Current Economic Crisis Illuminating Path Ahead

Economy

Some very old ideas about investing have been dying a slow death for many years, losing ground in a survival of the fittest. Their weakness is being even more exposed now.

Charles Darwin’s portrayal of the evolution of biological species being a matter of the survival of the fittest is an idea that applies well beyond the realm of biology. This also a good way to understand the evolution of ideas, where the fitter ones survive over time and the less fit ones get left behind.

Darwin’s ideas don’t just speak to the survival of species, they actually apply more to the survival of various traits among species, where the better traits persist and those less effective diminish and eventually disappear.

The consequences of inferior physical traits tend to be more dramatic, where those who hold them are at higher risk of physical death, meaning that these traits become less and less likely to be passed on as the life span of those who hold them gets reduced. Inferior ideas such as those held by a lot of investors die a much slower death, where it can take decades for them to finally wake up to their inferiority, especially given that they are so widely held.

The concept of strength in numbers certainly applies to investing ideas, even though this involves a fallacy of practical reasoning, called the fallacy of popularity, which debunks the idea that the number of people that hold an idea has a bearing on its validity. If we decide investing ideas that way, instead of on their own merits as would be sensible, this tends to diminish and even preclude a proper examination of their merits and promotes misunderstanding and the poor decisions that emerge from this lack.

While there should be no need to preface a discussion of the evolving nature of investing today like this, the facts speak otherwise, as when we look at the ideas and strategies held by the mainstream, the biggest force that guides them is that of conformity and not deliberation. Unless we are prepared to abandon our desire to conform, we’ll never really get past this and will be prone to discard better approaches merely because they do not conform to the illusions we hold collectively.

This unwillingness to examine our ideas about investing critically is what holds investors back so much, and given that so many are in the same boat with them, they lack the needed contrast that would better illuminate their mistakes and have them at least asking if there is not a better way.

Like it or not, this contrast has been building over the years, albeit very slowly. As the information age has progressed, investors at least now become exposed to a variety of ideas that just turn out to be better, where this momentum of better education slowly results in a change of investor behavior, causing the divergence between the results of the better ideas and the inferior ones to widen.

A good example of how these changing beliefs can be to an extent self-fulfilling is the movement toward a better understanding of the role of momentum in stock prices, causing more people to recognize this and add to the momentum towards momentum.

Understanding stocks from a perspective of momentum might not appear to be that significant among those who really don’t understand the role this plays, with their perhaps seeing this as arbitrary, a fad, instead of perceiving the central role that this always plays. When we strip stock movements down to their most fundamental level, all we have left is momentum, which is not only the most basic force of price change, it is the only one.

All forces that are thought to influence stock prices only do so to the extent that they effect the momentum of a stock. If we seek to understand the movement of stocks, we cannot do so by trying to divorce our understanding of the actual process of cause and effect, how the things that we focus on may actually affect the market, the only place where these ideas matter.

This might not seem like a very important principle, let alone the central one of investing, among those who haven’t really thought about this very much, those who think that the idea of momentum being important to stocks is a recent development that may even pass. This goes much deeper though and drives all movement in all times, and even by definition, because momentum is how this movement is measured.

The force of momentum stands in stark contrast to how just about all investors view stocks, being satisfied to trade on much more narrow views of stocks, like their somehow being proxies for business results. It is not that business results don’t matter, as they clearly are one of the forces that acts upon momentum, but only one of several, and if we focus on this one thing, we’ll be doomed to an incomplete understanding.

This mistake runs very deep in the industry, to the point where it still engulfs it, where we people who are paid a lot of money for their advice telling how frightening valuations are now, where the fear has not arisen from objective conditions but instead from stocks being out of alignment with this proxy view of stock performance. What we really should be saying here is that the market is showing more optimism than we thought but they get to decide these things, not us.

As time has marched on, more and more investors are becoming at least a little wiser to the fact that some stocks simply do better than others because they are favored by the market more, in other words they have more momentum behind them. Momentum here is not the tendency for stocks that are doing better to do better, as this is just one manifestation of this force, and momentum itself encompasses a stock’s tendency to do anything, including notable underperformance by virtue of a lack of positive momentum.

As investors come to prefer stocks with better momentum, this in itself leads to an increase in positive momentum among the chosen stocks, and this is the force that we’re seeing build over the past years, and especially in 2020 when the stakes have been raised and the mistakes of choosing wrongly become magnified.

There are several ideas that are coming under more scrutiny this year, not the least of which is the actual role of fundamentals, both microeconomic and macroeconomic, upon the landscape of stocks. It is easier for people to get their heads around how distribution may affect microeconomics, where companies who fare better in downturns get more love, but seeing the stock market itself diverge so much from the macroeconomic crisis that we are in is even more difficult for them to understand.

You will always struggle to understand all of these things unless you understand that all of these things become decided at the level of the market, which always expresses the total effect of any and all factors that weigh in on stock prices. The ensuing result is the only thing that decides where stocks go, the degree and direction of their momentum.

This is not just an academic exercise, as being confused about this has real effects in the real world, the diminution of returns that result from decisions made not on the facts but instead arising out of a misunderstanding of what actually goes on.

The Market Needs to Lead When We Dance with It

Instead of trying to figure out what the market should be choosing, what path stocks should be following, this needs to start at what they are actually choosing and what path stocks actually are taking. What we tend to do instead is to choose other paths that we envision which start in opposition to the facts, and as our opinions further diverge from reality, we cling to them anyway, and pay the price for this.

This includes, and perhaps especially includes the tendency to hold positions too long, which includes both avoiding being in losing situations as well as accepting lesser positive returns. This also includes diluting our good positions with too many lesser ones in a pretentious attempt to manage risk better, which ironically adds instead of subtracts from the risks we face.

We end up in situations where we are betting against momentum instead of seeking to take advantage of it, where the market is deciding one way and we foolishly take the other side of this bet, with the deck stacked against us. This strategy is still the biggest one that is practiced out there, although this is changing, and is changing at an even faster rate with the current economic challenges that we face that is making the gap between the wrong approach and the right one even wider.

What would stock investing look like if we are able to strip away everything other than the idea that the market decides all of these things ultimately? Then and only then are we in a position to understand what really goes on because we are actually looking at what is going on. When we see the price of a stock or an index move a certain way, we now see that in of itself as the story, and while we may still choose to speculate on the why behind it, we always need to understand these views as being subordinate, and not doing so is the biggest mistake that investors and those who study markets make.

When we see stock indexes give up so little in the face of an economic calamity, or in the case of the Nasdaq, rising to all-time highs in the face of this, this is what the market has chosen, and whatever we believe that they should have chosen instead is both irrelevant and factually mistaken.

If we instead think that the tail should wag the dog, that economic or business circumstances should wag the behavior of investors, we’re going to end up confused a lot, because that’s not now the anatomy of this dog functions. The tail and the other parts of the body of this dog will move in the way the dog decides, and if it decides to wag its tail in delight as the Nasdaq has done when we think that it should not, the dog is always right and always gets to decide this.

2020 is serving to make this at least more transparent, accelerating this movement toward a better understanding of how stocks really work. The need to flee from stocks and sectors that are performing poorly now toward those doing better has increased notably enough that people are being forced into doing the right thing more now, and after they have been given a taste of the benefits of doing more of this, paying attention to results more and seeing the fruits of this labor manifest will become more conditioned.

Understanding stock prices from the perspective of supply and demand, from the decisions that the dog makes with his brain and not his tail, requires that we take a step back even further to view this from both a macro and micro level. The macro level here involves the total participation in stocks, where the micro level involves how all of the money that we have in stocks at any given time becomes distributed among the various stocks in the market.

We can measure both the changes at the macro and micro level in terms of market capitalization, where as the market cap overall grows or diminishes, there is more or less money in the market, and as a particular stock or sector’s market cap changes, there is more or less money in the particular stock or sector.

The economic principle that rules the value of stocks is the principle of comparative value, which pits the value of one approach alongside alternatives and distributes this value accordingly. An example of this in action is the influence of alternatives to stocks upon the aggregate stock market, where it is not enough to say that the market should be falling based upon economic concerns, as we need to account for where this money may move to otherwise.

This part is not hard for us to get our head around, and we might think that economic circumstances should be driving us away from assets that we find more suspect such as stocks and toward assets that we may believe may present better opportunities like bonds. Where we become lost is in thinking that this is somehow determined by objective forces instead of being decided completely subjectively by the market, and those who understand this one principle have a big leg up on those who choose to be guided by their illusions, leaving them so confused when stocks and markets behave in a way they find discordant.

People can see the grim economic conditions that we now find ourselves and just choose to remain in the stock market anyway, especially when they see a recovery underway like the one that we ended up seeing after the dust settled from the stock market panic that we saw not so long ago.

This choice to move to bonds more that many of us may think would be more appropriate is not left to observers to decide, as the market takes everything into account including people’s longer-term outlooks for these stocks as well as their personal preferences and then calculates whatever changes they feel appropriate, including simply flying in the face of whatever pretention that observers may hold.

The Market is Always the Sole Arbiter of Influences Upon It

The buck always stops at the market price for something and this is what is really missing from our preconceptions that so often diverge from reality. The sum total of the market cap for stocks is always grounded in the appetite of the market, where we may think that they should be eating more or less but it will choose whatever appetite for stocks it has at various points of time by virtue of its own will and its own will alone.

This is also the case at the micro level, the level of individual stocks, the distributive part of things that determines how big of a share of the overall pie of the total market capitalization that a stock may hold.

A company’s results may influence this to some degree, as well as macroeconomic influences, in addition to an assortment of other things. There are also various time horizons at work here, with some just looking to make a quick buck and others pursuing very long-term plans to keep investing in stocks and cash in on the long-term tendency for them to go up and help them achieve their retirement goals.

The response or lack of response that we feel would be appropriate tends to be overly focused on short-term traders, the ones that would want to step away during certain times, but there are others who are in the game for the long haul and may see pullbacks such as the one this year as an opportunity, not a failing. All of these views get thrown into a glass and shaken and the drink that is poured contains the sum of all this, embodying the “correct” market valuation with complete accuracy.

If we want to keep bidding up stocks with the economy in shambles, if we wish to keep bidding up a particular stock even though their business fundamentals at present may suggest that this be out of line with our understanding as well, we will simply do it, perhaps only because we can.

The best and only valid way to understand all this is to fully get the fact that stocks deal with facts and not norms, yet we still insist on understanding them in a normative way, the way that we think they should behave, and favor that over the way they actually are behaving.

We might think that we need to establish these norms to be able to predict future movements in stock prices, but to the extent that our predictions of how things should happen are mistaken, this leads us down some wrong paths that could be more easily avoided if we took a more humble and less pretentious view of our predictive talents.

There will always be the need for some predicting, but the mistake that we make is when we see our predictions not manifest but still insist that they should. We might think that stocks in general should be lower right now, we might think that some stocks are being valued more highly than we think that they should be, we might believe that other stocks aren’t valued as highly we think they should be, but being wrong needs to count for more than it does.

More people are waking up more and more to their illusions to some degree, and even a glimmer of light breaking through is preferable to being in darkness. You may only be able to see a glimmer of the truth from this, but a glimmer is at least a start.

The greater burdens that 2020 has placed upon us is serving to elucidate this gap between illusion and reality more, where the sun outside that we have tried to hide with our drapery of false beliefs has brightened and is not so easily kept out.

This is not necessarily a more difficult time to be in stocks, even though it may have become more difficult to maintain our beliefs about stocks that is still very prevalent but at least has been dimmed a little lately. There is still plenty of opportunity out there, and it’s the same opportunities that we have had all along, it’s just that the genuine opportunities have distanced themselves from the inferior ones more lately.

We want to be paying much more attention to going with what is working and become more prone to avoid that which is not working, and that in itself is enough to get us in the right frame of mind and on the right track. We ask far too many questions, but miss the most important one, if we are actually in touch with what is happening or not.

As we embrace this as a guiding principle more and more, we will be more and more likely to succeed. If not, we are doomed to repeat our past mistakes, where our ideas move further and further out of alignment with the real world and we pay bigger and bigger prices for them.

We can instead choose to join the growing movement to go with the flow more, to allow circumstances and not just beliefs that are so often mistaken to guide us, where we actually seek to make the most out of a situation rather than to oppose it and suffer the consequences.

We hope that this fairly abstract discussion has you at least questioning some of the tired old ideas that so many of us still hold, and especially the one that seeks to ignore the true power of the market to decide whatever it wishes and replace it with what we think it should be deciding.

Bruce Lee understood that the best use of power is not derived by opposing forces but using these forces to our advantage, where the force we apply is done in concert with these other forces. They swing at us, and we don’t just try to parry the blow but look to use their momentum in our favor. This applies to investing as well as martial arts, where we want to not try to fight the power of the market but instead use it to our advantage.

Given that investing Kung-Fu style is becoming more and more important all the time, where the right tactics become more rewarded and the wrong tactics get even more punished, learning to go with the flow is becoming more and more important. We need to come to a better understanding of this before we can properly fight this battle and achieve success.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

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