None of the following is investment advice. I recommend you listen to Frank Sinatra’s 1966 “That’s Life” album in full as you read this. Winchester Cathedral is a personal favorite.
The idea of depression, to a hard worker, is perhaps more important than the idea of success. Engineers at Facebook made the phrase “fail harder” ubiquitous in entrepreneurial circles, because at once it explains how to create, how to emote, and how to exist in your best state. Failure, as it turns out, is preponderant among all productive human stimulations, and for all destructive stimulations.
In this memo, in addition to routine market observations, I describe some personal observations as they relate to failures and successes. Although we all will respond to problems, the process of problem solving will resonate uniquely with each and every one of us, as will the results. Some of us will correctly be very sensitive to a situation while others will coolly say “So What?” Importantly, for humans to continue moving forward, we must confidently move forward into uncertainty, encountering and overcoming challenges, in both financial markets and in life. This constant striving is, by some accounts, the essence of humanity, and even though we react differently to the challenges, we all face them every day. That’s Life.
The world from here will be dominated by the media and volatility. Both of these things are among the greatest enemies of good investment decisions, as they should be. However, determining whether you are making decisions either with or against both of these enemies is imperative to profits in the next few years. Here are a few broad ideas I have at this moment – I don’t expect any of them to be correct or even sufficiently convincing, given the imperfect information that we all have:
Cash is king.
- Interest rates are up on treasuries, meaning that you can now buy a piece of the US that yields more than the stock market itself does. The risk is that treasury yields could go higher.
- Interest rates are unmoved for bank deposits. This anomaly seems to be the result of the Treasury’s massive balance sheet. Winding up that balance sheet deposited trillions with banks, which only raise deposit rates if money is needed to be brought in. Banks have virtually no risk of default, so there is virtually no interest paid on money. Moreover, the losses on loans banks made seem to be ultimately borne by the government, which is now winding down the balance sheet. The rise in rates reflects a higher default rate on the bonds it is selling. A year ago, the government bought trillions of dollars in bonds that banks issued at par. This year, those bonds are being marked down by about 4% – a discount the government is being forced to absorb.
- If/when bank deposit rates in the US rise near or beyond the level of the S&P 500 yield, investors will probably sell stocks to go to much less risky savings accounts. This will probably be the capitulation moment when businesses will be back in favor. Until this occurs, our economy seems to have poor fundamentals while cash appreciates with every move higher in the bank rates.
Tech is out
- For the past 15 years, tech has been a terrific investment. Whether that was the indirect result of standard of living gains or trillions of dollars of relatively free money, we nonetheless seem to be at the end of a cycle.
- Scaling growth using free money (where we were last year) is much easier than scaling growth using money that’s three to four times more expensive (where we are today). Typically, the end of a cycle manifests when many of the things purchased for growth (i.e. labor, machinery, inventories) have a steep drop in utility, so a fire sale process occurs. This is not a quick process, historically.
- Over this 15 year period, we have been convinced that growth must be subsidized by shareholders yearly – a money-losing company without stable, defined economics is O.K. This phenomenon is appropriate for very early stage investment, with valuations to match, considering the overwhelming risk involved. However, lately this very strategy has earned valuations that could only be imagined if the company were never going to be improved (i.e. perfection). It would seem that those valuations themselves reinforced the apparent soundness of those businesses as investments; for investors, for founders, and for employees.
- Confusing poor economics with perfection is a rare occurrence, and cannot last when money is no longer free. Some investors may stay confused for years, holding tech and losing money the entire time. We plan to avoid that pain.
Bonds are out
- Corporate bonds do not reflect combined actual and perceived risks inherent in macroeconomics. Quarterly reports prove that a business can go from strong to significantly weakened in only 3 or 6 months during this year. The fundamentals of businesses are eroding at the exact time that on the run corporates are yielding dramatically higher rates and those businesses are downsizing. Investing in corporate bonds is living in the fast lane so many different ways.
- All fixed interest bonds will be at risk of inflation, and at the risk of recession. Stagflation is the ultimate enemy of any bond, especially in the US, where we have roughly $13 in bonds for every $1 of cash (up from $11:$1 in 2020). Much of these bonds will simply disappear or be subject to the same fire sale process as described above.
Commodities are out
- Have commodities themselves ever been true investments? How are complete fundamentals truly known by any given market participant? And then, what about those owners that have significant control over the price of such commodities? And then, what about the volatility that can occur in the pricing, causing you to doubt the fundamentals you were recently so certain of? Any investor in commodities with perfect information must still ride mountains and troughs of volatility.
- Businesses deriving benefits or detriments from certain commodities are a less risky investment, but will ultimately have high correlation (+/-) with such commodities. Due to the historical volatility of commodities that geopolitical and macroeconomic risks represent, the volatility will be orders of magnitude higher than that of times of calm. Add in the factor that those businesses, unlike the commodities themselves, may have the same fleas as the other businesses described above, and the risks far outweigh rewards, in most cases.
Real Estate is out
- By my estimation, US real estate yields are slightly lower than the yields of the appropriate treasury benchmarks. This is not favorable for US real estate.
- Inventories seem to be increasing at the same time that rates are increasing. The demand that was pent up, waiting for inventory to rise, likely will taper off, leading to bargains. Those bargains will continue to stay depressed with a give/take on interest rates. As interest rates stay elevated, bargains will persist or become priced even lower. This is a major risk. Shrewd investors on both sides of markets understand the rate dynamics afoot today.
Very few things have favorable risk/reward dynamics at this time. Although this paints a dramatically tragic picture, what was investing like in 1983? In 2003? In 2010? Businesses at those times were relatively very cheap and warranted investment. The risk/reward dynamics were favorable, and earning a positive return on investment seemed much more probable than it would today, despite the significant drawdown in markets that we have already witnessed. These are hard times because making money is very hard, but we must remember how easy it can be to find profitable investments at points in time, too.
Furthermore, the “buy on the dip” mentality pervasive in almost every investment firm today saddens me deeply. Warren Buffett may be the originator of this idea that has become a Frankenstein. A good business that will recover from a current set of bad externalities is a buy, though Buffett basically wanted to know that the numbers warranted the purchase. Today, to say simply that “I believe Amazon (for instance) is a buy because it has dropped x% and it is a part of daily life” is intellectually lazy. With this process of thought, any given price could be appropriate to buy any given business so long as the buyer uses that business’s services every day. This is not how an investor should behave, and the laziness will cost people that blithely follow crowds into otherwise overvalued businesses that fail to render sufficient cash profits.
The catalyst for this memo is a failure that we experienced recently – a technical trade masquerading as a fundamental trade. 2022 has been the year of the technical trade; cash ($) has been the only true fundamental trade that has made money. In our “2022 Memo“, we noted this would be the case, but group think got the better of us.
First off, technical investing seems to be an oxymoron. Any given person is more likely to lose money than make money in technical trades. If you are right once with poor odds, the next time has the same poor odds, and you are just as likely to lose. No amount of research can improve your odds. Fundamental trades are probable if performed correctly. If you are right once with good odds, the next investment has the same good odds. Better research increases your odds. Research aside, the skill that fundamental trades require most is patience in overcoming volatility. It doesn’t take a genius IQ. The patience is investing when you have an obvious positive return. It’s avoiding buying other things. It’s avoiding buying the hot stock of the day. It’s avoiding selling if the trade goes against you. It’s avoiding media and instead only looking for numerical facts like earnings reports.
For many years, I have internalized these concepts, but after I hired analysts to form ideas, I quickly found how easy it is to be carried away with the herd. Our hypothesis began as “Cash will outperform all other assets” and finally became “Businesses with quickly eroding fundamentals will fall harder than good, stable businesses will move up.” We moved from a hypothesis of fundamental analysis (a hypothesis on what an asset will do) to technical analysis (a hypothesis on what a price will do), and invested accordingly. Virtually every day this year, we discussed the positions – whether to close the positions, increase the positions, or do nothing. That level of groupthink caused us to become too close and we continued through adversity despite that very adversity probably proving our hypothesis incorrect. We could write it off as a tough year, but how can you learn from your mistakes if you do not take adequate responsibility for them?
The failure was widespread, and we all lost something very dear during the several months’ testing period. The lessons, as is the case with most failures, are myriad.
- Learning more about what you don’t know to be sure of existing uncertainties
- Refraining from discussing investments with people unable to define probabilities
- Adhering to strict risk management standards, despite any team member objections
- Being thorough in hiring and promoting team members in decision making roles
- Being more cautious (“reducing volatility”) when investments are less probable to work out.
- Learning what it feels like to be overstimulated.
Most importantly, since cash was the only good investment going into this year, we found stimulation in the wrong places. For a business owner to pay dearly for employees to be around, it’s easy to be a penny wise and a pound foolish while investing. This was the situation I found myself in earlier this year, trying to improve upon my maudlin managerial skills, thinking that team approaches can only be additive to a business. Having experienced the resultant failure, I conclude that, for my business, investing successfully and creatively requires the removal of all static and stimulation. Investing can only involve facts.
Creative ideas are hard to come by, which is why they are the most valuable (or destructive) forces in the world. Those that commit to creating ideas never stop – they are always creating because they are never satisfied and probably never happy. This is not a cause and effect situation, but a natural phenomenon. The true cause of constant creativity and constant dissatisfaction is the human brain. The brain, of course, is often our worst enemy in creative pursuits.
I believe my most painful failures in business have revolved not around investing, but around attempting to form agency connections. Some connections, like those with clients, stand to benefit from my singular, iconoclastic approach to investing, and others, like those with employees, favor groupthink. Many people thrive on groupthink, but I have not found that ability yet; frankly, investing as part of a team seems to be one of those “expert” skills that requires years to master. I regrettably accept this to be a current shortcoming that I intend to improve upon. Groupthink ineptitude is not uncommon in business and among active investors, who are typically singular maverick types.
For all of the failures this year, groupthink has been the most significant, or at least naivety around my abilities therein. However, is groupthink truly effective as it relates to investing? A hypothesis: “An average individual is able to perform investment management more capably as being part of a group.” My ultimate conclusion on groupthink, and the purpose of labeling myself “naive” is that this hypothesis cannot be proven objectively through trial and error. Those that perform more capably in a group probably will end up in a group. Those that do not, will not. For me right now, I believe this is an appropriate reaction to the failure of groupthink: patience.
We all overcome failures, because what else can you do? When you believe the world is impossibly difficult, and every day your brain finds new evidence to corroborate, overcoming a challenge is never harder. But for the person that understands failure and your brain’s reaction to it, challenges are an opportunity to develop further emotional discipline, understanding that you have a greater choice than you realize in how you react. Investing on behalf of others, like running any business, requires temperament more than it does IQ. The smartest people will make the same mistakes as anyone else, but the reaction will dictate business and investment success.
Recognizing euphoria and despair is the true competitive edge for the best investors and business owners. This cannot be learned in any book. Early experience will show swings in confidence levels, which tend to normalize and increase to new heights over time. Ideally, we would be consistently confident in times of euphoria and despair. That confidence is necessary to be certain in an uncertain world, discerning when new ideas may be good and may be bad.
The mind of a business owner delivers wonderful, elegant ideas that motivate production on behalf of society, but also overconfident thoughts in euphoria and very negative thoughts in despair. The brilliant thoughts arrive from the same place and just as easily as the other thoughts do. Experience tells you which thoughts are good ideas and which ones aren’t. How can you make such a distinction without experiencing failures in judgment? Not just failing, but expecting to fail… is the hardest task of an entrepreneur, who makes decisions every day and is constantly accountable to those decisions.
In golf, if you miss a short putt, that was your failure. You didn’t read the line or stay down on the putt correctly. You can let it go or you can determine what went wrong. You can train your mind to make a perfectly coordinated stroke next time. How many of us really do that? How many of us just don’t want to do the work? To be okay with failing? How many of us blame externalities like the putter, the green, or the wind even? Anyone that does this will never improve, because they conclude that luck had more of a factor in the failure than it truly did. Those people will be responsible for failing, but will blame something else instead of appropriately adjusting to whatever externality caused the failure. A final cadre of golfers will mark the putt as having been made, completely in denial of the problem. I scarcely need to tell you how problematic such behavior is, but altogether quite common in both investing and in life. It’s easier to lie about our shortcomings.
Kobe Bryant famously used to say, “It’s not the destination, it’s the journey. And if you can understand that, then what you’ll see happen is that you won’t accomplish your dreams. Your dreams won’t come true. Something greater will.” I believe Kobe would have liked missing the game winner just as much as making it, because if he misses it, it means he has more to work on. If he made every shot, plays every game perfectly, he never fails. If he misses just one shot, he is still on his journey.
Performing any task includes an element of uncertainty, which plagues the mind of uncertain people. Determined people, however, expect the uncertainty and the ensuing challenges those uncertainties might bring. Investing today seems more uncertain than in any other time in history (isn’t this always the case?). Importantly, making any investment requires that you are both certain about a result, but also expect a level of uncertainty in your decision. This is also known as defining a probability. I’m sure this is a shortcoming in human beings’ ability to invest well – we are paralyzed by what might happen instead of using today’s fundamentals to model probabilities.
If you convince yourself it’s a bad idea, even the best fundamentals and probabilities can’t make a difference. Similarly, if you completely believe something is a good idea, even the worst fundamentals can’t make a difference. With any luck, you will move away from convincing yourself, and toward allowing probabilities to convince you, failing every step of the way.
Failures around important decisions can be devastating, but failure is necessary. Everyone will have those failures, but only the strong will push through. When you fail while you are leading people, you have no choice but to own that failure. Problem solving is the most stimulating process for creative people because the stakes are impossibly large and there will be collateral damage when failures occur. Those damages affect others, not just yourself. And you are responsible for it all.
Failure stimulates the mind possibly more than any other situation, causing a response, which can be productive or counterproductive. Many creative people are self-titled “workaholics”, and while some can continue focusing in productive ways, others become counterproductive and even die young, trying to find the ability to produce like they used to. Creative, thoughtful people are prone to burn out (i.e. mental injury), and history is littered with very bright flames that have burnt out, seemingly refusing to rest long enough to avoid mistakes. Working through burn out is obviously counterproductive but not obvious to understand. Experience is the only tell for when your brain is burned out, and the burn out threshold certainly must be specific to each of us.
Mastering the balance of stimulation and productivity seems impossible, but there are examples of hope. Warren Buffett’s process is enigmatic – he seems to have endless energy but does very little to stimulate himself. He’s able to manage vast sums without showing normal emotional responses. Buffett has always been an archetypal investor to me, though not because he makes a lot of money, but how he is capable of managing all that money and at the same time, doing almost nothing else. He has such little stimulation in his life, and yet has so much ambition to produce.
Observers of Buffett often call him out that for his first decade or so, he bought and sold stocks like a trader. In his mid-30’s, Buffett changed his approach, coinciding with his takeover of Jack Ringwalt’s National Indemnity. Throughout the ensuing years, Buffett’s annual reports included updates of National Indemnity moving into new areas of the country. Thus, Buffett found stimulation in his work, away from being a trader, and still more productive.
The evil side of finance may be that illegal price manipulation is the true pricing mechanism, but equally bad is the abundance of such short term stimuli. I often wonder how much tech founders today are driven to destroy their customers in order to make their own lives better. I remember hearing about Facebook as a sophomore at the University of South Carolina. Life suddenly revolved around it for many students. 15 years later, try asking any user of Facebook two questions.
- Do you believe Facebook was founded on the premise of making profits by providing users short term dopamine boosts?
- Do you believe that Facebook currently exists to make profits by providing users short term dopamine boosts?
The first answer is normally yes or no, but the second answer is nearly unanimously yes, based on my own experimentation. Research has proven that social media use provides stimulation not unlike that of banned substances like cocaine or heroine, but Facebook, for example, continues on without many barriers to use (i.e. relatively unregulated). Facebook seems to exist to destroy unsuspecting peoples’ ability to create and produce solely for economic gain.
The evil is not Facebook itself, but that billions of people have no defense against what is a business driven to enrich itself by tricking people. And while these conclusions may sound accusatory, they only serve to show how hard it is to overcome challenges.
Trend following algorithms have gained importance to ‘ensure market liquidity’ in recent years. By definition, such an algorithm “Attempts to identify developing price patterns with this property and trade in the direction of the trend if and when they occur. They use only the current and historical price of the asset to make trading decisions and the approach can be summarized by the expression, ‘follow the herd.’”
We now have (evidently) legal processes upon which large amounts of money can create a trend and have many, many billions of dollars using trend following algorithms follow, moving prices in that same direction, completely irrespective of the fundamental reason for the move. If a local gas station raised prices by 10% and all the other gas stations followed that trend, irrespective of the gas price, that trend seems to reward gas stations with an artificial profit margin and hurt everyone else. This process, coincidentally developed by gas stations decades ago, is called price fixing and it is illegal. And yet, such things are fair game in finance where trillions are at stake.
Similar to the Facebook harangue above, these statements are not accusatory*, but educational. This is what goes on and we must endeavor to understand it. Also like Facebook, the government cannot and will not regulate these things. It is what it is. To think – all you need to do to make 100% per year of returns is to have tons of money, irrespective of fundamentals…. Of course, I then wonder if institutions with giant positions to unwind in lousy businesses call those deep pockets and ask them to create a trend in those stocks so they can actually profit while selling. This sounds tongue in cheek, but it seems to escape regulation, so why not utilize it as a bona fide strategy?
*However, mental health is certainly at risk for all of us. Anything that continues to encourage us toward addiction is deleterious of mental health. Unfortunately, Facebook and it’s counterparts in other parts of society are too complex to regulate, but are also a serious threat to the human brain if not checked.
Trillions of dollars don’t exist in dollar amounts, but they do exist notionally. The equity swap market is over $400 Trillion, and the rates of interest are startlingly low. In technical terms, if your goal is to trick these trend followers, be they human or algorithm, you could take a three month horizon and lever up 100 to 1 at an annualized rate of about 4%, or 1% over the horizon. If you are able to move the market more than 1% over that time horizon, you make a killing. Trend followers exist not only in the general market, but in individual assets like stocks. So on a much smaller scale, the same economics are true, with the addition of market impact as an expense.
An important conclusion I have likewise drawn is that the random walk is proven. If such algorithms for pricing are in control of market valuations, I nor any of you will know what they are. As frustrating as it is that “the rich” probably control valuations in seemingly unethical (if not illegal) ways, traders will never be successful. Investors that are cognizant of these things, completely expecting volatility to be pronounced in any short period of time will be successful. As stated earlier, the enemy of fundamental investors is volatility.
An example of just how easily market timing is, we look at the experience of two prominent traders.
In 2000, Julian Robertson (Rest in peace), at the time one of the richest people alive, closed his entire $22 Billion hedge fund after 20 years due to what he would vaguely refer to as a short squeeze. The very week following his defeat, the Nasdaq dropped 10%, with Robertson saying, “This would have been the best week in the history of our fund.”
Ironically, while Robertson was short the Nasdaq and closed everything out 2 days from the high of the Nasdaq in March 2000, Stanley Druckenmiller went long the Nasdaq on almost the exact same day, causing multiple billions in losses in the following two months. Druckenmiller, today one of the richest people alive, closed his entire book of nearly $10 Billion after the loss, all but told clients to withdraw their money, and spent 4 months without communication in Africa. Neither one seemed to know what was happening in markets – Robertson was trading based on fundamentals while Druckenmiller on trends. In August of this year, we were in a similar situation.
Long story short, I incurred a failure that I intend to learn from, both in personal and professional terms. The lessons that I have encountered derive from my interpretation of the failure. Whether they are true, false, probable or improbable is too difficult for any of us to say. The stimulation to create such scenarios and the scholarly effort to continue digesting negative feedback to create these scenarios was not easy. I could choose to believe I was a poor thinker, and just give up. Or I could come up with scenarios of how I could have been wrong and learn from that, thinking better and failing better next time.
There are no failures, only challenges
Failing over and over without giving up is very hard work. The only people that can do such things are people that can’t have it any other way. It seems counterintuitive that you would spend more time failing in discomfiture than working in comfort. But entrepreneurialism is almost exclusively problem solving and thus thinking through both expected and unexpected challenges.
Burn out, which is the thinker’s equivalent of a serious injury, is the risk to failing over and over again and the risk to entrepreneurs. Having unrealized losses in your business is much different from realized losses, which once realized bring almost all of the pain instantly. In such situations, we must move on to something else for a while. Pushing through burn out can compound the losses we have experienced. Mental health is at risk if you do not rest appropriately after burning out. Just look at how Robertson and Druckenmiller handled their failures. Truly, burn out is a kind of failure just like all the others, but overcoming it requires a much different remedy than saying, “Thank you, may I have another.”
Burn out seems to be directly correlated with making bad decisions, since in burn out, your ability to logically decide erodes in favor of emotionally driven decisions. This is called “tilt” in certain circles and increases your risk of compounding mistakes. Being relaxed, contrariwise, seems to increase logical judgment at the expense of emotionally charged judgment. Of course, these are hardly provable, but probably true.
Basically, nothing really affects the path of the person committed to getting better at something. That putt might never go in, but he will keep trying for perfection. This is why in failure and success, a creator should have a consistent baseline of confidence, even if a given failure is particularly destructive. Creators will continue working and striving, because they get enjoyment from the journey and not the reward.
What does that look like? Well, you just spent 15 minutes experiencing it first hand by reading this.
Finally, how much of your daily life is your choice? Are you choosing how to be stimulated? Work without financial gain is just as important to our brains as work for financial gain. Social rewards (friendship, peace) may be more important to you than money ever could be. And the work that yields no benefit other than financial gain is destructive. Certainly it’s better to do something you love for no money than something you hate for money. But what is your day comprised of? How much of it are things you really are stimulated by appropriately?
The end goal should not matter – the striving does. You ask yourself – will I ever be satisfied? Well, in fact, you were continuously satisfied. The person that’s comfortable in life is life’s biggest loser because that person doesn’t understand the joy in life is in struggling. If you are comfortable, you aren’t striving, your brain isn’t stimulated sufficiently, so you may as well be dead. It’s never how you win or lose, it’s how you play the game.
Although it’s hard, the prerogative for creative people is to keep going, despite all challenges, including critical review, illness, personal loss, and anything else. The creative person has a duty to mankind not only to create, but to effectively have unstoppable confidence and to never falter.
So here I am, hungry, exhausted and dissatisfied… completely happy. It’s painful to keep going, but it’s the only choice any of us really has. If not, that’s death.