Zero-sum thinking has begun. Despite comparative advantage, mutual cooperation, and specialization proving indisputably more beneficial than any other approach to economic interaction, this ideal is under threat. Rules and norms for economic integration lifted hundreds of millions of people out of poverty, created an order-of-magnitude increase in the average wealth of the Western population, and benefited countless hundreds of millions enabling a way of life otherwise unimaginable post-World War II. Now that system is under threat as developed countries subsidize alternative energy, attract manufacturing via expensive subsidies, and restrict the flow of goods and capital. Mutual benefit is out; national gain is now the highest priority. In other words, stupidity and zero-sum thinking have taken over. A handful of bureaucrats, regardless of how brilliant each may be, can never equal the mind of the market. Management and control usually spell disaster eventually. Managed focus on technological development for products and services the central government believes have greater substantial benefit to the overall society may not be calamitous, but the law of unintended consequences has not been repealed. It will be inefficient, substandard, and create potentially dangerous side effects. Innovation, creative freedom, and unstructured thought are essential components to the development of any technology of substance and disruptive benefit.
Volatile stock and bond markets are not going away anytime soon, and investment strategies focused on discipline, market-tested algorithms, and the patience to withstand near-term turbulence will continue to deliver better results. As US stocks have dropped about 25% and US long-term treasuries dropped nearly 30%, specific strategies that combine futures, derivatives, and other securities along with market-neutral equity trading have produced superior returns. This impressive overall performance can be expected to profit from market movements and even market shocks that, while specifically unpredictable, will be inevitable from now on. In the face of dismal predictability and lack of confidence, it is discipline, time-tested algorithms, and a multi-strategy perspective toward broad market sectors that have outperformed and will continue to deliver superior risk-adjusted returns and better overall performance.
The onslaught of market-making bad news seems almost a daily event. A gloomy picture of slowing economic growth, elevated inflation, and confusing fiscal and monetary policy has added a lethal mixture to the market’s performance. Fiscal stimulus is sidelined, and monetary policy is constricting economic growth and entrepreneurial innovation. It makes for a gloomy outlook and an even more depressing long-term perspective. The next 10 years look more like a lost decade. High-growth company valuations have been significantly discounted, and over time as discount rates drop, their valuations are likely to increase substantially. Higher-yielding fixed income securities will be a standout performer as interest rates are reduced, the higher-yielding BDCs, REITs, leveraged loan securities, and high cash flow instruments, along with high-dividend equities, will prove extremely attractive and are currently available at bargain prices. Providers of value and users of value will be the winners for the next decade. Those generating real cash flow and disruptive innovation will define the next decade.
Predictions usually end up being nonsense. We simply draw a trajectory from what we know today. But innovation is a discontinuity. Things are unpredictable because innovation does not come from consensus thinking. It comes from small groups and individuals with a spark of entrepreneurship, intelligence, and vision. One of the fundamental tenets of predicting technology is that most forecasters get things spectacularly wrong.
The market is consensus thinking. Performing above average means being different. Simply being different doesn’t define success. Success means understanding what it takes to not only think differently but understand when consensus thinking is wrong and executing and implementing those choices effectively. Doing better (generating superior returns with less overall risk) is difficult. Understanding “what’s really going on” is not a simple formula. It requires different, deeper, and better thinking. Depart from the investment crowd, focus on the factors that are necessary and, in combination, sufficient to make a difference, sustain performance and manage risk. It’s not easy or obvious, but it is superior.
Let the data tell the story. Remove human bias. Intuitive investment ideas may seem compelling, but more often, these ideas are time-consuming, inefficient, and inferior. Data and verification are more effective, and this approach has generated more successful investment strategies. Diverse thinking, diverse data, innovative approaches, and a willingness to be wrong and start over typically bring superior results. Trust the model. Data, discipline, and rigor win more often.
Automated trading strategies provide numerous advantages for implementing successful investment strategies. A rigorous and disciplined approach can lead to profitable strategies far superior to human discretionary trading.
Automated trading is disciplined trading. The strategy will do exactly as the underlying software is written. The software will enter trades based on the core logic of the strategy and likewise exit trades according to its exit logic. Irrational human behavior and biased decision-making do not interfere.
Risk is higher. Markets are more unpredictable, and valuations more volatile. So, when anyone says “this time it’s different” it usually makes good sense to stop listening. However, these days the markets have given us more frequent and intense volatility. The NASDAQ is down almost 30% so far this year, and shocks from the pandemic, the Ukrainian war, massive central bank interest-rate maneuvers, and China’s zero-covid policy, are all ongoing inputs for turmoil that will continue for some time. Persistent uncertainty creates higher costs of capital and less affordability, weakening business investment, slowing GDP growth, and reducing investment returns. Hyperbolic “this time it’s different” statements are turning out to be true. This time days look darker, uncertainty greater, economic growth lower, vulnerability to additional shocks higher, and investors fear many more dark days to come. More frequent and intense volatility will not be calmed anytime soon. It really may be different this time.
While most of Europe and the United States suffer sweltering heat, darkening economic skies and bitter winter of discontent are looming. Threats to the world economy are chilling. Rising interest rates are slowing activity for discretionary spending while rising prices for nondiscretionary spending are also slowing economic activity. It would be miraculous if the compounding of both effects would not lead to a recession in both Europe and the US. China’s growth has stalled. The Ukraine conflict will ultimately resolve itself to the West’s dramatic disadvantage and the West seems to be willing to let it happen – much to each economy’s long-term disadvantage. Don’t count on anything miraculous.
Interest rates are increasing, and bills are coming due for banks, taxpayers, and bondholders. More worryingly, rising interest costs will squeeze government budgets more than realized. Toss this onto the pile of higher energy costs, rising defense spending, aging populations, slowing growth, and the need to address climate change. As short-term interest rates rise, profits from quantitative easing will disappear (it was over $1 trillion from 2010 to 2021, for the US government).
More broadly, a full accounting of interest rate sensitivity is terrible news for the central banks in Britain, Japan, Europe, and the United States. Higher interest rate costs will impact budgetary flexibility, central-bank profits will be limited or disappear, and costs will be substantial, whether born initially by governments, the banking system, or taxpayers. Eventually, taxpayers will pay.
Government budgets will continue to be squeezed and economic flexibility will be limited or lost. That’s right, I don’t hear any music either.
The Fed’s latest projection was for annual inflation to fall from over 5% at the end of 2022 to about 2.5% by the end of 2023. At this point, we’re not taking the Fed’s projections seriously, and for good reason. They were spectacularly wrong when a depth of understanding and insight into critical future events was essential. In other words, the understanding of how the economy works, the Fed’s ability to predict the effects of economic shocks, and its policy actions have gotten no better over the last 50 years. More specifically, price stability doesn’t seem to be coming anytime soon because people simply don’t think it will. If we look at the combination of rising wages and inflation expectations for both consumers and businesses, it is these expectations that drive inflationary pressures more than central bank policy. Inflation levels will be stickier than first theorized by the Fed, and the time to resolution is likely longer. Expect more “surprises” that will be no surprise.
The illusion that one can either predict or get ahead of cycles, or predict when they will end is why most investors underperform the market. Markets are driven by human emotion, and it is human emotion combined with the supply and demand dynamic that determines price. Therefore, pricing is independent of anyone’s perspective about “intrinsic value.” Markets are based on price, price is based on supply and demand, and that dynamic is subject to abrupt changes based on the whims of small numbers, and sometimes exceptionally large numbers, of investors. Human behavior controls the markets. Optimism, pessimism, psychology, fear, conviction, and resignation all play a role in adding to volatility and uncertainty. Frequent and intense volatility is here to stay. Market movements really can’t be predicted unless they are at extremes when prices are at absurd highs or lows. But, picking the high or the low is a fool’s errand. Understanding and profiting from volatility, managing risk, and believing in a sustainable investment model is still the best strategy.