In our previous article, Why some believe a crash is imminent, we discussed the contradictions between the US stock market and the economic fundamentals. In other words, we believe that we are at a turning point in the economic cycle that is not yet recognised by the stock market. However, as contrarians, we expect the majority of market participants to disagree with us. But bear this in mind: at turning points, an investor is either a contrarian or a victim. The difference between the two is the quality of their thinking.
What are the common mistakes of those who fail to see turning points?
Adopting turkey thinking
Recall that in our earlier article, Parable of the turkey, that poor turkey extrapolates the good life it had into the indefinite future and became a victim during Thanksgiving day. Likewise, a common mistake that investors make is to look at the current situation as it is and project what is current into the future. Looking back into history, we can see that the majority failed to anticipate the Great Depression. As we said before in The Great Crash of 1929,
Contrary to popular belief, the Great Crash of 1929 was not completely without any warning. As early as November 15 1925, Alexander D. Noyes, a highly respected financial editor of the New York Times, warned in a very long article that the ?speculative mania? of the 1920s was not unlike previous bubbles and that stock prices could not rise forever. Long before the Great Crash, the contrarians of the day were already sounding the alarm.
The only fault of the contrarians is that some of them were far too early. The lesson for us, as contrarians, is that it is foolish to make any forecast, especially with regards to price and timing. Instead of predicting, we highlight the possibilities of what may happen. Again, many critics of contrarians fail to understand the difference between the two.
Failure to see the connections
The global economy is made up of highly complex connections of systems within systems. Therefore, it is more appropriate to see the global economy as a network rather than just a disparate collection of entities. The nature of the network is that any changes on one part of the network can have unpredictable side-effects on the entire network itself. Furthermore, the nature of networks is such that it exihibits behaviours that arises from self-reinforcing and stabilising feedbacks. That’s why sometimes markets move in cycles and sometimes market revert to the mean.Though there may be disagreements and differences in opinion on the workings and the side-effects of a network, it is a colossal mistake to see the global economy as just a collection of incongruent units. Thus, one of the most common mistakes investors make is to look at one part of the network and assume that it is immune to whatever is happening to the other side of the network.
With that in mind, what are the questions to ask? For example,
- What are the effects of the Fed’s normalising of interest rates from 1% to 5.25% from 2002 to 2005?
- How will the slowdown of property asset price appreciation affect the solvency of consumer debts?
- How does the sub-prime crisis affect the financial system of the US?
- How will the credit crunch affect the operations of businesses?
- When will the solvency of consumer debts affect consumer spending?
- Will falling profitability of businesses result in self-reinforcing feedback effect on consumer solvency?
- What are the connections between the credit crunch and financial solvencies of funds and businesses in far away China and Australia?
- How much will consumer spendings in the US affect the Chinese economy?
- If the Chinese economy slow-downs, how will it affect the resource industry in Australia?
- How vulnerable is the Australian economy on the resource boom?
- If the vast majority of the world’s assets are deonominated in US dollars, what are the implications of a loss in confidence in the US dollar?
- … many many more questions…
If you have been with us for quite a while, you will notice that we are always trying to work out these connections in the ‘network.’
Under-girding this process, we need a strong theoretical framework to help us build a model of the complex environment that we are in. If you use a flawed theoretical framework, then your model will be flawed. If your model is flawed, then your understanding will be flawed. If your understanding is flawed, your conclusions will be flawed.
Failure to understand the nature of Black Swans
Back in How to take advantage of an impending crash- Part 2: understanding a subtlety, we said that,
If someone asks us, ?Is the market going to go up or is it going to come down?? a simple and direct answer of ?Up? or ?Down? will be too simplistic to reveal a subtlety.
…
This implies two things:
- In today?s market, the probability of the market going up is higher than the probability of it coming down. Hence, it is rightly called a bull market.
- But should it come down (which is unlikely), it can collapse at extremely great speed and magnitude.
Hence, the stronger and longer this uptrend continues, the greater in magnitude and speed (as in volatility, not timing) the Great Crash III will be. Hence, the coming Great Crash III is a Black Swan event?an improbable but colossal impact event.
The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.
Therefore, when contrarians are preparing for a crash, it does not necessary mean that they are predicting doom and gloom. Rather, they see the vulnerability of Black Swans and prepare for them.
Failure to see underlying causes
Look for underlying causes behind seemingly unrelated events. Try looking deeper than what is apparent and obvious and ask questions. Those who fail to see the turning points did not ‘join the dots’ together.
For example, in Why some believe a crash is imminent, we did mention about the apparent contradictions between rising stock prices and bad economic news. What is the connection? The answer to this question can be found at Zimbabwe: Best Performing Stock Market in 2007?.
That’s why we are very insistent on building up a strong foundation of theoretical framework. As we said before, faulty models lead to faulty understanding.
Finally
Do not get caught out at turning points. Be aware of the signs and be prepared.
