by a steep fall. (This helps to explain, in part, why we have more mice than elephants!) We need an economic system that distributes risk along a wide range of sources.
Rule No. 4: "Trial and error beats academic knowledge." Potential errors should be small; potential gains should be large.
Rule No. 5: "Decision makers must have skin in the game." We ended up in the financial and economic soup in the last cycle because bankers had a "tails I win; heads you lose" compensation system. Whether that compensation includes a large portion of stock or whatever it takes, corporate executives must have a significant and vested interest in the companies they manage. They must be accountable for lack of success and must suffer financially when there is failure to execute.
So, how do we incorporate Taleb's socioeconomic lessons into our trading/investing playbook, and how do we deal with a market without memory from day to day?
Many of my most successful hedge fund friends as well as investors such as Warren Buffett have made their fortunes in buying and holding -- namely, by discovering investment acorns that rise into mighty oaks. They contend that, regardless of the environment, there will always be those opportunities.
Many of these hedge-hoggers have prospered by bottoms-up stock picking and have often downplayed the macroeconomic backdrop and the market's short-term volatility.
But perhaps the landscape has changed, and the investment fields are simply not as fertile as they were in the old days.
Perhaps substandard and meager returns lie ahead and buy-and-hold is dead or dying.
Perhaps, trading more aggressively in the future is a way to deliver better investment returns.
Perhaps a trading-sardine strategy will trump an eating-sardine strategy.
Investment Conclusion: How Should We Operate?
I would conclude that, while my hedge-hogger friends might be correct -- as for many, it has paid mighty dividends -- the unique conditions that exist today make the harvesting of those great investments ever more difficult in the future relative to the past. Indeed, there are numerous fundamental, valuation, sentiment and technical factors (and uncertainty) that support the notion that volatility, randomness and a market without memory from day to day will be more of a mainstay.
Generally speaking, my tactical response to an unsteady backdrop is to err on the side of conservatism. Here are my rules in the market's new normal:
- Maintain lower-than-typical long exposure. For example, if your normal invested position is net long 70%, think about maintaining net longs of 40%-60%, depending on your risk tolerance.
- Be careful of large, maturing companies whose time has passed. More often than not, they are value traps subject to disruptive competition. (See Taleb's rule No. 3 above.)
- Be receptive to committing an expanding part of your investing portfolio to smaller and more disruptive stock positions.
- Reduce the amount of investing you do while expanding your short-term trading activity. Be more active in long and short rentals.
- While being more active in trading, be more patient than usual in your longer-term investing and wait for your right pitch, both with regard to an earnings and price timing setup. Volatility and disorder are accompanied by repeated opportunities to capture attractive entry points.
- Be more active on the short side. Volatility encourages disappointment for those companies' managements that are inflexible, that are unable to respond to shorter economic cycles, whose margins might come under pressure (and pricing power limited) and whose profit stream is vulnerable to an economic wind no longer at the global economy's back.
- Avoid concentration by diversifying your portfolio across industry lines, and keep individual equity commitments lower as a percentage of your total investment book.
- Learn to trade based on specific catalysts, ranging from generic industry developments, earnings and other factors.
- In order to be a nimble trader, you must learn how to buy red and sell green. To do that, you have to overcome your emotions and learn to acquire more of a contrarian streak.
In summary, looking out over both the near and intermediate term, as unappetizing as it appears to me (and others), we must learn how to operate successfully in a trading-sardine market, not in an eating-sardine market.
At the time of publication, Kass had no positions in stocks mentioned.
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