Palisade Research - Sun, Oct 15, 2018

Part 1: Blowing up, The Minsky Moment, and A Turkey on Thanksgiving

image of businessmen climbing the steep slope of a bull market with one man plummeting off the cliff at the top

Last Wednesday and Thursday we saw markets get whacked.

Hard.

It seemingly happened for no reason - it was just another plain ol' Wednesday when it kicked off. Who could have seen it coming?

I know we cover lots of news and give market commentary that the mainstream doesn't pick up on or care about (yet). But I think its time I start doing more write-ups about strategies, mental models, and fundamentals for readers.

The following is the first of a five-part series covering speculation, fundamentals, and strategies.

An old saying popped up in my head after seeing this week's bloodbath. . .

"If you can't swim - then don't cross a river that's on average only four feet deep."

What this means is - the river could be one or two feet deep for most of it. But when you get to the middle - and it's suddenly 16 feet deep and you can't swim - you're screwed.

So the main takeaway from this is: putting too much faith in averages can be fatal.

But unfortunately - that's exactly what the mainstream does all the time.

I believe many economic models and financial 'experts' put way too much faith in the law of averages - or Normal distributions (the bell curve) . . .

They believe the market will move slowly - and usually up - 99% of the time. Why? Because historically that's what has happened.

While I do agree with this - that doesn't mean you should discount that 1% of the time when things will go crazy. Financial markets over the last 100 years weren't some smooth trend upwards.

That '1% of the time' (what many call a Black Swan - more on this later) still wiped out trillions in wealth. Bankrupted many. Ruined governments. And demolished portfolios.

bar cart of changes in value over time, eventually ending in a crash

But thanks to the wisdom of successful investors and philosophers like Nassim Taleb, Mark Spitznagel, and Benoit Mandelbrot - we can avoid being wiped out.

And instead - actually use that 1% of the time to our benefit.

This is how I look at it - markets are usually efficient. About 90-95% of the time. But there's a couple things to understand here.

First - the big money is made finding that 10% of the time the market is not efficient and completely mis-pricing assets. It's rare - but the market does sometimes value things completely wrong. It's important to find those times and exploit them (more on this later).

And second - the market really doesn't have a good long-term memory. If things lately are going well - the crowd starts believing it will be that way forever (and vice versa).

As I've written before: thanks to Hyman Minsky's 'Financial Instability Hypothesis' (FIH) - a cornerstone to our investing philosophy - periods of peace and calm are the seeds for future turbulence and chaos.

When investors get comfortable during the peaceful times - they take on more risk. But this added risk taking by the crowd piles up, and eventually things sour - it could be from an external problem like 9/11 or the Federal Reserve hiking rates.

Or maybe it's internal, and the market's attitude towards the future and risk changes.

As I've called it before - this is the 'tipping point'.

The crowd rushes to liquidate and salvage what they can - sending markets spiraling.

Now - suddenly - investors are filled with fear and are 'risk averse' (i.e. won't invest in anything).

The rubber-band whiplash of markets changing from risk tolerant to risk averse is called a 'Minsky Moment'. . .

So, just remember this about FIH - a long period of consistent low volatility is the breeding ground for future high volatility; and vice versa.

I've written about Minsky often throughout the year - I think his ideas are very important for investors (you can read a more in-depth explanation of the FIH I wrote here).

Another great example of when the crowd gets betrayed by that '1% of the time' event is what Nassim Taleb (one of my favorite thinkers and traders) calls The Turkey Problem.

Just imagine a nice plump turkey on a farm.

The turkey's taken care of and is given food daily. It lives in a nice open-range pen and freely trots around.

As time goes on, the turkey becomes use to how things are - its daily routine - and It feels safe and secure eating its meals every day at noon.

If you were to graph this, you would see an upwards sloping line. Investors and economic 'experts' can use fancy math and collect past data to make forecasts over the next five years - feeling confident things will continue.

That is - until it's Thanksgiving Day and the farmer takes the turkey out back and cuts its head off. . .

line chart of a turkey's well-being growing over time until slaughter just before Thanksgiving Day

The irony was that - with each passing day - the turkey felt his risks decreasing as it became use to the daily routine.

But - in reality - its risks are actually increasing as each day passes.

So - looking at the graph - we can see that the turkey was at peak well-being and confidence just as the risks were at their highest.

The takeaway from all this is: don't be the turkey. . .

So to summarize everything here:

1. Be cautious of Normal Distributions and models that the economists show and use in their forecasts. While data is handy for decision making - don't put all your faith in it.

2. Markets are relatively near-sighted and only remember the immediate past - if things have been good lately, investors will expect that trend to continue. And if things are bad lately, they'll expect the future to be lousy.

Don't be fooled by this. Like Minsky taught us, the calmer things are - the bigger spike of turbulence there will be. . .

3. Markets are rational most of the time - like 90% - but there's that 10% of the time markets get irrational and mis-price assets significantly (like during bubbles or brutal bear markets for example).

Finding that 10% period and betting against it can be very lucrative. . .

4. Just because markets are going up and they have been for a while doesn't mean they will continue indefinitely.

Just like the Turkey that got used to his daily life - the risks were piling up all around him. . .

The next step in this series will be how to exploit the irrational 10% of times when market's are irrational. Be aware that finding this 10% of the time isn't exactly easy.

You need to be an independent thinker, knowledgeable, realistic, and have a contrarian intuition. Don't forget a lot of luck.

That's why we need to hedge ourselves by positive optionality and finding asymmetric opportunities (low risk - high reward).

I'll go into asymmetry and optionality later on in the series - but long timer readers know what I'm talking about.

But for those of you that want to get an idea of what I'm talking about here with asymmetry and exploiting the irrational 10% - read this article we published months ago.

History Shows us Why Gold Equities Belong In Every Portfolio And Why We're All In. . .

This article's still extremely relevant today - especially after gold and gold mining stocks broke out while everything imploded this week.

Stay tuned for the remaining Strategy & Fundamentals Series. I know you'll enjoy them and find them very useful.


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