Palisade Research - Tue, Nov 13, 2018

Part 3: Keynes Beauty-Contest, Roundabout Investing, & Second-Level Thinking

image of birds on three wires with one bird alone to the right side

For the Part-Three of our Palisade Strategy & Fundamental Series - I'm going to explain an important principle and framework for speculators to use. And it's something you absolutely need in your 'mental toolbox'.

That's right - we're turning investment theory into something practical to use. And speculators can combine this with what I went over in Part One and Part Two of the series.

So - let's begin. . .

When you invest - we already know that you can't simply do what the crowd does and expect to outperform the market.

It takes diligence, foresight, imagination, risk, and most of all luck - to beat the market.

But putting it into one easy phrase - you must be two moves ahead of the competition (the crowd).

One of my favorite contrarian investors - Howard Marks - calls this concept 'second level thinking'. . .

Basically it means that you need to look past what the crowd's expecting today and instead anticipate what they'll be expecting in the future.

For instance - if news broke that there's an expected over-supply of oil coming, investors would sell - pushing oil prices down. This is how 'first-level thinkers' operate - they price new information immediately in.

But a 'second-level thinker' looks at things past the expected short-run and focuses on the long-run.

In this case - they would study the oil market and conclude three contrarian opportunities given the outlook. . .

First - marginal (aka 'on the edge') oil producers can't keep producing at these lower prices. Thus the declining oil production will rid the over-supply problem.

Second - since everyone's expecting falling oil prices, they're selling and even shorting oil stocks. But we know that when someone shorts stocks - they're simply borrowing shares to do so. And eventually, they'll have to buy those same oil shares back to 'close out' short positions (i.e. return to borrower). Thus, the additional demand from closing short positions will push prices higher.

And Third - one report indicating an over-supply of oil could be exaggerated. Or flat out wrong. Maybe increased global demand will absorb more oil than what's expected. For example - news could break next week that a foreign country took advantage of the lower oil price and bought much more than expected - ending the over-supply of oil.

All these reasons are why the 'second-level thinker' will take advantage of the crowd's simplistic and superficial views. They are thinking two moves ahead - going long oil.

Another of my favorite 'second-level thinkers' next to Howard Marks was John Maynard Keynes.

Keynes - one of the most influential economists in the last 100 years - is known for his interventionist policies. Most notably being the concept of using Central Banks and fiscal policy to get the economy out of a recession (this is the view modern-day central bankers take).

But what many don't know is that Keynes was a major influence in the behavioral finance field. And he was also a phenomenal investor. . .

He was aware of how strong human emotions were and how even though the market was usually efficient - sometimes it got completely out of whack.

Keynes called this phenomenon the Animal Spirits. . .

Keynes was especially critical of money-managers - aka the smart money (and so am I - read what I've written before on that here).

He believed that money-managers - in the end - were humans also. And therefore prone to the same mistakes that the crowd makes, except with huge amounts of money. And instead of money-managers acting efficiently - they would likely ride the bubble higher and fear the market bottoms.

Keynes knew that market perceptions were bigger drivers than the real events themselves.

To explain this - Keynes came up with his beauty-contest analogy (a form of game theory) to show how financial markets really work and how second-level thinkers could exploit market inefficiencies.

The gist of the beauty-contest goes like this. . .

Everyone was to vote which model in the fashion show would be deemed the best looking by two-thirds of the judges - a panel of ten.

This meant that each vote wasn't to pick who they themselves thought was the prettiest - but rather who the majority of judges would think was the prettiest. And if the voter picked the model that the majority of judges picked - they would win a prize. If not, they would get nothing.

So - putting it simply - you're deciding which model you thought had the best chance as being seen the prettiest by at least seven of the judges.

A 'first-level thinker' would pick who they thought was prettiest. And since they thought she was the prettiest model, chances are most of the judges probably do also.

But a 'second-level thinker' would study who they thought the judges would think was the prettiest.

See how different that is?

Therefore - just like stocks - Keynes showed how behavioral finance was key to markets and how a 'second-level thinker' was able to take advantage of market inefficiencies and investor perceptions.

So far - I've covered how Wall Street and 'the crowd' act on emotions and immediate news. And thanks to the dominating thought of efficient markets (known as efficient market hypothesis - E.M.H.), many don't even bother looking for inefficiencies (which are what offer large profit opportunities).

Think about it this way. . .

Imagine you're walking down a busy sidewalk in Manhattan during winter. And next to you is a friend.

"What are the chances there's a $100 bill just laying here that someone dropped," you say.

"That's not possible. Because if there was, someone else would have picked it up by now," he says back.

You think to yourself: that's true, I suppose. If there was money on the floor someone would have snatched it up by now.

But imagine if everyone thought this way. . .

Suddenly - you spot the opportunity.

If everyone already expects that any money dropped would have been picked up by now. Then no one would ever even bother looking down at the sidewalk floor since they wouldn't expect to find anything.

So now you decide to start ignoring everyone's assumptions - and start looking for yourself.

And next thing you know, there's tons of bills scattered over the sidewalk. All while the crowd keeps walking on by. Leaving the cash yours for the taking.

This is exactly what's going on in these 'efficient markets' today. Everybody's convinced that there's no cash on the sidewalk - so they don't bother looking.

The crowd believes that markets are so efficient that it's not possible to find huge opportunities. Because if they existed, they would have been priced in already.

But like I wrote in Part One of the series; markets are mostly efficient - but only 90-95% of the time.

It's the 'second-level thinkers' job to find those 5-10% opportunities and exploit them.

So there's two things here we now know and must always keep in mind. . .

One - since markets are widely expected to be efficient, many don't bother looking for inefficiencies (aka huge opportunities). Instead this gives the 'second-level thinker' the opportunity to do so.

And Two - the fact is to beat the market, you must think two-steps ahead of the crowd - your competition. And that being early is better than being late.

So how does this all shape up into practical advice and end up in our 'mental toolbox'?

We can take the 'second-level thinker' concept and turn it into something I call the Speculators Gambit.

But first you need to know what a gambit is. It's an "action, or opening remark, typically one entailing a degree of risk, that's calculated for gaining an advantage."

A gambit's often used in chess. A player will deliberately sacrifice a pawn (looking weak) to put himself in a better position long-term (looking strong).

Or otherwise said - he'll deal with a short-term loss in the attempt at a long-run gain. . .

So - as speculators - sometimes we need to make a position today that could potentially cause a mild short-term loss (only on paper though). But lock us in for a huge long-term gain.

The principle here is the importance of being roundabout.

You can visualize the Speculators Gambit like this. . .

roundabout diagram of the speulator's gambit

The 'second-level thinker' decides if there's an inefficiency currently priced in the market. And then exploits it.

One must have vision and can see moves two-steps ahead. To make out-sized gains. you must make an investment today that looks risky and doesn't make much sense now. But will make complete sense in the future.

And if you make a position early on - don't be afraid to hold it even if there's short term declines, as long as you see gains two moves ahead.

That's the fundamentals of good investing - buying something now and selling it later at a huge profit.

And that's how you beat the market - seeing what the crowd doesn't.

This is why I believe the Speculators Gambit concept stacks perfectly with the 'Favorable Optionality' principle from Part Two of the Series (click here if you haven't read it). Both concepts work off each other.

Later in the upcoming issues I will go over Cycle Theory, George Soros's Theory of Reflexivity, and how 'Favorable Optionality' and the Speculators Gambit all combines together. . . publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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