Editor’s Note: Today, we have a special guest essay from our good friend Chris Mayer, editor of Chris Mayer’s Focus. Below, Chris shares how you can profit when other investors are uncertain.
Remember when people used to say that when quantitative easing (QE) ended, the stock market would tank? Surely you haven’t forgotten about QE? That’s when the Fed bought bonds to drive interest rates lower.
Well, if you plotted the Fed’s QE program against the S&P 500 (“the stock market”), you saw a nice, clean correlation. Ergo, it appeared that QE propped up the market. That chart got a lot of play.
But QE ended in 2014. And the market kept rolling. And here we are near all-time highs. So much for that!
Still, even today, you’ll find some people citing how the Fed’s actions “explain” 93% or whatever of the stock market’s movements since such and such a date. They’re like Flat Earthers with fancy charts and impressive-sounding lingo. But they’re just as hidebound and wrong.
This is the old “correlation is not causation” that your statistics teacher used to tell you about.
You may remember the old joke about the man on the street corner waving a red flag. Someone goes up to him and asks what he’s doing.
“I’m keeping the elephants away.”
“But there are no elephants here.”
“Then it’s working.”
Right.
And yet we still see nonsense like this example every day. But the nonsense is usually not so obvious. It is subtle. The correlations plotted seem plausible. But as Caltech professor David Leinweber warns us, “Just because something appears plausible, it doesn’t mean that it is.”
As I say, the world is a much more confusing and complex place. Drawing out reliable cause-and-effect relationships that hold firm in financial markets (and life in general) is hard. Maybe impossible.
Humility and Doubt
As ever, humility and doubt are good guides here.
Whenever you see an “If X then Y” statement, you should distrust it.
If interest rates rise (or fall), then stocks will fall (or rise)…
The problems here are many. First off, in markets, you can’t change one variable and leave everything else the same. Rates may rise (or fall), but what happens to sales growth? What about profit margins? What about countless other things that also continue to change?
Besides, which stocks? The earnings of brokers, banks, and insurance companies generally rise when rates float higher. We’ll see more about why generalizing is dangerous in a minute.
If the economy picks up speed, that’s good for stocks…
We got the “Trump bump” as the market rallied under this belief. But there are a lot of problems with this. The connection between economic growth and stock returns is murky. You can have a fast-growing economy and a lousy stock market (and vice versa).
There are a lot of other variables at work—such as valuations. And again, you must ask which stocks. (Plus, people throw around “the economy” as if it’s some big animal in the backyard that we can go out and measure. It’s not as if “the economy’s growth rate” is an objective number. It comes from making a lot of assumptions.)
So never be too sure of any prediction, no matter how seemingly logical or plausible it seems, based on such simple cause-and-effect analysis.
What we’re doing when we search for causes and effects is looking for patterns. We are pattern seekers. But that’s a risky business.
You See What You Want to See
It was a physicist, R.D. Carmichael (1879–1967), who said: “The universe, as known to us, is a joint phenomenon of the observer and the observed.”
In short, we play an active role in what we see. Our experiences, our beliefs, our particular vantage point, among other things… all impact what we think we see.
This is why you should value perspectives that differ from your own. There is a chance someone else “sees” something you don’t see.
When I like a stock, I also try to understand the bear’s case. If I think a stock is cheap, I want to know why it is cheap. It may be that I’ve missed something or don’t understand something as well as I thought.
But sometimes, you get a good, firm grasp on what the prevailing thought on a stock is. Sometimes it is clear why people hate it and why it is cheap. And yet, at the same time, you also know why that view is not correct… and will soon be proven wrong.
I am particularly attracted to these situations where there seems to be a hard negative consensus. Those are situations where people are probably not doing a lot of thinking. (As Robert Anton Wilson used to say, “Convictions create convicts.”) I get very excited when I find them…
For example, last year I recommended AIG for Bonner Private Portfolio, the trading service Bonner & Partners chairman Bill Bonner chose to follow with $5 million from his family trust.
We heard quite a howl from the gallery on that one. “AIG? That disgraced insurer? That blown-up relic from the financial crisis? This is madness!” The mailbag showed that more than a few readers were disappointed.
Only a few years earlier, Time magazine had a cover story showing a bomb with a lit fuse and the comment “Why AIG = WMD.” This was a company that had lost a lot of money.
Fast-forward to 2016, and AIG still had a terrible reputation. But all those old troubles were gone. The only thing was… most people still clung to the company’s embattled image.
What I saw, though, was an activist investor—the billionaire Carl Icahn—who had bought $2.5 billion worth of stock. He got himself on the board of directors, too, meaning he was in for the long haul. And he put pressure on management to improve.
But the stock price still reflected—more than reflected, even—all the poor results. Investors who bought the stock when I recommended it took little risk of loss because the stock was already about as low as it could possibly go.
Meanwhile, CEO Peter Hancock—hired in 2015—had crafted a credible plan for a turnaround. It included selling off noncore divisions and returning excess capital to shareholders.
As of this writing, it’s been almost one year since my recommendation, and the stock is up almost 20% for us. Not only that, but I made it the biggest position in our portfolio.
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Don’t Look for Certainty
For sustained success in the markets, it helps to remember that we are not passive viewers on the scene. We see actively. We make our world, in many respects; we see what we want to see. You must always consider the observer(s).
In short, don’t look for certainty. (A variant on a funny old saying: If you want certainty, buy a dictionary. If you want uncertainty, buy two.)
But that’s the key. You learn to embrace the uncertainty, to thrive on it, to make it part of your thinking. You construct a portfolio based on it.
As Bill himself has put it:
For my own money, I’m sitting tight… in cash, gold, and long-term stock holdings, about a third in each category. My investment horizon is likely to be longer than yours; I don’t mind if the current price of any of these things goes down 50% and stays there for years… as long as the real value doesn’t go away permanently.
That’s why I’m still bullish on AIG at current prices. If you want to take advantage of the market’s disconnect between correlation and causation, it’s a strong “buy.”
Regards,
Chris Mayer
Editor, Chris Mayer’s Focus
P.S. I spent six months and $138,545 analyzing every company between 1962 and 2014 that could have turned every $1,000 invested into $100,000… My colleagues have dubbed it the “Mayer Method: The breakthrough new formula that lets you identify tomorrow’s biggest stock market winners today.” It’s the same method I used to find companies like AIG.