earthStrapped (33.27)

What to do when dispair sets in...

July 23, 2008 – Comments (0) | RELATED TICKERS: SKF , SH , SFK

Hey everyone's fearful, maybe now's the time to buy.

Like any pearl of wisdom, it can be more harm than good if it is applied inappropriately.  I think and talk a lot about the complexities of being a good investor.  There are so many data points to weigh and consider, so many philosophies to discover, understand, and incorporate, so many conflicting opinions about what to make of this or that event, past, present or future.  It can certainly be overwhelming, particularly when the market does what it has done in the last 6-9 months.  It's certainly much easier to be confortable with your market savvy when everything's humming along nicely.  In this entry I look at one aspect of who I am as an investor, having to do with discipline versus aggressiveness.

Let me ask what may or may not be the most important question, but is certainly the most sensational.  Are we headed into a deep recession or even a depression?  Most well read writers don't think so, while a vocal few have been clamoring for a major correction for the past several years and are convinced that by putting it off too long, we've made a catastrophe inevitable.  In case you've been living in a financial news cave, the main line of reasoning is something like the tech bubble (brought on by low interest rates and a large pool of neophyte investors) was met by the Fed with even lower interest rates in an attempt to boost the economy, but which had the regrettable consequence of inflating house prices, which led to a period of rampant consumer confidence despite two shallow recessions, only to be finally tamed by a slowdown in housing and fears of a financial crisis, despite which and because of, rampant growth in BRIC countries, witnessed an upsurge (bubble?) in commodities which is leading to a perfect storm wherein the supply side, growth side, and consumption side of the economies are all being squeezed.  The Fed has little room to operate and can't really save us, so what they should do now is what they should have done a few years ago and get out of the way of the impending storm rather than artificially propping up those high-risk investments that some people had profited handsomely from until the whole house of cards came tumbling down.

The question lingers and really is far to big and ugly to simply ignore.  Even if I'm 99% convinced that we are facing an epic downturn in the market, it still is a question.  I'm no genius.  I haven't study the economy really.  Why should I listen to the naysayers who are relatively few?  Is it because their contrarian message resonates with me because I'm somewhat of an egotist that thinks running away from the herd is automatically a little better than following?  Sure, there are a lot of people out there running scared, but isn't that all the more reason to try and remain dispassionate and take advantage, as SpecBear puts it, "of the lies they tell themselves?"

No matter how you try to dissect this thing, whatever you think it is, exactly, you will find a chorus that agrees with you, and an even louder chorus that completely disagrees with you.  That's what makes this so tough for all of us, whether we want the safety of the herd, or the advantage of beating the herd.  We want to beat the market, to be honest, many of us want to cream it.  We really want to see our money growing, even when the market takes a spill like it has so far in 08.  To do so, we have to make predictions about the market, which means we have to pick a side.  The better we want to try and do over the long-term, the more we're going to have to bet on our superior judgment, intuition, and even luck.  There's a little nugget of wisdom in there, I feel.  It's harder to be consistently 10% above the market then it is a consistent 5% above the market.  If you don't really know enough to earn the 10% above, you might still get lucky, but more often than not you'd do better sticking with what you know and accepting the 5%.

In other words, know your limitations, and live within them.  That's not new.  But it's tough.  Can I even pretend to know my limitations?  Do I know a great company from a good company?  Do I know a great price from an okay price?  What about a temporary recovery from a bottom?  I know that most of what I think and say and write comes from something I've read and not original research.  So how smart are the people I'm reading?  How good of a judge of character am I?  How well do I understand them?

Some of you, if you’re honest and fair, look at your portfolios and you think, how the hell am I doing this well with what I know, while all these other poor sobs who sound like they know so much more than me apparently can't get it right?  Am I just lucky?  The unequivocal truth is... Yes, you are, probably.  There is far too much noise in this system to really know for sure.  The difference between good fortune and good sense, particularly in the short-term (3-5 years) is almost perfectly obscured.  Even in the medium term (5-15 years) I'm convinced that most high performers are just lucky.  That's not to say that they don't have good sense or even the right answer for the day.  But if you can't move to the next right answer before the current ones stop working completely, the market will turn you into an average Joe quicker than you know.

I think this is why so very few people become great investors.  It isn't really that there aren't a lot of smart people out there capable of making incredible reads on the goings on in the world.  It's that eventually the rules change, and these once prescient beings are now handicapped by their own belief that they know something of value.

Professional poker is a lot more like investing than it is like gambling.  Professional players are often known by their particular style of play.  There are the very flashy, very entertaining, aggressive or even ultra-aggressive players that rise to stardom, and the boring consistent players that time and again make it to the final tables (a few of which are also stars in their own right). The boring players sound a lot like value investors if you get to know them.  They only bet when they should, which is precisely when the potential reward outweighs their evaluation of the risk, so that over the long run, they will win more than they lose.  Even though the aggressive players can amaze us with their ability to seemingly read the minds of their opponents, something the best do far too often to be merely lucky, these players are the most likely to get it wrong, get shaken, and start making a lot of mistakes.  Therefore, only the very best of these players actually succeed consistently.  They have to be aggressive and dispassionate, a rare combination.

If you invest aggressively, you are capable of making big mistakes as a result.  You’re also quite susceptible to making even bigger mistakes in an attempt to recover from your last mistake, or even interpreting your last decision as a mistake, when in fact, it was a far more rational decision than many that would have proven to be more profitable.  It’s a slippery slope frequented by avalanches.

If you stick with value investing, certainly you can still make mistakes, but you can be almost certain that discipline alone will be enough to get you ahead of the masses in the long run.  You must recognize, however, that you won’t keep up with everyone, and in fact, if you look at a small enough time slice, there’s a pretty good chance you’re going to be behind most other investors, whether they’re aggressive, disciplined, or just dumb-lucky.  The risk here is getting discouraged and deciding to change styles, when a more aggressive style just doesn’t suit you.

Now, back to the question of whether or not we are facing a serious recession, or even a depression.  The value investor should consider the current environment, but not focus on it.  Rather, they should stick to their plan.  Continue trying to find the best quality companies from which they create a diversified portfolio, calculate their fair value, and buy those most undervalued, all the way down if the market provides that opportunity.  A more aggressive investor, like me, will continue to make value investments, but will also play the read that they have on the market.  How, much to play aggressively is an important question.  The answer depends on your confidence in the current opportunity, as well as how that compares to your forecast for future opportunities.

Based on what I’ve read and come to think, again primarily on the backs of the others who I trust know far more than me and are hopefully smarter than me, I think the answer is yes, we're headed for serious trouble.  How sure am I?  I’m at least 80% confident that I’m in the right camp.  I could be wrong, but if Vegas offered decent odds that there wasn’t at least another 20% downside in the market, I’d place a bet.  Furthermore, since the outcome we face is potentially dramatic, there will be comparatively more overreactions and underreactions to this situation than to a situation where, say, the market will likely grow 5% in the next year.  The severity of the prediction thereby creates additional opportunities due to the large swings from confidence to dispair.  On top of that, the market offers us pretty decent odds with short and ultra-short ETF’s, and we can reverse our bets if we learn more down the road.

My final conclusion is that a 15% move of my overall portfolio to ultra-short on financials (SKF), short on the S&P (SH), and ultra short Russell1000 Growth (SFK) feels like the right balance given my style, confidence, and experience.  Given the recent rebound in the market, tomorrow seems like a pretty good day to start squeezing the trigger on this plan.