“You need to know very little to find the underlying signature of a complex phenomenon…. This is the gift of training and expertise – the ability to extract an enormous amount of meaningful information from the very thinnest slice of experience.”
Malcolm Gladwell, Blink
The ability to make accurate decisions in the face of overwhelming amounts of information can require a great deal of experience, but what does that experience actually do? My impression is that experience – studied and absorbed carefully – nurtures the ability to see and identify subtle elements in the landscape, and eventually to recognize patterns. Accurate decision-making doesn’t rely on weighing and deliberating over every detail of that landscape. As Malcolm Gladwell brilliantly writes in Blink, accurate decisions often rely on “thin-slicing” – a kind of pattern recognition that perceives and filters out the very few factors that actually matter.
That’s not to suggest that simplicity, in and of itself, is the objective. Ockham’s Razor doesn’t merely say that the simplest explanation is usually the best; it requires that the explanation must also be consistent with the evidence. Likewise, Einstein joined his advice that “A theory should be made as simple as possible,” with the essential condition “but not so simple that it does not conform to reality.”
One of the striking features of investing by the simplistic aphorism “Don’t fight the Fed” is precisely that it doesn’t conform to reality. For example, the Fed was persistently and aggressively easing through the entire market collapse of 2000-2002 and again through the collapse of 2007-2009. As I’ve often noted, “The trend is your friend” does much better historically, though the primary benefit is to reduce the depth of periodic market losses, as most popular trend-following methods fail to outperform a passive buy-and-hold approach after transaction costs. If I were on a desert island where I could invest using only one aphorism, I would choose “Don’t fight the tape” –Â provided that “the tape” was properly defined to capture the uniformity and divergence of a very broad range of individual stocks, industries, sectors and security types, including yield spreads on debt of varying quality. "Buy low, sell high" is a tempting aphorism but is difficult to execute without additional information; while valuation is extremely informative about long-term returns, valuation is most useful when joined by market action. It's the combination of the two that distinguishes a bubble from a crash, and a crash from a recovery, and thereby identifies when to take action.
Early in my career, I worked for Ralph Peters, an enormously successful investor and the former head of the Chicago Board of Trade. Out of an endless expanse of available data, he discerned a handful of essential considerations that he drew from the behavior of various markets. He called one of them his “lucky coin.” Research can be exhausting, experience can be painful, invention can be fraught with trial and error. Yet it’s exactly through that painstaking process that one gradually discerns a few central elements that actually matter. At the end of that enormous effort, many of the greatest discoveries seem simple - even obvious. As Peters told me, “Everything is easy, once you know how it works.”
Thin-slicing can’t be done well without developing a very detailed vocabulary that allows key features to be recognized. One has to think about a given issue enough to develop an exhaustive vocabulary that can describe each case. That vocabulary is what then allows an expert to identify a handful of critical features in a blink of an eye, instead of losing all of that detail in a blur. As Gladwell writes, “Every moment – every blink – is composed of a series of discrete moving parts, and every one of those parts offers an opportunity…”
Refining market vocabulary
I’ve often observed that the central elements of our own discipline fall into two primary areas: “valuation” and “market action.”Valuation provides enormous guidance about long-term returns. Every security is a claim on a very long-term stream of expected future cash flows that will be delivered into the hands of an investor over time. Given a stream of expected future cash flows and the current price of a security, it’s straightforward to estimate the long-term expected return. Conversely, given a stream of expected future cash flows and the long-term expected return that one requires, it’s straightforward to estimate the current price that would be consistent with that required rate of return. As I’ve detailed in numerous recent comments (see, for example, All Their Eggs in Janet’s Basket), the most historically reliable valuation measures currently suggest a negative nominal total return for the S&P 500 over the coming decade.
Our concept of “market action” captures a broad range of market behavior, including not only the uniformity and divergence of individual stocks, industries, sectors, and security types (what I often call “market internals”), but also trading volume (e.g. “accumulation” and “distribution” measures), extremes in the extent and duration of prevailing trends (e.g. “overbought” and “oversold” measures), and other indicators based on data generated by the trading process.
Undoubtedly the most difficult aspect of the half-cycle market advance since 2009 has been this: in prior market cycles across history, a combined syndrome of overvalued, overbought, overbullish conditions was typically accompanied or closely followed by deterioration in market internals. Quantitative easing did one thing to make the half-cycle since 2009 legitimately “different”: it repeatedly and deliberately encouraged continued yield-seeking speculation regardless of those overvalued, overbought, overbullish extremes. From the standpoint of longer-term financial stability, it has been the most reckless central bank policy in history, however glorious it has been for speculators in the shorter run. Yet if one carefully examines the data, stocks have lost value, even since 2009, in periods where market internals have been unfavorable.
Those of you who have followed these missives for a long time know much of our vocabulary by heart. It is the same vocabulary, and the same considerations, that enabled the rather striking success of our discipline prior to 2009. My decision to stress-test our methods of classifying market return/risk profiles against Depression-era data in 2009, after a financial crisis that we had fully anticipated, led to a glaring stumble during the recent bull market advance. Put simply, based on a century of prior evidence, the resulting methods encouraged us to take a hard-defensive outlook immediately as an overvalued, overbought, overbullish syndrome emerged. QE intentionally encouraged speculation, introducing a long delay between the emergence of overbought extremes and the subsequent breakdown in market internals. Since 2009 the market has lost ground, on average, only when market internals have actually become unfavorable. It is precisely that exception that establishes the rule:
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