This week we will no doubt see photos in the press of President Trump announcing the annual pardoning of a lucky turkey. Unfortunately for most turkeys, but fortunate for most of the rest of us, this Thursday, the fate of the average turkey is not to be pardoned.
I spent a good part of last week in a very small workshop with Nassim Taleb, author of many of my favorite books on risk (“Fooled by Randomness,” “The Black Swan,” and “Antifragile”). It was an awesome workshop that helped me refocus on the reasons for risk management.
In the latter two books, Nassim describes “The Turkey Problem”:
For a thousand days, the butcher feeds the turkey. With each passing day, as he steadily grows in size, the turkey becomes more convinced of the butcher’s benevolence and the probability of an ever-brighter future. Then the day before Thanksgiving arrives, and the turkey gets a surprise.
The poor turkey falls prey to an issue that we all have to deal with in our daily lives. Humans have necessarily evolved into creatures that survive by taking a few events and generalizing them into a prediction of the future that they think they can reliably act upon.
We touch a stove and are burned, so we don’t touch a hot stove again. A forecaster examines a stream of earnings reports that looks like the turkey’s first 1,000 days and predicts that the next quarter will be even better.
While such “inductive” reasoning serves us in many tasks, it does a very bad job of preparing us for surprises to come. Like the turkey on the day before Thanksgiving, the surprise comes abruptly, and the result can be shocking. One can learn overnight that the hand that feeds you can literally be the one that also wrings your neck.
Our goal should be to avoid being the turkey.
How can we do that in investing? We all rely on the past to help us cope with the future. But most of us rely too much on the recent past. We need to use more data.
Stock market strategies should not be based on the last five years, for example. It’s been a bull market for most of that period. Any strategy that’s worth its salt must be tested through at least a full cycle of rising and falling markets. Better yet, strategies should be tested through the two bull and bear cycles stretching back to the 1990s at the very least, as in our Illustration Generator. The turkey did not know what was coming, but the butcher with a larger perspective did.
Even when we have a lot of data, it is never enough. The turkey had a lifetime of data!
In the fall of 1987, when my company, Flexible Plan Investments, moved all of our clients to the safety of money-market funds, there had never been a day in the 100 years of stock market history when the stock market had fallen 25% in a single day. Yet, there were events that had signaled a negative stock market environment in the past that had not been as extreme. You act on such signals even though you can’t predict that they will lead to a day as bad as down 25%.
When we test a strategy, we can examine on a more micro level how various asset classes respond. A burn from a slight touch of a stove allows us to decide that putting one’s hand in a bond fire is not a good idea. And a strategy that does worse than its benchmark on a small down day can tip you off that it is going to have even more trouble with a major decline.
Of course, even this is not enough. Sometimes you are just surprised. “Every strategy works until it doesn’t,” is our oft-spoken mantra. The turkey’s strategy of daily eating at the feed trough always worked … until it didn’t. The only solution to this dilemma is to diversify.
While high fences and the clipped wings of the turkey prevented it from diversifying its risk, investors are not so limited. Instead, they have the freedom and ability to not put all of their eggs in one basket.
Traditionally, this has been accomplished by creating portfolios made up of multiple asset classes. The hope is that when most go down, some will go up.
But in the last two major market declines, almost all asset classes plummeted. Bonds and gold have been the exceptions. Yet, looking into our future, with bond yields historically low—and worse yet, rising—it’s possible that they will not deliver as much protection as in the past. And while gold seems to shine in a crisis, few investors or advisors seem able to muster the 25% investment that would have given maximum protection in past declines.
Diversifying into a number of uncorrelated, actively risk-managed strategies is a sounder, more robust way of dealing with surprise. These strategies are usually not related to a single asset class, as they can dynamically switch or rotate into defensive positions when the environment warrants it.
A portfolio of these strategies can provide a more robust solution to “The Turkey Problem.” The key is uncorrelated strategies. If they all are moving in the same direction, they are not likely to be uncorrelated. If you don’t choose recent losers with the winners, you will probably have a portfolio of all losers when the next bear market begins.
Remember, you are creating your portfolio for what lies ahead. When you do that, the risk you are preparing for is not in the past. Like with the turkey, the real risk is in your future.
Have you been complaining about the weak stock market of late? Two down weeks in a row—six of the last nine days have ended lower!
If so, you’re not looking at the big picture. Yes, all of that is true, but did you realize that the S&P 500 just set a record for the longest time period without a 3% decline in its almost 100-year-old history? Or that the NASDAQ 100 has now set a record for the longest period without either a 5% or a 20% setback?
These are indeed record times we live in with respect to stock market performance! And now Goldman Sachs tells us that next year aims to be a great year as well.
Economic indicators all seem to be pointing to higher price levels in the future even without the Congressional tax reduction that has now passed the House and is awaiting Senate review.
Housing starts hit a new expansion high last week. Industrial production set its best levels since 2014. And the NFIB Small Business Optimism Index remained close to its high water mark, although it has weakened a bit.
I was also at the Schwab Impact Conference last week and saw one of my favorite data miners, Jeffrey Gundlach of DoubleLine Capital. He reviewed a broad array of early warning signals that were unanimous in showing no signs of a recession out six months on the horizon.
We had further confirmation earlier this week when The Conference Board released its Indexes of Leading and Coincident Indicators. Not only was the Leading Indicator Index at a new high, but the ratio of that index to the Coincident Indicator Index was rising, indicating that the recovery was still accelerating.
While declines have occurred in this ratio without a recession (in the mid-1960s and 1990s), in the past, a decline in this ratio has always preceded a recession. The declines usually give us a warning of about a year and a half. Note that weakness in the ratio also forecast the sideways to down markets in 2011 and 2015, but right now the ratio is soaring.
Earnings season has just drawn to a close. The optimism generated by its first few weeks was maintained, even in last week’s retail stock numbers. Among S&P 500 companies reporting, earnings gains averaged an eye-popping 10%. Earnings beat expected levels in over 60% of the cases, and revenues topped forecasts 57% of the time. Even guidance by companies that had until this year languished in negativity, was positive this time around for more than 50% of the companies reporting.
Of course, there are always exceptions to the rosy environment. The smoothly ascending S&P 500 weekly price chart since the first quarter of 2016 looks remarkably like the turkey chart that we started with in this article:
Similarly, a graph of the “fear index” (VIX) shows that fear has been decreasing, which suggests inversely a rise in complacency, just like the turkey felt.
I’m not suggesting that a “day before Thanksgiving” event is nearing for the stock market, only that we can all experience times like the present, when risk is practically invisible and all of our recent experience is so good that the chance of peril is no longer in the forefront of our minds.
Fortunately, indicators remain bullish. Investor sentiment, with less than a 3% decline providing the inspiration, is negative and declining—a contrarian buy signal.
Those of you who missed out on the run-up in international investments earlier this year may be heartened that a buying opportunity seems to be at hand. It’s a dip in those markets, but, in my opinion (and Gundlach’s also), it’s a dip to be bought.
Seasonality is very bullish. The last two weeks of November have usually been one of the more bullish periods of the year (except for the Monday after Thanksgiving, which has been pretty negative of late).
Still, the lesson of the turkey should be that even when all is going well, risk is always with us; remember that our feeling of safety can reach its maximum just when risk is at its highest.
We need to use our superior intelligence and all of the tools at hand—maintaining an active vigilance with our investment portfolios, and using time-tested and dynamic risk-managed strategies in a diversified portfolio—to protect our investments not from the risks of the past but from those that are always in our future.
May your Thanksgiving deviate to the max from that of the turkey’s and be full of family, good food, and holiday joy.
Disclosure: No communication by Dynamic Performance Publishing or our employees to you should be deemed as personalized investment advice. Any investment recommended in this newsletter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. Dynamic Performance Publishing, its affiliates, and clients may hold positions in the recommended securities. Results are not indicative of holdings for clients of Flexible Plan Investments. Forwarding, copying, or otherwise duplicating this information for the use by anyone other than the intended recipient is expressly forbidden. These results are not representative of those achieved by clients of Flexible Plan Investments, Ltd. (FPI) due to differences in security selection, timing of trades, transaction fees, and FPI’s management fees.