You see, it's all right, uncle when I'm sure! Then we go strong for all we're worth, don't we Bassett?...sometimes I have an idea, and sometimes I haven't even an idea. Then we're careful, because we mostly go down." - D.H. Lawrence, "The Rocking-Horse Winner"
At the present moment, I don't have a market opinion for the short or intermediate term. From the present moment to a random point 20 years from now, I'm confident the market will have gone up, but more modestly than many people expect.
The idea of an article on not having an opinion crystallized around the above D.H. Lawrence quote thanks to a comment I wrote to a piece by Ian Bezek. To Ian's generous-spirited piece detailing his worst market mistakes of 2016, I commented that we all make mistakes but the important thing is to make them in modest position size and cited the Lawrence short story. A commenter responded telling me that anybody quoting D.H. Lawrence in a piece on investing caught his attention and that I had earned a follower.
In fact, I think every investor would benefit from reading the easily accessed Lawrence story. Lawrence was not a money guy, but he does have some important things to say about money. He had a definite view of how money should (or should not) fit into our lives.
Lawrence thought liking money too much is bad for you. He believed that obsessive lust for money - "filthy lucre" - was a terrible and soul-killing substitute for the really important things like vitality, especially sexual vitality, and a deeper sense of wholeness and purpose. Freud had a similar view.
The family in the Lawrence story appears to have everything they need, but there is never enough money. Their house whispers the need for money, but when more money appears the whispers just grow louder. Have you experienced this phenomenon? I certainly have noticed it, in myself and others. If getting money just makes you need more, you are in a very unhappy rat race. Moreover, when it comes to investing, the compulsive need to feed your life more money is downright poison. You do better with investments when you are not coerced to do low-percentage things.
That's sort of an aside (but a really important one). Now let's drill down on the boy riding the rocking horse. He and the servant Bassett and ultimately, his uncle, operate as betting partners using some familiar principles. Lawrence apparently knew a bit about betting on horses. His rocking horse boy would have appreciated the famous Kelly Criterion for position sizing: Size your bet by "edge" over "odds," but take care not to overbet a strong hand, which can lead to "gambler's ruin."
The Kelly Criterion is a pretty good idea, especially when you're betting horses. I took William Poundstone's Fortune's Formula down from my bookcase to reinforce my memory and turned to the pages on Kelly's formula, which by the way uses the example of Secretariat. I saw to my amusement that I had written the first half of the above Lawrence quote on the bookmark.
Okay, then, bet edge divided by odds. But what's the "edge" right now? Not much, I'm afraid, at least for me. My private rocking horse isn't telling me anything definitive. Or maybe it's telling me too much.
What Does It Mean Not To Have A Market Opinion?
Not having a market opinion doesn't mean that you don't have thoughts about the market. I have plenty. It's just that they don't come together in a satisfactory way. It means that nothing I know about the market is sufficiently definitive to be a base for a heavy bet. Here are a few of my conflicted market thoughts:
- The market looks pretty expensive - not ridiculous like Japan in 1989, the dot.coms in 2000, or the Nifty Fifty around 1972 - but expensive enough to be trouble. A simple correction to average valuation would take a pretty good tumble. I have a very high level of conviction about that.
- The market may not be quite as expensive as it looks. We appear to be coming back from a two-year recession in corporate profits, especially among industrials, and there may be some catching up to do. Tax rates may be about to improve. That's all to the good if it happens. We're still expensive, though.
- I have no idea what event might bring the market valuation back into line. Nothing seems as out of whack as mortgage lending and default swaps were in 2008, or as tulip-bulb bubblicious as 1989 Japan or dot.com 2000. So what will trigger a major correction? Something eventually will. I have no idea what it will be or when.
- I think the several Republican plans for tax cuts seem pretty good for the markets, and probably for the economy. I think the odds for tax cuts getting written into law are pretty good. Trump needs to take some time off from tweeting and get it done, though.
- I think a massive infrastructure program is a great idea, especially if the Republican majority can be persuaded to do it without worrying too much about a budget deficit. (I know conservative old guys like me aren't supposed to be Keynesians, but the logic of it at this moment just sweeps me away.) I'm not secure in the odds of a major reflationary infrastructure package getting through Congress, however. I can't attach any sort of probability to it.
- As for the present economy, it is improving at a higher rate than in recent years but not such a high rate as to require a major tightening of monetary policy. That's good. How much longer can it chug along without a recession? I can't come up with a hypothesis of any value.
- A political gaffe on trade could be deadly. I can't handicap that one either, but the possibility is not trivial. A war or a constitutional crisis wouldn't help the market much either. I've lived through both as an adult (Nixon's resignation, Vietnam).
- The distance from best case to worst case is about as large as I have ever seen it, and the outcome looks rather binary. I can't game it.
I could analyze each of the above points in a much more nuanced and complicated way, but the truth is, I just don't know. My rocking horse isn't sending a clear message. My cold-blooded analysis isn't helping me much either, so it certainly wouldn't help you.
Gaming A Binary World: How To Hold Two Opposed Opinions
The test of a first rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function." - Scott Fitzgerald
First rate mind or not, I think this Fitzgerald quote is the key. What separates successes from failures is the ability to begin by recognizing that you don't always have a clear and single view. Therefore:
- Don't force a view. Accept indeterminacy. When you don't have an opinion, admit it. This should go without saying, but the temptation is great. Unless you're a quant outfit trading in nanoseconds, it's hard to function without a general view, but the situation doesn't improve if you force one. Resist the itch to take an action for its own sake.
- Have a clear understanding of your time frame. Can you stick it out with your portfolio through a tough time? The problem is more acute, of course, if your investment horizon is short or if you are likely to need cash over the short to intermediate term. The idea of staying the course works better if you are in your twenties, healthy, and employed.
- Value is likely to provide both a good offense and a good defense. A cheap stock is a stock which already has modest expectations, and thus less vulnerable to a broad market setback. If things go really well for a while, several major value areas are likely to be major beneficiaries.
- Instead of taking risky actions, use the moment to study. Keep looking at individual stocks and don't leave out the ones that look too expensive at the present moment. Maybe they will be available at a good enough price in a deep correction. Hold on to your sales resistance, though.
- Have an asset allocation that makes sense, and stick to it. I don't mean anything like the standard 60-40. I haven't owned a bond, other than I Bonds, in a decade. I've got nothing against bonds and would own them again if rates on the 10-year Treasury got up to around 4-5%, but not now. Bonds are a value proposition: you buy them for the coupon, and portfolio ballast. Other than that, you are speculating. You could be right or wrong. At current rates, I'll still take cash for portfolio ballast.
- Try to work out a strategy with which you will (1) survive a bad period and (2) do well enough for your own reasonable needs if the markets do well.
A Binary Portfolio For A Binary World
Around the middle of last year, I saw two things starting to happen that had nothing to do with Donald Trump. The first was that the REITs I had bought in the middle of 2015 had rallied so strongly that they were absurdly priced. The second thing I noticed was that the balance of economic indicators showed subtly accelerating economic growth, reflected in slowly rising interest rates.
Any uptick in rates would attack REITs on two fronts - competition from bonds and high dependence on borrowing to raise capital. I sold every last one of them during the first 10 days of August. I then bought the cheapest sector of the market, which happened to be banks. I wrote about it in an article which links to a real-time piece I wrote while making the trades. While I was at it, I wrote a deep in the money call on my large position in Johnson & Johnson (NYSE:JNJ) near the top tick. It was overpriced as a bond proxy, but I had large cap gains and wanted to keep it.
In part because of these two moves I had probably my best ever year in the market. I beat the S&P, slightly. The thing is, I held 50% cash throughout the year. I mention this not as a boast - I freely admit that I was more lucky than prescient, especially in the timing. I doubt that I will ever have another year that works that well. I write about it here because it exemplifies a strategy for binary market outcomes.
The strategy is pretty simple. In times like these, with treacherous uncertainties, have a binary portfolio. In my case, that means holding 50% in cash. I still do. With the rest of my portfolio, however, I take a few highly focused positions which should do well if the world follows the best case scenario. The groups and individual stocks are selected from the cheapest areas of the market for which I can make a strong case in a strong economy. The hope is that if everything breaks in a positive way they will do well enough that I'm reasonably satisfied with the result despite holding 50% in cash.
Here's an outline in descending order along with a bit of rationale:
- Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B): By far my largest position, self and family - close to 20%. Berkshire is the ultimate all-weather stock. It is highly leveraged to economic growth, especially industrial production and housing, but it is also well defended against downturns, almost never having a negative year in book value growth. Its best deals come in tough times. Yes, Warren and Charlie are mortal, but the market is on to that, and Berk is still the cheapest blue chip.
- Banks: I'm up roughly 40% on the sector since the middle of last year, but they don't seem overpriced in the way REITs were back then. I didn't buy the absolute bottom, by the way, which was four months earlier. If things heat up they'll do great. If the economy muddles along, they'll do OK. Better times are probably in their future either way. I own the big four in size and I'm sticking with them.
- Industrials: I own three, and around half of my position consists of embedded capital gains. They are no longer cheap, but they are cheaper than the market and have better prospects. They will do very well if the Trump program gets passed. And I hate paying cap gain taxes. I'm keeping them.
- Property and casualty insurers: Everybody hates them or just considers them dull. Their top lines are flat and slightly downward sloping, but they pay dividends and buy back shares so that per share earnings increase every year. A steeper yield curve would help a lot. Again, half of my position is now house money. I'm sticking with them.
- Home builders: My newest position. We are absurdly under trend in the building of houses and apartments. Millennials are going to become more like us, I think, and builders should profit big time. Maybe there is an economic downturn between now and the payoff. That's okay. It's a pilot position. I would add if a recession intervened.
- That Johnson & Johnson position: I expect to keep it when the calls I wrote expire worthless in mid-year - a nice short-term gain.
What I don't own: everything else in the market. Here's why. If things do go south, the traditional safe stuff - utilities, staples, etc. - won't help much. They may even be the downside leaders. If the economy heats up they will be laggards. The FANG stocks won't help either. Jazzy and expensive stuff will contribute PE contraction to any major decline. A couple of areas might surprise by hanging in there, but I like the sectors I own even in a downturn. Value is really the best defense. The one thing that really works in a downturn is cash.
I don't have a market opinion. I can't resolve the major uncertainties - from valuation to major changes in economic policy. I doubt that many others can either, including those on CNBC who have to present an opinion. Instead, I resolve to live with uncertainty - the existence of opposed outcomes to which I can't attach a probability. My personal solution is a portfolio which is likely to work well enough for me under either worst or best case.
A very simple but useful reference to bet-sizing is contained in the D.H. Lawrence story "The Rocking-Horse Winner." I recommend it to all of you. It contains a deeper message useful to all investors.
Disclosure: I am/we are long BRK.B, JNJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.