By LEWIS JOHNSON – Co-Chief Investment Officer | May 6, 2015
“The only thing we know about the future is that it is going to be different.”
The business of investing is a strange business. It utilizes all the modern tools that one would expect: computers, spreadsheets, detailed financial modeling, earnings forecasts, research trips and background fact checking. This is the science of investing. We have highlighted in these pages many of the techniques that we use, such as replacement cost valuation (“From the Analyst’s Toolkit: Replacement Cost Valuation,” 06/11/14) and how we think about cycles (“Making Volatility our Friend: Trading the Kitchin Cycle”, 05/28/14; “Revisiting the Inventory Cycle”, 10/01/14) as just a few examples. But the science of investing is only the beginning.
Investing, like most fields, has an art to it as well. The art of investing is to take objective scientific data and with it to drive the most insightful and impactful investment strategy. It is in the art of investing that creativity and experience matter the most. The best investment results come from the successful combination of science and art. In today’s “Trends and Tail Risks,” we explore the art of investing by illustrating how we can use what is known to intelligently guess at what is unknown. We do so by listing what we believe are among the most widely-held beliefs in the market, and examining the potential for the opposite case, as I explain below. This is the art of contrary thinking.
The Art of Contrary Thinking: Asking Better Questions is the Pathway to Better Answers
Investing is the most rewarding when we successfully position our investments now to profit from what we anticipate in the future. But how to anticipate an uncertain future? Thankfully, there is one surprisingly easy shortcut – we can be creative! We can gain insight into an uncertain future by examining the most widely-shared beliefs held in the marketplace – what is widely “known.” Once we identify these widely-shared beliefs and opinions we can increase our odds of success by asking the opposite question: what set of circumstances would confound current thinking? This is the hidden secret to more effectively forecasting an uncertain future.
The key is to find a way to ask a question that you can answer rather than remaining stuck on the question that you cannot answer. This contrarian secret lies at the heart of an analyst’s progression from a novice to a more seasoned observer of the market. It’s effective because the most widely-held views represent the prevailing opinion of most people hence the market has already incorporated these assumptions into market prices. Just because this is simple to do does not mean that it’s easy!
What Everyone Knows Is Often not Worth Knowing!
Below is my list of what I believe are among the most widely held views in the marketplace. These are events or relationships that are almost universally embraced.
Everyone knows that:
(1) Gold’s role as a traditional store of wealth is dead. Larry Fink, the CEO of Blackrock – the world’s largest asset management company – made this point at a conference keynote he gave on April 20, 2015. Fink suggested that New York real estate or the fine art market were better alternatives.
(2) The now five year-long commodity crash – a greater than 40% decline of the equal weighted CRB index (CCI Index in Bloomberg) – proves that commodities – and many emerging markets that produce them – are dead forever.
(3) The U.S. recovery is (finally!) self-sustaining. The Fed will definitely hike interest rates this year – and certainty won’t have to resort to quantitative easing again in the near future, if ever. U.S. bonds are a terrible long term investment.
(4) The U.S. dollar will continue to strengthen relentlessly as the Fed tightens monetary policy while the rest of the world struggles with lackluster growth.
(5) A stronger U.S. dollar would definitely be bearish for gold prices. Gold is merely an “anti-dollar” bet and there is no way that gold could rally while the U.S. dollar was rallying at the same time.
(6) U.S. economic growth will remain robust despite the negative effects of a strongly higher dollar, the Fed’s intended rate hikes, and the competitive devaluations of our trading partners.
(7) Greece’s sovereign debt problems are definitely “contained” and – if Greece is really forced to exit the Eurozone – the authorities can manage that transition smoothly and do so without any possibility whatsoever of contagion to other EU sovereign debt markets.
(8) Volatility will remain low as quantitative easing and stronger and more powerful unconventional central bank intervention prevent any bad things from happening to the financial markets. Global debt levels that continue to grow, now exceeding those of the last financial crisis, are irrelevant and do not represent a systematic risk.
(9) The high yield crash in the U.S. that began after the inventory cycle peaked late last summer (“Is Credit Quality Peaking?” 08/06/14), will remain isolated only to high-cost energy producers and has little risk of spreading to other sectors.
(10) Rising international tensions (U.S. vs. Russia, Saudi vs. Yemen + Iran, Japan vs. China) will remain isolated and have little risk of escalation or contagion into broader or longer-running military conflicts.
Contrarian Implications: Hints at an Unexpected Future?
First let me say that many of these views that have come to be widely held now were once themselves contrarian views! These events have already transpired – many of which we anticipated. For instance, we have long warned of a decline in commodity prices (“The Most Important Question in Investing Right Now”, 07/02/14; “Unsustainable Steel Premiums,” 09/03/14) and of a peak in credit quality (“Is Credit Quality Peaking,” 08/06/14). More than a year ago we began to warn of problems in Greece (“Big Problems Start Small,” 05/21/14; “Ghost of Invergordon?”, 06/04/14). But again one of the hardest things that we as investors must do is to be willing to change our minds once our views are embraced and thus factored into market prices (“Unexpected Change”, 03/25/15; “The Constant of Change”, 04/29/15). This is why we study cycles – to avoid obvious errors and to understand unexpected change before it happens!
A few common points leap out from the list above. They tend to cluster around a few bigger themes. First, a lack of concern about overindebtedness in general – whether it’s in the U.S high yield market or in Greece. Second, conviction abounds that gold is dead and commodities are too. Emerging markets, much like gold and commodities, are now irrelevant and doomed to continued underperformance. Third, that tomorrow will look like today: peace will prevail despite periodic but isolated flare-ups. Fourth, that confidence remains high that the world’s central bankers are fully the masters of all events. Disciplined contrarians who practice the art of investing will take the opportunity now to examine the opposite of these consensus views for evidence of a turn in the fundamentals. Few will do this. But for those who trouble themselves to do so I can promise that this time will be well spent!
The art of contrary thinking can be a powerful tool. This subtle technique of finding a way to answer the question that we can answer is one of the hallmarks of a creative analyst. This is one of the key ways that we seek to understand what is unknown from that which is known! This is a key method by which we bring all the resources we can to bear on the question of investing.
This art of contrary thinking is an essential ingredient to the most successful investment results. But the final – and most essential – ingredient is often the hardest to come by: patience! Such a combination is the goal of all of our research efforts.
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