One of the great lessons of investing is that earnings matter. Banal? Trite? Tautological, even? Sure. But it’s amazing how folks lose sight of such a simple thing in times like these.
Open any financial periodical, on any given day this year, and you’ll read about how this “recovery” is a weak one relative to history (even though GDP is at new all-time highs). And in those same publications you’ll find stories buried in the back pages about earnings that continue to beat expectations.
So, there’s a disconnect for many in terms of understanding why or how the market has been so strong the last couple years. Many have gotten into the modus of believing economic metrics like unemployment, durable goods orders, services indexes, sentiment indexes, even GDP itself, are proxies for how stocks will do. They are not—economic indicators are not earnings. Econ metrics, of course, are relevant in understanding how earnings will come in (and because I work for a top down money manager, I tend to believe that stuff matters more than many), but they are not a straight proxy for earnings.
Simply, this is a time where earnings are zooming globally (and continue to—so far 2Q reports have trounced expectations), but other parts of the economy are not (like employment). This is actually pretty typical as new bull markets and early to mid cycle economic recoveries go—corporations get leaner and more efficient faster than the broader economy, with their prosperity rising before it’s reflected in the aggregate economists’ numbers. This is particularly true right now as governments (federal all the way on down to municipal) are still contracting and laying folks off. The private sector has fared better lately. The net result is mushy, and masks booming earnings growth.
The lesson: don’t ignore macro economic news, but don’t take your eye off the earnings of publically traded firms, which continue to be robust globally—those are telling a much different tale than today’s “slow recovery” gurus realize.
Back in April, I highlighted a phenomenon scrambling investors’ minds by the score: people were seeing so-called “black swans” everywhere:
Sorry, but Japan’s earthquake (devastating as it was in human terms), or the problems of the Middle East are not only NOT Black Swans, they’re not all that uncommon. I challenge someone—anyone—to find a year where some major geopolitical, geological, financial, or otherwise big scary event didn’t happen. The world is full of them through history—now is no different than any other, though folks always feel the present moment is “different this time”. Goodness gracious, 1998—a fabulous year for stocks—was also the year of Long Term Capital Management, among other things like the Russian Ruble problems and Asian banking issues.
As I said on Fisher Investments’ MarketMinder months ago, the whole point of a real black swan (if they exist at all) is that they’re hugely rare. Note that recent events did not crater the markets—they were grey pigeons.
To my mind, the issue of the US debt ceiling is archetypal Grey Pigeon drama—one that’s played itself out scores of times in US history, has never sunk global markets, yet folks fret about it often. Now we’re getting theories about Swans hopped up on some kind of hallucinogen to make them glow: Forget About Black Swans, the One Floating Ahead is Neon.
Scary as it might feel, today’s US debt ceiling drama is a classic, not a new thing. Grey Pigeons are flying again.
He never gets as much fanfare as Adam Smith, and tends to get pushed aside by contemporaries like Von Mises these days, but Frédéric Bastiat is one of the great humanistic economists ever, and his work should be on every serious econ student’s desk.
A free marketer, yes, but also one of the great prose writers of the dismal science. This wasn’t just ornament; he believed verbal rhetoric and reason was as much a part of proper economic thought as math-based empiricism. That makes for a rare breed today.
And while it’s impossible to know what he’d think of the state of today’s economic thought, I’m quite certain he’d be pleased to see the proliferation of capitalism and the astounding wealth creation the world has seen since his time.
Here’s a great little primer on him from the weekend’s WSJ:
A world where lumbering global bureaucracies work less effectively and swiftly than individual countries pursuing their own trade destinies is a world I like living in. With the Doha round of talks stuck in quicksand (the more they meet and talk it seems the more they sink), it likely never occurred to many that trade never needed an elite entity governing it in the first place. (Mind you, global trade is surging again these days, with or without the WTO.)
And then wouldn’t it be grand if next mercantilist individual countries digested this same lesson and let their constituent trading companies go free of tariffs and other similar trade obstructions? That would be an even better world for all.
Think for a moment about the perversity of this headline:
It’s perverse because it’s misinformation. The recovery is over. US GDP is at nominal and real all-time highs. There’s, of course, nothing wrong with musing about somewhat slower-than-expected growth so far this year, or pondering why unemployment remains stubbornly high; but the simple reality is the recovery ended some time ago to make way for a new expansion.
If you haven’t been to Café Hayek, it’s worth a visit. It’s one of the leading economics blogs, with a heavy skew toward free markets, complexity and emergence, and snarky, snappy writing. Don Boudreax (the main writer) is a professor at George Mason University , and his views are inflammatory, smart, and informed. Even if you disagree, for those who follow economics closely, it’s worth a check in at least once in awhile.
If you want to understand how supply side economics really works—how great companies create great products and conjure demand (not the other way around)—study the rise of ESPN. A true supply side triumph of the era.
There are really only a few things you need to understand about probability and the stock market.
- Stock markets are Complex, Emergent, and Adaptive Systems (CEAS). Which means no mathematical model on earth can predict them accurately all the time. Instead, the best you can do is think of the future in terms of probability. In my view, most economists would do better to study meteorology than econometrics.
- There is an important difference between risk and uncertainty. The famed University of Chicago economist Frank Knight elucidated this idea (known as “Knightian uncertainty”), and it’s imperative for market forecasting. There’s “risk,” which can be computed, and “uncertainty,” which can’t be computed. For instance, you know the odds of flipping a coin: 50/50. This is quantifiable risk. But in events of much greater complexity, where the actual parameters or possible outcomes aren’t known, an actual understanding (in a mathematical way, anyway) isn’t possible. This is uncertainty. The degree to which you believe the market is “risky” or “uncertain” will drive a significant portion of your investing philosophy. (Most economists and stock analysts want to believe more in the “risk” part than the uncertainty part because that makes their jobs seem more relevant.)
This second notion in particular is a core idea at the heart of probability theory still hotly debated today. (I detail perspectives on risk and probability at length my book, 20/20 Money.)
In this spirit, four books on probability and randomness.
The Drunkard’s Walk: How Randomness Rules our Lives – Leonard Mlodinow
This is an excellent primer on probability, free of jargon and mathematical ornament. That’s important because in investing, it’s better to understand probability as a concept than as pure mathematics. Because of Knightian uncertainty (above), there really isn’t a lot you can put a definite number to–instead assigning possibilities often needs to be more qualitative.
A disappointment of this book is that it fails to really separate randomness and probability in a memorable way for the reader. This is a darn shame. Mr. Mlodinow at one point actually uses the phrase “the patterns of randomness.” Which is of course an oxymoron. Randomness, true randomness, has no pattern. And this is principally why stock markets are not purely random—they have patterns that don’t recur exactly the same every time, but often do. (Bulls, bears, panics, euphoria…you know the cycles by now.) But they have enough variance and false alarms, and there is such a general ignorance about market history, that most investors get thrown off the scent by greed and fear each time.
Drunkard’s Walk also integrates a bunch of neat behavioral psychology into the framework of probabilistic thinking. Errors like the “post hoc ergo prompter hoc fallacy” (because something happens afterward doesn’t necessarily mean the former caused it) are common in life and in investing.
The discussion of stocks in this book is a few pages and very shallow—there is no consideration here of the particulars of stock market probability and randomness tied to the efficient market theory, which deserve far greater treatment if they are to be commented upon. This makes Drunkard’s Walk good for thinking about probability and how it affects your life generally, but not so good for investing.
Fooled By Randomness: The Hidden Role of Chance in Life and the Markets – Nassim Nicholas Taleb
I am so ambivalent about Mr. Taleb. His books are thought-provoking, eloquent and often smack-dab-right-on true. But I’ve never been on board with his investing strategies or constant doomsday forecasts.
That aside, this is the best book in recent memory on investing and probability. Mr. Taleb has a feistiness to his prose that is so engrossing, you’ll scarcely realize you’re reading about a very dry subject.
Where I believe Mr. Taleb is wrong is his total belief in randomness. He even goes so far as to describe the last 100 years’ rise in the stock market as “stochastic drift” and that all perceived cycles and patterns therein are nothing more than illusion. This can be debated among philosophers forever, but MarketMinder has long believed that at a minimum human psychology features semi-repeating patterns over time that manifest in market cycles.
Never have I met with such a bipolar book. The first half constitutes simply one of the finest explanations of how stock market efficiency works I’ve read. Malkiel understands this issue like few do and debunks a litany of common investing strategies, from charting and technical analysis to value investing and discounting dividends. The first half of this book is a tour de force in right thinking about the stock market and its ability to reflect widely known or believed information.
So I was profoundly confounded by the book’s second half, which ignores many of the first half’s natural conclusions. This part is the “practical” investment advice for “laypersons.” I find the advice to be neither practical nor executable for the general public. As Malkiel lays out each complex financial instrument and describes how much detailed analysis and work it takes to efficiently manage one’s own money, the strikingly (almost hilariously) obvious conclusion is that no layperson should be doing this on their own. The fees incurred by a competent money manager—whether they have a record of beating the market or not—clearly deliver value for the non-professional in simply navigating the territory.
As has been said in this space over and again—investing is not a game for geniuses, it’s about discipline. Those who make the most money over time are those who make the fewest errors. It’s not about being the smartest; it’s about not being dumb repeatedly. Everyone will make forecasting errors, but great managers at a minimum can deliver the market’s return over time—a feat most folks on their own cannot do. That much alone is a tremendous wealth builder.
Siddhartha – Hermann Hesse, Sherab Chodzin Kohn, trans.
Ok, forget about the math and the logic for a moment, and let’s end things by thinking in terms of true human experience.
Herman Hesse’s Siddhartha is a book I read about once a year—a true classic, a quasi-biography of the Buddha story. (Note: It’s a rendering of the “story” of Buddha, which is archetypal. The actual historical person and his biography matter less than the story, which here is more or less repeated as fiction.) It’s a classic heroic adventure in the Joseph Campbellian arc and focuses on the life journey of seeking after “enlightenment.” What it ends up being is an adventure highlighting the importance of cultivating awareness and the integration of experience.
After many adventures, many futile attempts to gain enlightenment, Siddhartha returns to a river he encountered in his youth and finds that simply being with the river—observing it and paying it careful attention—yields the simple wisdom he’d sought all along.
A few weeks ago, I was rafting down the American River in Northern California with my dad and brother to celebrate Father’s Day, and I had all these books about randomness and probability on my mind. If you watch a river, even just for a short time, it becomes a near-perfect metaphor for the stock market and probability.
At any given time, in any given place, a trillion unique things are happening in a river, yet patterns are discernable—ultimately the waters flow in a similar way, yet no single water molecule will ever take precisely the same course. As you steer through the rapids, you have to think a couple moves ahead, you can’t truly control the river, just influence where you steer your raft; you have to go along for the ride in the right way—that’s the job (this is basically what good money managers do). One minute the waters are calm, but rapids can be just around the corner. It sometimes looks like you’ll careen into a rock if you keep on the current course, but that’s often the place you want to be—the trend doesn’t continue, and by the time you get there the water moved you to safety. And sometimes, completely unexpected things happen. Yet, the experienced and skilled guide gets you through every time, every river cycle, even if occasionally you get a little soaked.
I find most of those lessons to be true of the stock market. Specifically though, read Siddhartha for the joy of it and for one of life’s most important lessons: Don’t just seek after experience for thrill or adventure, seek to integrate experience in the project of self development. Experiences are as random as life without reflection.
Being Wrong: Adventures in the Margin of Error – Kathryn Schulz
I’m throwing this book on the blog today because I don’t feel like writing a separate book review about it on MarketMinder, and there’s been plenty written ad nausem on cognitive investor errors on this blog and elsewhere.
I saw Kathryn Schulz speak at the TED conference earlier this year, and as a result picked up her new book: Being Wrong. By taking some time to think through the qualitative pieces of erroneous behavior, this one stands out from the pack of what are now legion books about cognitive errors. Most psychologists today have been terrorized by science. Mind you, that’s not a terrible thing—science in psychology has been the thing to pull much of the discipline forward in the last decades. But, as with many things tied to the modern religion of science, it’s become so dominant in the field that most people in psychology have sort of forgotten what it means to be human.
When the world jettisoned Freud and Jung in place of strict empiricism over the latter half of the 20th century, it gained much, but lost some of the most truly artful and subtle thinking the world had to offer. You become more attuned to people and their minds generally by reading Freud and Jung and others like James Hillman. You understand people better, and in a way that numbers aren’t going to express. (And, all those guys rank among the best writers of their era in my view. Freud, of course, won the Nobel Prize for literature.)
Schulz brings some of this grand tradition back—weaving in careful metaphors with a good bit of art and craft into her discussion of common cognitive errors. She actually explores what it means to be wrong as opposed to revealing some statistics about how often people are wrong.
This makes for a great read—one you can take to the beach with you, but will still deliver a solid intellectual punch.
Have a great weekend everyone.
Liu Junning writes an important piece in yesterday’s WSJ on how to view China and its burgeoning economy.
- The Ancient Roots of Chinese Liberalism: Westerners who think that authoritarian rule is China’s natural state misunderstand its culture.
Indeed, this perspective is bolstered by Henry Kissinger’s (too long and often turgid) On China. The first few chapters of the book lay out a cultural/socio-historical framework for understanding China that downplays communism and holds Confucianism as the still primal underpinning.
Make no mistake: China’s still full of communists. But to say liberalism isn’t a part of “their culture” is both erroneous to the culture and a misunderstanding of its foundations. As Lao Tzu said: “The more prohibitions there are, the poorer the people.”