Nobody Knows Anything
This month, Chris Mayer is filling in for me on The Bill Bonner Letter. There are two reasons for this, one for me and one for you.
For my part, I have been very busy with personal family issues and unable to keep up with my regular schedule. But from your point of view, this is an opportunity to get better acquainted with Chris.
While I focus on the macro issues – fake money, the rigged economy, and increasingly politics – Chris turns his attention to more important issues. That is, he has the responsibility for real money in the real world.
If you have some money to invest, what should you do with it now? I have only general answers: Keep a substantial amount in cash and gold… stay out of bonds… avoid the U.S. “stock market.”
As you will see, these general instructions take on new meaning when you begin to look more closely at the details.
In a credit crisis and/or recession, for example, some bonds go down as investors fear defaults. But there is no risk of default on U.S government bonds, so Treasurys become more attractive and go up.
And as Chris explains, there really is no “stock market,” just a market for stocks. Some go up. Some go down. Chris’s job is to find the ones that are going up.
But whether you are looking at the big picture or the little picture, it is important to remember that what you see is only a very small part of the whole thing. And the picture is likely to be distorted in many different ways.
The media, the financial industry, regulators – all have their own agenda, motivations, and favored narratives. What we see has already been refracted through several lenses. But the most dangerous distortions appear in the light we bend ourselves to fit our own prejudices, delusions, and desires.
“We see what we want to see” is the popular expression. If we are long stocks, we see a rising stock market. If we are short, we see calamity around the corner.
“Your first loss is your best loss,” say old-timers on Wall Street. If your hypothesis proves incorrect, you should abandon it as soon as possible. You’re missing something important.
Instead, when the future doesn’t shape up as we think it should, too often we come up with explanations and excuses… further distorting the light. This can be disastrous; we are likely to double down on a losing position, turning a little loss into a big one.
“Nobody knows anything” is another old-timers’ expression. Chris reminds us why this is so… and what to do about it.
February 22, 2017
Welcome to “Chapel Perilous”… Where Markets Are No Longer What They Seem
By Chris Mayer
“In his books, and most importantly in his autobiography Cosmic Trigger, [author] Robert Anton Wilson talks about the psychological state where you have no way of making sense of what is happening, where all your maps have run out, and where you have no fixed point with which to orient yourself by. He called this place Chapel Perilous. This is where we are now…”
– John Higgs, author
We live in strange markets… if you can call them markets at all.
Welcome to Chapel Perilous. We really are in uncharted waters.
How to figure this out? How to invest your savings or plan for the future? As Bill likes to say, doubt is our guiding star. We poke and prod and ask questions. Sometimes we find answers.
When you are inside Chapel Perilous, you have to question everything. In this letter, I’ll share with you some of what I’ve learned in more than two decades of navigating perilous markets. And we’ll map out a course to get us through Chapel Perilous…
Distrust Simple Cause and Effect
“…history has chance after chance to prove men fools.”
– Charles Bukowski (1920-1994), poet
Investors tend to rely too readily on simple cause-and-effect-type thinking.
Remember when people used to say that when quantitative easing ended, the stock market would tank? Surely you haven’t forgotten about QE? That’s when the Fed bought bonds to drive interest rates lower.
Well, if you plotted the Fed’s QE program against the S&P 500 (“the stock market”), you saw a nice, clean correlation. Ergo, it appeared that QE propped up the market. That chart got a lot of play.
But QE ended in 2014. And the market kept rolling. Here we are near all-time highs. So much for that!
Still, even today, you’ll still find some people citing how the Fed’s actions “explain” 93% or whatever of the stock market’s movements since such and such a date. They’re like Flat Earthers with fancy charts and impressive-sounding lingo. But they’re just as hidebound and wrong.
This is the old “correlation is not causation” that your statistics teacher used to tell you about.
You may remember the old joke about the man on the street corner waving a red flag. Finally, someone goes up to him and asks what he’s doing.
“I’m keeping the elephants away.”
“But there are no elephants here.”
“Then it’s working.”
One of my favorite examples of correlation analysis gone awry comes from David Leinweber at Caltech who wrote a paper in 1995 called “Stupid Data Miner Tricks: Overfitting the S&P 500.”
He showed that butter production and the sheep population in Bangladesh, along with U.S. cheese production, “explained” 99% of the movements of the S&P 500 between 1983 and 1993.
In other words, if you knew what butter production was in Bangladesh along with its sheep population and U.S. cheese production, you could predict where the S&P 500 would go next.
Leinweber used regression analysis, which is the statistical technique that people use to produce this kind of analysis. But Leinweber’s was an obvious parody. He was making fun of a type of thinking that is all too common. His was a blatant example of why you should distrust such analyses.
And yet we still see it everywhere. The financial world pumps out nonsense like the Bangladesh example every day. But the nonsense is usually not so obvious. It is subtle. The correlations plotted seem plausible. But as Leinweber warns us, “Just because something appears plausible, it doesn’t mean that it is.”
As I say, the world is a much more confusing and complex place. Drawing out reliable cause-and-effect relationships that hold firm in financial markets (and life in general) is hard. Maybe impossible.
I once heard Robert Anton Wilson give a talk on YouTube – he died in 2007 – where he explained an interesting exercise. He said he got it from reading a book by the mystic Aleister Crowley (1875-1947). Crowley said he got it from a monk in Ceylon (now Sri Lanka).
The exercise goes like this: You go find a quiet place to sit and then you trace out all the reasons you are there at that moment doing that exercise.
So, you might start by saying, “I’m here because I read about this exercise in The Bill Bonner Letter. I read The Bill Bonner Letter because a friend of mine recommended it to me at lunch about a year ago. Why did he recommend it to me? Because we were talking about the market. Why were we…?”
And you keep going and pushing as far as you can stand to do it. What you come to realize is the role that chance and happenstance play in your life. Everything had to happen just as it happened for you to be sitting there at that moment.
It also begs the question about what “the cause” was. If you push on far enough, you’ll get to when your parents met. And if you keep going, you’ll eventually get to ancestors. There is, as should be obvious, no end to the trail. And so it sort of throws the whole question of “cause” out the window.
The philosopher Alan Watts (1915-1973) talked about this ancient problem of cause and effect. “We believe that every thing and every event must have a cause.” He shows how the problem comes from not seeing the whole picture. We rely too much on our own little chosen set of data points.
He has a most interesting little story to bring home the point:
Here is someone who has never seen a cat. He is looking through a narrow slit in a fence, and, on the other side, a cat walks by. He sees first the head, then the less distinctly shaped furry trunk, and then the tail. Extraordinary! The cat turns round and walks back, and again he sees the head, and a little later the tail. This sequence begins to look like something regular and reliable. Yet again, the cat turns round, and he witnesses the same regular sequence: first the head, and later the tail. Thereupon he reasons that the event head is the invariable and necessary cause of the event tail, which is the head’s effect. This absurd and confusing gobbledygook comes from his failure to see that head and tail go together: they are all one cat.
Remember this when you see analysts pull out one or two data points – price-earnings ratio, or debt to GDP, or whatever – and use it to try to “explain” the market. They are all just looking through a narrow slit in the fence. And those data points are all one cat.
As ever, humility and doubt are good guides here.
Whenever you see an “If X then Y” statement, you should distrust it.
If interest rates rise (or fall), then stocks will fall (or rise)…
The problems here are many. First off, in markets you can’t change one variable and leave everything else the same. Rates may rise (or fall), but what happens to sales growth? What about profit margins? What about countless other things that also continue to change?
Besides, which stocks? The earnings of brokers, banks, and insurance companies generally rise when rates float higher. We’ll see more about why generalizing is dangerous in a minute.
If the economy picks up speed, that’s good for stocks…
We got the “Trump bump” as the market rallied under this belief. But there are a lot of problems with this. The connection between economic growth and stock returns is murky. You can have a fast-growing economy and a lousy stock market (and vice versa).
There are a lot of other variables at work – such as valuations. And again, you must ask which stocks. (Plus, people throw around “the economy” as if it’s some big animal in the backyard that we can go out and measure. It’s not as if “the economy’s growth rate” is an objective number. It comes from making a lot of assumptions.)
So, never be too sure of any prediction, no matter how seemingly logical or plausible it seems, based on such simple cause-and-effect analysis.
What we’re doing when we search for causes and effects is looking for patterns. We are pattern seekers. But that’s a risky business.
Let’s take one more example. Suppose I show you this string of numbers: 14, 23, 34, 42… and then I ask you to pick the next number in the series. What would your answer be?
I’ll give you a minute…
Now, you could try all kinds of plausible ways to do this – to try to figure out the mechanism of how one number “causes” another to appear. There is no single pure-math answer. But in this case, using math in this way will lead you astray from the get-go.
The answer sought is 59.
Well, it’s the next street level where diagonal Broadway crosses an avenue in New York City. (This example comes from Edward MacNeal’s Mathsemantics: Making Numbers Talk Sense.)
Trick question, you may protest.
No. Real life, I say.
At the start of this letter, I talked about U.S. stocks. That is an example of a generalization investors make all the time.
But how useful is it? My answer is: “Not very.”
Whether you thought stocks would go up in 2016 or whether you thought they’d go down in 2016, you were wrong on both counts. The only right answer is to say that some stocks went up and some went down.
Take a look at the table on the right, which shows the top and bottom performers in the S&P 500 last year.
After seeing this, does it make much sense to talk about “U.S. stocks” as a whole? The disparity here is enormous and typical.
The best stocks in most years will about double and the worst will about get cut in half. (Besides, what is a “U.S. stock”? Is Coca-Cola a U.S. stock? It gets more than two-thirds of its profits from outside of North America… The S&P 500 overall gets more than 40% of its earnings from outside the U.S.)
But investors routinely treat stocks as if they’re all basically the same and will basically move in the same general direction together.
This is not to say that you should never make generalizations. It is to say that you should know when you make them (and be able to see them) and you should distrust them.
Over the holidays, I read a great collection of essays by Murray Stahl, the big brain behind the money management firm Horizon Kinetics. In more than a few essays he shows the danger of generalization.
He looks at the Market Vectors VanEck Coal ETF (KOL). This is an ETF made up of a basket of coal companies. Presumably, people who buy this ETF are looking for ways to get exposure to coal.
But as Stahl asks: “Should someone investing in this fund know something about the various companies in order to form a generalized premise about the fund?” My answer would be yes. Maybe that’s just me. I can’t buy a bucket blind. I want to know what’s in it.
If you look at what’s in it, you find some interesting things, as Stahl shows. Jastrzębska Spółka Węglowa S.A. is one coal miner in the index. It mines coal in Poland, most of which stays in Poland.
This is just one company. The fund has 28 holdings. Imagine meeting 28 people about which you know nothing except that they are all employed in the coal mining industry in one capacity or another. Now imagine being asked to make true generalizations about those people as a group.
Exactly. It’s kind of silly. And how correlated are these stocks, really?
The Polish stock was up 3.5 times through July of last year. But another stock in the coal ETF was the oddly named Korean coal firm Kiwi Media Group, which Stahl points out fell 45% through July. Another holding in the ETF is Joy Global, which doesn’t even mine coal, but sells equipment to miners. FreightCar America is also in the coal ETF.
There are worse offenders…
My favorite might be the PowerShares Dynamic Leisure & Entertainment ETF (PEJ). The fund has $132 million in assets. Presumably all the people who put money here were looking to get exposure to the leisure and entertainment industry.
Once again, the obvious conclusion is wrong. (We’re inside Chapel Perilous, remember?)
As Stahl points out, the top holdings of PEJ include some baffling choices. McDonald’s is the third-largest holding at 5% of the fund (as of August). Then, the next largest holdings – slots 4 through 8 – were as follows:
Southwest Airlines, 4.9%
American Airlines, 4.9%
United Continental Holdings, 4.7%
Delta Air Lines, 4.4%
SkyWest Airlines, 3.2%
That’s about a quarter of the fund in airline stocks. Sounds like an airline ETF to me. As Stahl joked, “Perhaps the logic is one needs to fly before one can have entertainment, and while one is being entertained, what is better than a Big Mac?”
Even stranger, PEJ doesn’t own obvious choices, such as Disney. Nor does it own Lionsgate Entertainment, which makes movies. It even has “entertainment” in the name.
A funny duck, that PEJ is…
Yet, this is the way investing is today. It’s industrial investing, like industrial farming. It doesn’t have to taste like a real tomato. It just has to look like one so they can sell it to you.
I told you this one fund has $132 million in it. I think it’s safe to guess that the owners of those $132 million never bothered to look and see what they were actually buying.
But maybe it wouldn’t matter. People see what they want to see.
Don’t Trust Labels
I’ve always been fascinated with how you can give something a name and that name can completely change the way people view that thing.
This is an old trick, well known by advertisers. But it works in markets, too. When the internet was hot back in the 1990s tech boom, some companies would change their name to add “dot com.” And their stocks would pop.
What’s funny is that after the tech crash, companies would change their name again. This time they’d drop “dot com” and their stocks would soar.
There are papers written about this phenomenon. And it didn’t just happen in the 1990s. In the 1960s, the same thing happened with “electronics” when they were hot.
Anyway, an anecdote from the tech bubble will tell you all you need to know.
In 1999, there was a company called The Publishing Company of North America, Inc. Enviously eyeing the booming market for internet shares, management decided to change the company’s name to Attorneys.com. The stock doubled.
Then the tech bubble burst. The stock fell more than 75% from its 2000 peak. Well, the firm decided to change its name again. This time it took on 1-800-Attorney. In days, the stock jumped 40%.
And the professors want to tell us the market is “efficient.” Uh-huh.
Still, I see this all the time. The ETF examples above fit. Think about it: All PowerShares had to do to get $130 million in assets was put together a fund and call it “leisure and entertainment.” They can put whatever they want in it, apparently, and investors don’t seem to care.
PowerShares executives are probably chuckling over it right now and wondering what else they can get away with.
But here’s another interesting comparison from C.T. Fitzpatrick. He’s the chief investment officer at Vulcan Value Partners, an investment advisory based in Birmingham, Alabama.
Consider Post Properties, Inc., an Atlanta-based apartment REIT. REIT stands for real estate investment trust. It’s a popular way to own real estate because it’s like a mutual fund that’s made up of properties instead of stocks. It’s also a popular type of stock to own right now because REITs (by rule) pay out most of their earnings in dividends.
So, Post Properties was recently acquired at a price of 26 times free cash flow. This valuation is not out of line with most REITs, but Post Properties is arguably a worse asset than most REITs.
While higher quality retail and office REITs have longer leases ranging from 3 to 10 years, apartment REITs generally turn over roughly half of their units annually. So just to break even, they have to resell half of their product annually before they can grow.
Now, consider Oracle.
People don’t call Oracle a “REIT.” Yet, it has long-term contracts (licensing agreements). These even have inflation-adjusted escalators, just like a lease. Oracle enjoys over 90% customer retention. And it can add customers without having to build a new apartment.
Fitzpatrick tells us:
In real estate terms, Oracle can grow its ‘occupancy’ without physical constraints… Moreover, unlike REITs, which are highly leveraged, Oracle has net cash on its balance sheet. So Oracle can grow twice as fast as the typical REIT without leverage. Adjusted for cash, Oracle trades at less than 11.5 times free cash flow…
So, let’s see… Oracle has a business that in its essential characteristics is much like a real estate firm. Except it is better. It has cash and no net debt. It’s growing faster. And yet the market values it at half of what the acquirer paid for Post Properties.
Strange. It’s almost as if the market says, “Well, Post Properties is a REIT.” And you say, “Yes, but clearly Oracle is a far superior asset in every respect.” And the market comes back and says, “Yes, but… Post Properties is a REIT.”
The power of labels! Don’t trust them.
You See What You Want to See
As we make the turn and head down the homestretch, we must deal with this idea…
It was a physicist, R.D. Carmichael (1879-1967), who said: “The universe, as known to us, is a joint phenomenon of the observer and the observed.”
In short, we play an active role in what we see. Our experiences, our beliefs, our particular vantage point, among other things… all impact what we think we see.
A fun way to see this is to look at the work of Adelbert Ames, Jr. (1880-1955). I recently read a biography on Ames by W.C. Bamberger. Ames is most famous as the creator of a variety of “demonstrations” of impossible things. Illusions. As the back of the book puts it:
Rooms where small children tower over their parents, where water runs uphill; he created demonstrations where playing cards and cigarette packs and matchbooks seem to change size and position in the blink of an eye, where stationary balloons seem to draw near then move away, where chairs deconstruct into wires and white trapezoids, and where a steel bar bends around a rotating window frame.
One of his famous demonstrations – the Ames room – is below.
The trick is one of perspective. The smaller figure on the left is simply further back. The windows are not the same size, either. The one on the left is actually bigger than the one on the right. And the room shrinks as it moves from left to right. You can see how it’s done in the picture below, “How the Ames Room Works.”
But it’s impossible to see this, even when you know how it’s done!
Ames used his many demonstrations to develop theories of perception. The idea that we “see” objectively crumbles under his analysis.
Instead, you come to understand that the mind makes “gambles.” It makes what it sees fit with what the mind knows. If the eye was not an objective instrument, Ames thought, then perhaps all knowledge is equally subjective.
Uncomfortable ideas. And in Ames’ time they were cutting-edge. But now they’ve become largely accepted.
I read about Ames and couldn’t stop thinking about how his work applied to markets. It makes one humble. It’s possible that what we think we see is simply a trick of perspective. Perhaps our minds craft a story… and that story is not real.
This is why you should value perspectives that differ from your own. There is a chance someone else “sees” something you don’t see.
When I like a stock, I also try to understand the bear’s case. If I think a stock is cheap, I want to know why it is cheap. It may be that I’ve missed something, or don’t understand something as well as I thought.
But sometimes, you get a good, firm grasp on what the prevailing thought on a stock is. Sometimes it is clear why people hate it and why it is cheap. And yet, at the same time, you also know why that view is not correct… and will soon be proven wrong.
I am particularly attracted to these situations where there seems to be a hard negative consensus. Those are situations where people are probably not doing a lot of thinking. (As Robert Anton Wilson used to say, “Convictions create convicts.”) I get very excited when I find them…
For example, early last year I recommended AIG for the Bonner Private Portfolio, the trading service Bill chose to follow with $5 million from his family trust.
We heard quite a howl from the gallery on that one. “AIG? That disgraced insurer? That blown-up relic from the financial crisis? This is madness!” The mailbag showed that more than a few readers were disappointed.
Only a few years earlier, Time magazine had a cover story showing a bomb with a lit fuse and the comment “Why AIG = WMD.” This was a company that had lost a lot of money.
Fast-forward to 2016, and AIG still had a terrible reputation. But all those old troubles were gone. The only thing was… most people still clung to the company’s embattled image.
What I saw, though, was an activist investor – the billionaire Carl Icahn – who had bought $2.5 billion worth of stock. He got himself on the board of directors, too, meaning he was in for the long haul. And he put pressure on management to improve.
But the stock price still reflected – more than reflected, even – all the poor results. Investors who bought the stock when I recommended it took little risk of loss, because the stock was already about as low as it could possibly go.
Meanwhile, CEO Peter Hancock – hired in 2015 – had crafted a credible plan for a turnaround. It included selling off noncore divisions and returning excess capital to shareholders.
As of this writing, it’s not been even one year since my recommendation, and the stock is up almost 25% for us. Not only that, but I made it the biggest position in our portfolio.
For sustained success in markets, it helps to remember that we are not passive viewers on the scene. We see actively. We make our world, in many respects; we see what we want to see. You must always consider the observer(s).
As Ames showed, what we think we see may not be what is…
The Way Out Of Chapel Perilous
At this point, we can draw some conclusions about Chapel Perilous. I submit to you the following four propositions, though we could surely come up with more.
Post these on your wall for easy reference…
- Our world changes continuously; nothing stays the same.
- No two things exist exactly alike.
- We can never know all the details; we always leave things out.
- Observer and observed create what the observer sees.
In short, don’t look for certainty. (A variant on a funny old saying: If you want certainty, buy a dictionary. If you want uncertainty, buy two.)
But that’s the key to escaping Chapel Perilous. You learn to embrace the uncertainty, to thrive on it, to make it part of your thinking. You construct a portfolio based on it.
Once you do that, Chapel Perilous dissolves like a mirage.
As Bill himself has put it:
For my own money, I’m sitting tight… in cash, gold, and long-term stock holdings, about a third in each category. My investment horizon is likely to be longer than yours; I don’t mind if the current price of any of these things goes down 50% and stays there for years… as long as the real value doesn’t go away permanently.
That’s a portfolio designed for Chapel Perilous. (And I handpick the stocks he owns in Bonner Private Portfolio. Artisanal investing, you might say, not the industrial kind.)
I look for companies that seem prepared for Chapel Perilous…
Companies like Fairfax Financial. The guy who runs it, Prem Watsa, is a celebrated investor in the Warren Buffett mold. And Fairfax is his Berkshire Hathaway. He’s grown Fairfax at a 20% clip for more than 30 years.
It’s a remarkable record – the best in the property and casualty insurance industry over that timeframe, and with the top 10 best returns of any company in the S&P 500…
He’s also careful. His company carries lots of cash, and he hedges its portfolio against disasters. He writes straightforward shareholder letters where he shares his thinking.
In his latest annual letter, he even mentions AIG as an example of why it pays to be careful:
We remember it took 89 years for AIG to build $90 billion of shareholders’ capital, and only one year to lose it all!
Watsa has a knack for avoiding – and even profiting from – disaster. Consider these tidbits from his past:
- In 1987, he took half his money out of the stock market before the crash.
- In 1990, he bet against the Nikkei before Japanese stocks fell by 40%.
- In 2000, he bet against the S&P 500 just before it collapsed.
- In 2008, he bet against the housing bubble and made a fortune.
- In 2016, he showed his brilliance once again.
In early November, just ahead of the U.S. presidential election, he sold 90% of his U.S. long-term Treasury bonds. Interest rates subsequently spiked and bond prices fell. Watsa narrowly avoided a huge loss on bonds.
Watsa has also done lots of interesting deals to create value for Fairfax shareholders over the years.
One of them is in India (Watsa is of Indian descent). Fairfax set up Fairbridge Capital Private Limited, an India-based investment management office.
It acquired Thomas Cook India (a travel and financial services company). It also created the Fairfax India Holdings Corporation, which raised $1 billion in its initial public offering. Exciting stuff.
As Watsa says:
We have a strong, successful and growing Indian operation, built on the Fairfax guiding principles, with unlimited potential in India.
And he’s showing no signs of slowing down…
Late last year, Watsa did the biggest deal in Fairfax’s history. He acquired Allied World, a fellow insurance company with an excellent record as well. We can expect Watsa to do more deals and build more value for Fairfax shareholders.
But Fairfax’s stock is down because Watsa’s most recent returns have not been so hot. That 20% clip slowed to about 3% in the last several years. But a look at his track record shows periods of low returns followed by high returns.
Great investors are not great all the time. They are great through cycles and over a period of many years. People so easily forget that. The market’s selloff of Fairfax’s stock is a gift, a chance to invest with one of the best.
Fairfax is another good example of how confused the market can be. The market looks at the company’s temporarily lower returns and says, “This thing is in big trouble.” But when you dig beneath that one shallow performance measure, it’s easier to see that’s not the case at all.
Fairfax is a solid, well-positioned company. And, just like AIG, it’s proof that this market is no longer what it seems.
Coda: The Trump Era
On Trump’s inauguration day, I met an old friend for lunch.
“Well, it’s official,” he said. “Trump is president.”
“Yes, and here we are eating lunch,” I said. “Just as we did before.”
Presidents come and go. True, the actions they take can affect you directly. But so, too, it may rain on a day you plan to play golf. Or you may get sick on your vacation. You have no control over those things, either. But do they stop you from playing golf or planning vacations? Life goes on.
Stock markets, too, go up and down. Sometimes they go down a great deal. But you play on.
We are in control of so very little. We are buffeted about by forces – call it fate, God, chance, whatever you wish – that do not seem to care about what we want to happen. It seems insane to get upset and stew over politics, or much else for that matter. Why bring misery on yourself? Life is hard enough. Be easy on yourself. Be kind.
You do what you can. If you fall down, get back up again. And do so with good cheer and a light heart.
As the great gonzo journalist Hunter S. Thompson used to say: “Buy the ticket; take the ride.”
Thank you for reading. I hope you enjoyed this letter. It’s not easy filling in for Bill!
February 22, 2017