When You Have No Idea What Happens Next
After a nail biting month of March, April was full of surprises...and of course a "never before in history" event, when we saw Oil prices go Negative. And that is actually the point I want to emphasize this month.
How many times in the past 6 weeks have we heard the words "first time in history that this has happened"? Quite a few.
So when I read the below article by Morgan Housel, I felt compelled to share it with you as he once again so elegantly describe the importance of having an investment strategy that does not try to forecast or predict in your portfolio. Please read this short post:
"When You Have No Idea What Happens Next"
Do we know more about what’s going to happen in the next 12 months today than we did in January?
You’d think so. We now know there’s a pandemic that shut the economy down. We didn’t know that in January.
But remember what Daniel Kahneman says. “The correct lesson to learn from surprises is that the world is surprising.”
The things we thought about the world in January now look oblivious. But what does that tell us about our view of the world today?
Couldn’t the world change in as surprising a way between April and June as it did from January to March?
Of course it could. That should be the main takeaway of 2020.
We’ve learned this year that assumptions you have about the future can be destroyed overnight. That’s true for the poorest to the most successful, the old dry cleaner to the tech startup. It was true in January, and it’ll be true again in the future. Things change.
If that’s the lesson, the question is: what do you do about it? How do you think about a world where fundamental assumptions about the future are so fragile?
“Humbly and with fingers crossed” is the answer. But two other ideas:
1. Read more history and fewer forecasts.
Studying history can feel like intellectual candy that offers no practical use to investors who are paid to foresee the future. But once you accept how fragile our assumptions of the future are, you realize that forecasts are the real fluff and history is where the meat is.
Think of all the 2020 market forecasts published in December. Oof. Authors of these reports – most of which have been quietly removed – might say, “I couldn’t have foreseen Covid-19 in December, and it upended my entire forecast.” To which my response would be, “Yes, that’s my point.” If you claim an ability to foresee events, you can’t use events you didn’t foresee as an excuse – especially when unforeseeable events move the needle most. When a company reports poor earnings it’s often said they missed analysts’ estimates. But earnings don’t miss estimates; estimates miss earnings.
Accepting that forecasts have little use doesn’t mean you become a blind fatalist. When you pay more attention to history than forecasts you pick up on the patterns that guide how people respond to unforeseen events, which – given how stable behavior is over time – is the next best thing to knowing what will happen next.
I don’t know when this recession will end, and I’m not interested in your forecast. But I am interested in the historical observation that progress happens too slowly for people to notice but setbacks happen too quickly to ignore, which causes most people to recognize when a recession ended only with considerable hindsight, which requires maintaining investing optimism even when the economy around you feels broken.
I don’t know exactly what companies will survive or perish from this mess, and neither do you. But I know that, historically, it’s normal for the majority of the investments you make to perform poorly while a small handful do extraordinarily well and drive the majority of returns – a truth that’s mathematically obvious but psychological torture to deal with in real time. Knowing that fact alone can be more valuable than listening to someone who professes to know what companies will die or thrive. And you learn it by paying attention to the enduring themes of history rather than the alluring promises of forecasters.
2. Have more expectations and fewer forecasts.
If I say, “The next recession will begin in 2024,” I’ve made a forecast.
If I say, “Recessions occur roughly every 5-10 years,” I’ve expressed an expectation.
They seem similar, but they’re very different.
Forecasts rely on knowing when something will occur. Expectations are an acknowledgment of what’s likely to occur without professing insight into when it will happen.
Expectations are healthier than forecasts because they provide a vision of the future stripped of all false precision. If you know a recession will occur at some point, you won’t be that surprised whenever it arrives – which is a huge benefit. But if you assume you know exactly when it will occur you’ll be tempted into all kinds of dangerous behavior, leveraged with overconfidence. And you’ll be shocked when time passes and what you thought would occur hasn’t happened (yet).
Here’s a useful expectation: assume the world will break once or twice per decade. I don’t know where, or when, or how, who it will affect. But when you expect the world to break every once in a while you prepare for events you can’t foresee and you don’t have to rewrite your playbook when they happen. You’ll prefer big cushions and room for error. When people ask, “What are you preparing for?” you’ll say, “A world that history shows is both a growth machine and a continuous chain of unforeseen agony.” A world where we have no idea what will happen next. Nothing more specific.
What a beautiful way to remind all of us, that we need a boldly sized allocation to strategies like Trend Following.
"No Earnings...No Problem"
If you just looked at the strong rebound it equities since March 23rd and the reversal of the strong down trend, you probably wouldn't think that some of these companies will be reporting Q1 and later Q2 results that will show vastly lower earnings than only 3 month ago. Clearly the bulls have found every excuse to buy stocks in the past month or so, helped by the ever growing Reserve Bank credit (i.e., the Fed’s sum total of interest-bearing assets) which jumped to $6.598 trillion.
But as far as I know...this is not unusual...because even during bear markets, you often see more up-days than down-days. That is what makes it so hard to trade in a bear market...that is, if you are not rules-based.
But stocks was not the only sector that had a strong rebound from its lows. Energy also saw some incredible (in percentage terms) up moves in the past couple of weeks, after the May Crude Oil contract went negative. Oh yes, we had another of those "first time ever in history" events in April. Perhaps the rebound is linked to the amount of money flowing into the 2 largest OIL exchange traded products and EFTs, which is a way for retail investors to buy "cheap" oil.
Now let's dive in to see how the trends developed.
Market moves this month:
Trend Barometer statistic this month
The Trend Barometer finished the month at a slightly below average level of 39, which follows two really strong readings in February and March.
The next chart below shows a snapshot of a 44-market portfolio with markets listed in “groups” of market sectors:
The number of markets recorded in a trending state at the end of the month halved to 14...down from 27 in the previous month, and if we include those ending right at the neutral reading (indicated by the "grey" shade right at the 30% level) we get up to 17, which leaves the Trend Barometer in a NEUTRAL state. Please note that for the individual markets a reading of 30 is considered neutral as opposed to the Trend Barometer itself, where this level is 45.
In the RED camp (down trends) this months, we find most of the trend markets and all of them being from the Commodity part of the portfolio...perhaps indicating the risk of Deflation. Carrying the GREEN flag (up trends) at the end of the month, we only find some Fixed Income markets, and mostly the Short-Term Interest Rates.
In the chart below, I have grouped the markets into 10 sectors. Since last month, the number of sectors exhibiting an overall trending state, decreased from 4 to 3 out of 10 sectors. But we did have the Grain Sector bordering a trending state, so perhaps we call it unchanged this month.
I think what we are witnessing in markets like crude oil has more profound implications for other financial markets than most investors realize. From their year-to-date highs, crude oil and US stocks paint remarkably different pictures of how bad things are in a COVID-19 world characterized by social distancing and isolation, lockdowns, fear, distrust, economic dislocation, and tremendous uncertainty about the future. Crude oil's decline in the May contract ended up being more than 100%. The story crude is telling is that demand and overall economic activity has collapsed, and that financial disaster seems both likely and imminent.
By comparison, the US stock market, even with the last two days of declines, seems positively sanguine. The Dow is down less than 15% from its February highs and is actually UP more than 25% from its March lows. Indeed, the total decline from all-time highs at this point in the Dow is roughly equivalent to the maximum losses that occurred in the fourth quarter of 2018, during which the US economy never even hiccupped in terms of growth. The stock market, to date at least, is telling investors that it expects business as usual to prevail in both the global economy and financial markets by the end of the year at the very latest.
It is most improbable that the worst is behind us. The "jab" was financial markets realizing (belatedly) that COVID-19 was a global pandemic. But the "hook" will be when we see the worst global economic figures ever reported over such a short duration, and the subsequent realization that the severe magnitude of economic and financial market contractions will be self-reinforcing, causing an almost inevitable cascading downward of total economic activity.
If you want to check the current state of trend following, join me each weekend on The Systematic Investor Series, where we give you a raw and honest account of what it's like to be a rules based investor and share with you which trends are happening right now.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
I hope you found the information useful as part of your own evaluation of the trend following part of your investment portfolio. I will continue to do my best to keep you up-to-date with regards to the environment for diversified trend following strategies and would love to discuss any of this information with you. Just reach out to me.