Musings Report 2023-4 1-21-23 2023 Investment Outlook: How to Get Filthy Rich in the Confusion Ahead
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2023 Investment Outlook: How to Get Filthy Rich in the Confusion Ahead
I'm completing my series of Investment Outlooks today, on every investor's favorite (but generally left unsaid) topic: how to get filthy rich. Here's the series to date:
#1 (1/1/23): Housing
#2 (1/7/23): The Year Everything Happens at Once
#3 (1/14/23): What's the Real Wealth in our Lives? (Health)
OK, so health is the only real wealth, blah blah blah: nice, but tell me how to get filthy rich the easy way, making money with money and moxie.
Interesting, isn't it, how the word "filthy" goes so easily with "rich." It's almost as if we're conceding the process is inherently dirty or perhaps corrupting.
But money is a good thing, and more money is even better, so let's discuss how to get rich without earning it the hard way.
1. Of course it still takes work to get rich as a speculator/trader. So those who win and actually keep their winnings, beating long odds, typically invested a great deal of time and effort in order to do so.
2. My context is my own trading, which tends to be poor, interrupted by occasional astounding gains in one stock,
and my experience working for Stewart Pillette's boutique quant shop in San Francisco.
Our clients were mostly professional money managers (mutual fund managers, etc.), with a smattering of wealthy people who managed their own accounts.
Watching what the wealthy and professionals do is always instructional.
Quantitative analysis attempts to boil off emotions and memes and identify patterns which when back-tested pointed to the correct trend around 75% of the time. (One of my first tasks was building the back-test data. Pillette's quant system hit 80% over a five-year period, which is all the data I had to work with.)
Any such system is not intended to be the sole-source of a trade; it's intended to augment fundamental and technical analysis.
Pillette's system was long-term and intended for human traders. It wasn't for day-traders or high-frequency trading algorithms.
3. It's useful context to note that there are hundreds of thousands of smart people trying to get rich off the markets as professionals, and tens of millions of other smart people trying to do so on their own.
If it was easy, or there was one method or trick that was always spot-on, then we'd all be rich. But very few actually get rich trading.
Indeed, there is a rather severe time decay in the number of traders who beat a "dumb" passive index fund.
There are quite a few hot hands who manage to beat the index over the course of a year, but very few who manage it over five years. After a decade of active trading, the number of traders who beat the index funds is so small it's essentially signal noise.
This suggests that those with a hot hand--be it a proprietary algorithm or system, or perhaps just intuition--
tend to lose their touch. Many blow up their accounts, destroying their gains.
Hubris is an insidious opponent. The hotter our hand, the more tempting it is to assume we can extend the hot hand for a few more trades.
Those are the trades that blow up our account.
Any system tends to lose its edge over time. Maybe others stumble upon something similar, or the market changes its character.
The market rarely give us notice when our system no longer works. We find out it no longer works by blowing up our account.
4. No matter how careful we are and how appropriately modest we might be, we're still prone to confusing a trend with our own brilliance.
Everybody's a genius in a powerful uptrend that only pauses for breath before advancing ever higher. We only discover we confused the trend and our brilliant trading when the trend reverses and we fail to trade accordingly.
As a general rule, the really big fortunes aren't made in volatile eras of great confusion; they're made at the start of multi-decade Bull Markets that greatly enrich those who bought early and were never tempted to sell.
Most of us succumb to the temptation to take a profit long before the Bull trend actually ends.
(Technical term: coulda, woulda, shoulda.)
But identifying the end of a long-term trend is tricky. It's also possible to expect a continuation of a trend that has reversed, and lose all the gains by holding on too long.
5. The really big gains go to those who start out with a big wad of capital, or those who gamble with huge amounts of leverage.
A general rule, those who lack capital have to take on greater risks to make outsized gains. Of course leverage works both ways, and so leveraged bets that go against us go to zero.
6. Money managers who beat the indices over the long haul tend to concentrate their positions. Rather than hold 25 positions, they hold five.
This requires taking only the best bets, and setting aside the rest.
If 25% of our portfolio gets a 10-bagger (goes up tenfold), that's consequential. If 5% of our portfolio gets a 10-bagger, it's nice but not a life-changing gain.
7. Legendary trader Jesse Livermore offered many pointers, but one that I think may be under-appreciated is
the benefit of only trading when there's a great trade.
The average gambler/trader wants to make money now, and so they look for a trade, any trade, at all times. There may be OK trades out there, but not great trades.
It's less risky and more rewarding in the long run to do nothing if there are no really good trades. It's fun to churn one's account, but that usually accelerates losses, because OK trades rarely pay off like great trades.
I am impatient and typically regret jumping in too soon. It can take months or even a few years for a tradable top or bottom to become a high-probability opportunity.
8. The entire economic / financial system is geared for Bull markets and trends: up, up, up. That's what maintains the status quo.
This leads to a strong bias in favor of up-trends rather than down-trends. There are vast institutional and state forces that will fight with everything they have to restore an uptrend or reverse a downtrend.
This means as a general rule going short / betting on an extended / deep drop is riskier than betting on a uptrend.
Declines might last a few days, or weeks or in severe Bear markets, a few months, but it's rare to have downtrends last years. It does happen, but the forces trying to reverse the downtrend are powerful and the stakes are high: the sustainability of the entire status quo economy and financial system are at risk should markets not recover their uptrends.
9. But crashes do happen, often without any fundamental trigger. Benoit Mandelbrot explained the dynamics in his book
The (Mis)Behavior of Markets.
It's difficult to predict when fractals and non-linear dynamics will manifest as crashes, but they do happen with greater frequency than is generally understood.
10. It's generally a lower-risk bet to go long (buy assets) at the bottoms of sharp declines that betting on a decline at the top of a bubble.
Tops can last longer than is rational, and can even pause at absurd levels and then rise to even more absurd over-valuations.
For the reasons mentioned above, markets reliably reverse at the lows of capitulation / marketing-clearing crashes. These reversal may not endure, but they are tradable in a short-term time frame.
11. Though the financial industry pumps out millions of pages of analysis and millions of charts,
markets are ultimately manifestations of human emotions.
Speculative trading is exciting and winning inspires the compelling emotions of greed and hubris (I'm a genius, I can't lose). Losing is debilitating and the emotions of loss and regret cloud our decision-making just as much as greed and hubris.
12. It's easy to confuse what "should happen" with projections of what "will happen." Over-valuations "should" revert to the mean or trendline, but this doesn't mean that's what will happen.
If markets drop, they "should" bounce off strong support and return to their uptrend. But this isn't always what happens.
As frustrating as it may be, human emotions can extend rallies and declines far beyond what rationality might suggest is "fair value."
13. Bets made on insight tend to be higher probability bets than investments placed on meme-stocks or assets one doesn't know much about.
Here are two examples from my trading history. In the first case, I had built up some experience reading Phase I, II and III trial data from biotech / pharmaceutical companies.
This small biotech was trading at cash value, i.e. the share price reflected zero value for research and development. The company's Phase I trials were due out and so I acquired a significant (for me) number of shares for $.30 a share.
The Phase I data was positive and the stock eventually topped $6 (A 20-bagger). Unfortunately, I succumbed to greed and reckoned an analyst's valuation at $10 was surefire, and didn't sell.
Phase II trials disappointed and the stock cratered. As the song says, you have to know
when to hold 'em and when to fold 'em.
In the other example, being self-employed / owning enterprises gave me experience in reading financial statements.
A medical supply company had overborrowed and was veering close to bankruptcy. Its stock fell from $5 to $.15. I noticed it had huge cash flow and thus seemed a likely candidate for acquisition.
I assembled a position at around $.25 / share, suffering angst as it dipped to $.15 share. But I held on and within a year a bid from a competitor came in at $2.50 / share. I took the 10-bagger and sold.
Eventually a competing bid came in at $5 / share. But since there was no way to predict such a windfall, I had few regrets.
(You can see why my spouse calls me the "On the Edge Hedge Fund.")
The point here is my few big wins arose not from a hot tip or chasing a meme stock--though many have reaped huge gains buying on tips and chasing meme stocks--but from my own analysis of data that was available to everyone.
Biotechs trading for cash-value, companies with substantial revenues and cash flows--these are examples of finding potential value in what the market has written off as near-worthless.
Other classic examples include changes in the entire management team, new partnerships, etc. Such changes may be mere window-dressing, of course, so due diligence--serious research--is required.
Sectors left for dead are another example. The coal industry, for example, was written off a few years ago for seemingly bulletproof reasons. Yet coal was not phased out, and valuations soared.
Even a cursory analysis might have suggested that coal might not be phased out as quickly as many assumed because replacement energy was simply not available at the scale required..
In other words, insider knowledge isn't required. Simply looking at companies and sectors without the bias implicit in the price (i.e. a contrarian perspective) might yield tradable insights.
There are no sure things, only higher or lower probability trades, and higher or lower confidence trades.
14. If we are in a structurally transitional period where volatility and uncertainty render any trend unreliable, the "buy and hold" strategy that works so well in durable uptrends is no longer a low-risk strategy.
In volatile markets, the risks favor 1) staying out of markets entirely and awaiting capitulation or other evidence of a tradable trend or 2) accept that the majority of trades will be short-term and that multi-year uptrends may not occur.
The 1970s illustrate such a market: huge swings up and down offered numerous tradable short-term trends but by the end of the decade, "buy and hold" ended up gaining essentially nothing in nominal terms and when adjusted for inflation, ended up handing buy-and-hold investors enormous losses.
While the stock market went from 1,000 in 1966 to 1,000 in 1982 16 years later, inflation destroyed 2/3 the purchasing power of the dollar. According to the BLS, $1 in 1966 was worth 34 cents in 1982, meaning those who held stocks for those 16 years did not retain their wealth as the Dow Jones remained at 1,000--they lost 2/3 of their wealth.
Dividends eased the losses, of course, but few equities yielded large enough dividends to compensate for a 2/3 drop in the purchasing power of the capital.
For all the reasons I've discussed in previous Musings and blog posts, I believe we're in
a profoundly structural transition.
The reasoning boils down to this: no trend lasts forever, the current Bull trend is 40 years old, and the drivers (causes) of the trend--financialization and globalization--have reached diminishing returns.
15. If technology is indeed accelerating the pace of change, as Alvin Toffler outlined in his 1970 book
Future Shock, "
The classic work that predicted the anxieties of a world upended by rapidly emerging technologies,"
then we can anticipate a compressed series of wild swings up and down that plays out not over 16 years but perhaps only a few years.
I discussed Douglas Rushkoff's book
Present Shock: When Everything Happens Now in
Present Shock and the Loss of History and Context (May 22, 2013).
If Rushkoff's analysis proves prescient, we can also anticipate a much higher level of incoherence and confusion once the primary trends of the past 40 years give way.
Is it possible to profitably trade incoherence and confusion? If we accurately identify the primary dynamics affecting human emotions and trend-following algorithms, it seems possible, though by no means easy.
Such an environment would place a premium on the traits listed in Investment Outlook #2:
1. Understand every investment is a speculation and calculate the risks accordingly.
2. Manage our calculated risks tightly. Take nothing for granted. If the opportunity to gain is highly uncertain, avoid speculating. As Sun Tzu advised: "
If a battle cannot be won, do not fight it."
3. Understand gains may be both impressive and fleeting.
4. Limiting our losses (to inflation, deflation, churning our account, etc.) may take precedence over racking up gains.
5. Flexibility and nimbleness become the most valuable traits in periods of flux. Lao Tzu: "
Rigidity leads to death, flexibility results in survival."
16. Such periods tend to discourage "buy and hold" investors and gamblers alike. Note how the percentage of household assets in stocks fell from a high of 34% at the 1973 peak in the market to 13% in the extended trough in which people gave up trying to make money in the stock market and put their capital elsewhere.
17. The most dangerous markets are those in which liquidity dries up. Liquidity means many different things (access to credit, etc.), but for traders, it means
"there are buyers in size who will take these assets off my hands without crashing the bid."
When buyers hesitate or disappear, the market is bidless, meaning there's no one willing to take your shares, bonds, cryptos, etc. off your hands at the current price.
The resulting cascade down to prices where buyers start nibbling spooks potential buyers, and once the number of shares being dumped (sold) swamps buyers hitting the ask, price can drop to near-zero before brave buyers emerge in size, i.e. buyers willing to buy enough to absorb massive selling.
Illiquid securities--thinly traded stocks, ETFs, etc.--are inherently risky, as any selling above a few hundred shares can move the bid lower very quickly.
This is especially problematic if other owners have set stop-loss sell orders not far below the bid: the first wave of selling then triggers a larger wave of stop-loss selling, which then unleashes stops set at lower prices, and so on, with the bid quickly falling to near-zero.
18. As I have stated elsewhere,
a truly tradable bottom is only reached when participants have capitulated and the speculative frenzy generated by serial bubbles, crashes and central bank "saves" is extinguished by repeated losses.
Absent such a market-clearing event and the exhaustion of the urge to speculate, every investment is a gamble and must be played accordingly.
Those few who master their emotions and gain insight into volatility, incoherence, confusion and the desperation of the status quo to restore a Bull market by whatever means are necessary (while ignoring the potentially disastrous second-order effects of their policies), and who also develop a knack for buying in price troughs and selling in the last gasp peak--they might become filthy rich.
But if they lose their touch, and don't realize they've lost their touch, then they might proceed down the well-worn path to blowing up their account.
19. If we are indeed in a structural transition, the odds of there being "a sure thing" are low. A low-confidence bet may well be a prudent bet because the trader's finger is always poised above the "sell" button to preserve capital.
There will always be another trade, but capital lost may not be replaceable.
20. Nobody knows the future. Everyone is guessing. This is why it's hard to get filthy rich via trading. Knowing that informs our understanding of risk and probabilities. Sometimes doing nothing is both difficult and wise.
Highlights of the Blog
Contrarian Thoughts on the Petro-Yuan and Gold-Backed Currencies 1/19/23
-- so many hate this so passionately....
Want to Know Where the Economy Is Going? Watch The Top 10% 1/17/23
Best Thing That Happened To Me This Week
Made my second batch of poi from taro grown in our yard. First, pressure-cook the cleaned/sliced taro, then blenderize into poi by adding sufficient water to the diced cooked taro.
This is dry-land taro, not the kind grown in flooded paddies that commercial poi producers use. Our dry-land poi is a beautiful caramel color that tastes of caramel, too.
From Left Field
NOTE TO NEW READERS: This list is not comprised of articles I agree with or that I judge to be correct or of the highest quality. It is representative of the content I find interesting as reflections of the current zeitgeist. The list is intended to be perused with an open, critical, occasionally amused mind.
What price paradise? How a Mallorcan artists' haven became 'a ghost town'
With Great Demographics Comes Great Power (2019, but worth re-reading)
There's no planet B (i.e. no other habitable planet we can escape to)
Why the Middle Class Flees States That Tax the Rich
The top 1% captured nearly twice as much new wealth as the rest of the world over last two years
Majority of flights taken by a small percentage of flyers
Séamas O’Reilly: I open the book with trepidation. My name is on it, but I didn't write it -- sleazy theft masquerading as "summary"....
The Great Podcasting Market Correction
What’s Going On in This Graph? | Clean Energy Metals
"Hard choices, easy life. Easy choices, hard life." — Jerzy Gregorek
Thanks for reading--
charles
