Business

What the Big Short Can Teach You About Investing

My kids have the mental age of ten and eleven year olds, because, well, they are ten and eleven years old. So they fight pretty much constantly. When my son wants past his sister in the passage way and she’s “in the way”, he hasn’t yet formulated the reasoning to patiently wait for her to move and instead shoves past sending her into the wall. She, not having developed a cogent argument why this shouldn’t take place, whacks him.

Hard at work here are primal responses. Engaging the most developed part of our brain, the neocortex, which reasons and solves problems simply isn’t happening here.

Primal instinctive responses are the most common responses since they require almost no thought process. For instance:

  • Man sees lion running at him. Man runs away.
  • Man sees neighbor with new Porsche. Man wants it.
  • Man sees pretty girl in bar. Man wants to get frisky.
  • Man sees stock market going up. Man feels good, buys more.
  • Man sees stock market going down. Man feels pain. Man sells.

The reason that asymmetry exists in the world is, I believe, in no small part due to the overwhelming majority of people in any given country at an given time operating purely at an instinctive, primal level.

This asymmetry is representative in the distribution of wealth globally. The 80/20 law otherwise known as the Pareto principle remains pretty darn constant across time, and geographies, and exhibits itself in both nature as well as human endeavours.

The easiest and fastest fortunes made in the world have been closely tied to this phenomenon.

Case Study

A few weeks ago, I did what I only ever do on airplanes – I watched a movie. The Big Short. It is based on the book by Michael Lewis, which in turn is based on the story of several of the players in the creation of the credit default swap market and betting against the CDO bubble.

The story provides yet another (brilliant) example of this phenomenon.

Consider the reasoned, thoughtful, and decidedly non-primitive Michael Burry. Burry, unlike the overwhelming majority of his fellow primates realised that 1 and 1 could not equal 4 squared even it did have a ratings agencies’ bow and ribbon on it.

The overwhelming majority of the investing market, on the other hand, hadn’t thought much about it at all. As with most things which are entirely unreasonable but still accepted, the US housing boom began with sound fundamentals.

Securitizing assets and selling them is what Wall Street does. And so Wall Street did just that. They packaged up mortgages into bundles and flogged them to pension funds, mutual funds and various other mindless investors. Don’t get me wrong. Securitising mortgages isn’t a bad thing per se. Liquidity is increased, and capital can flow more easily between buyers and sellers.

The problem arose with what to do with those mortgages which were subprime or crap. No problem. The CDO squared solved this problem. Just take all the garbage that nobody wants, repackage it into new CDOs which, once blessed by rating agencies, looked just like the original “prime” CDOs and voila. The institutions, engaging their primal brain, bought them without bothering to look inside.

In the end both the debt and the equity landed up being worthless. Garbage is garbage no matter how you dress it up.

Now none of the above should be news to you.

Michael Burry made out like a bandit not because he shorted garbage but because he shorted garbage which was mispriced.

Just as my kids will thump each other instead of thinking through a reasoned response, the majority of the market will react to situations with a primal brain failing to think things through. The adult mind using only primal instincts is no different from my kids. Actually, it’s likely worse.

Furthermore, when asymmetry presents itself as it did with Michael Burry, it’s human nature to seek solace in the opinions of others who may share the view. You’ll almost assuredly fail to find it. Being social creatures, it’s only human to look for kindred spirits. Being alone is not a natural tendency. Hermits are not the norm.

There are a couple of notable takeaways from the film.

Firstly, Burry and a number of other characters identified not only the fraud but the mispricing of risk which presented such asymmetry. This is, of course, how 489.3% returns (the return generated by Burry’s firm Scion Capital between November 2000 and June 2008) are achieved.

The other takeaway is that the bankers involved should all have landed up in jumpsuits, allowed out of their cells only for a moments man-love in the showers. They, of course, didn’t and instead paid themselves billions in bonuses but that’s another story.

This is how the world works. And so it’s better to look for where the 20% of the market has the highest probability of returning 80% of the returns. Hint: it’s found where asymmetry lies.

In no particular order of preference right now we are researching and interested in:

  • Sovereign debt: What feels like a lifetime of central bank intervention has created a debt burden of proportions never experienced before. As we near the end of the debt supercycle this remains one of the most compelling areas for us.
  • Currencies: Short yen and remnimbi. Long US dollar as the USD carry trade unwinds.
  • Decimated resource markets: In particular uranium, precious metals, copper and zinc.
  • Artificial intelligence: Automation of knowledge work.
  • Synthetic biology: Gene sequencing really coming into its own.
  • Blockchain: I’ve previously spoken about this here, here and also in our Bitcoin and blockchain report.
  • Robotics: Exoskeletons, remote physical manipulations, manufacturing, healthcare and surgery, and of course basic chores and activities such as food preparation.
  • 3D printing: I’ll need an entire report (or 5) to cover this one. It’s coming and fast.
  • Iran: Yes, Iran.

You’ll notice that exactly NONE of these fit into “standard portfolio construction”. You’ll probably also notice that there is ZERO interest in mutual funds, indexing, or any of the nonsense preached to us in four walled institutions comically referred to as “higher education”. The 80% can gladly have all that.

If you, like us, are focused on harnessing the power of the 20%, then make sure not to miss out on our future articles on the topic.

– Chris

“Truth is like poetry. And most people f**king hate poetry.” – From the Big Short movie

 

The Big Short Steve Eisman
The Big Short