The Palindrome (Soros) once said, “The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.”
That last part is very important. Do you know what Soros means when he says the market is wrong because it’s biased about the future?
I’ll tell you. It’s an important concept to understand. And a helpful mental model to use in today’s choppy market action.
Klarman 2017 letter on
- the danger of Chinese leverage
- Discipline while value investing in bubby times
- Value investing is not dead
- Radicalization of politics
- Dangerous FAANG valuations
The market is supposed to be a forward discounting machine. It’s supposed to look out into the near future and make judgements on things like revenues, margins, earnings, inflation, the discount rate, potential risks, geopolitical shocks etc… and then make bets on what the proper value (the price paid today) is for those future cash flows.
That’s no easy task… it’s a lot of things to take into consideration. The market and economy is a complex beast. There’s a lot of unknowns and unknown unknowns. And like the great sage Yogi Berra once said “It’s tough to make predictions, especially about the future.”
To top things off, we (as in, we humans) abhor uncertainty. We can’t stand it. It drives us bonkers. Especially if it’s uncertainty surrounding something that’s a strong emotional trigger — like our finances or the stock market.
So here we have a problem. The future is hazy. The market is complex. The future path of the stock market is hazy and complex, i.e. it’s uncertain. Humans hate uncertainty. Round peg + square hole.
But the human mind is inventive when it needs to be, especially with the right incentives. Like making a lot of money in the stock market.
So to get around this seemingly intractably uncertainty-judgement issue, the majority of market participants simply extrapolate the present into the future. They take the hard numbers; the revenue growth, margin trends, and current cash flows. And just extend them out a few years. Boom… problem solved… no more uncertain future. Good earnings today = good earnings tomorrow. Money in the bank.
This is called anchoring. It’s a cognitive bias where we overweight the first or most easily available information when making judgements. It’s a useful heuristic and works pretty well, most of the time. Especially in markets. Financial and economic data tends to trend once it gets going. Kind of like Newton’s First Law.
The problem is, markets are reflexive. Meaning, our observations of the market affect the market itself, which in turn affects our observations and so on. You smell what I’m cooking?
This manifests itself in situations like the following.
The longer we see positive earnings growth, the more market participants begin bullishly extrapolating this earnings growth into the future. This results in the buying of more stock, which drives valuations up, and thus creates a market that’s now more incentivized to maintain and propagate the bullish narrative… and more importantly slap on cognitive blinders to new info that may threaten this narrative.
And so the narrative and the market form a self-sustaining feedback loop that goes on and on. It occasionally gets tested by disconfirming evidence. Each test it survives, the stronger the reflexive relationship becomes. As each dip bought leads to more confidence that so to will the next one and the one after that. Extrapolation ad infinitum…
This is why Soros said the market is always wrong because it presents a biased view of the future. The market is always biased in the direction of the established trend. Because it utilizes anchoring and extrapolation to form judgements instead of objectively and equally measuring the weight of available information.
And like I said, this works most of the time. But when it doesn’t, it really doesn’t…
As traders we always need to be cognizant of the trend. As well as the key data points that are the foundations of the driving narrative of that trend. But we also need to objectively look out into the future to see if any freight trains are headed our way that could derail the narrative.
Just the process of gaming numerous potential scenarios is a valuable exercise as it keeps our minds fresh, open, and unwedded to a single narrative or outcome.
Market Wizard, Bruce Kovner, attributed this process as one of the main reasons behind his enormous success. He said:
I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen. Second, I stay rational and disciplined under pressure.
What we’re talking about here is playing the game at Keyne’s second and third levels… Playing the player… Understanding what the market is focusing on and what exactly is being priced in. Then weighing that against the incoming data and gaming alternative futures to the one the market is focused on and thinking about what catalysts could trigger a phase shift.
Is this easy? No, of course not.
But there are a number of tools and models we can use to make this scenario gaming a more fruitful exercise. One of these is to focus on the second-derivative of data. That’s the trend in the rate of change instead of the trend in the absolute number.
This is important because trends lose steam before they turn. The market focuses on the growth — it wears the bullish blinders — while we want to keep our eyes peeled for a potential slowdown, or a change, in that growth. This will tip us off to a coming trend change in the data. A trend change that could destroy the narrative and cause a phase shift.
This is why we look at year-over-year data versus absolute numbers. It’s not the absolute level it’s the relative rate of change over time that matters.
And this brings us to an important point in how we should think about potential future outcomes going forward. Since it’s the relative rate of change that’s important, then the base period in which current data is measured against (the prior year in year-over-year) is pretty important. It’s essentially a hurdle. A low hurdle is easy to clear. A high one and the markets likely to trip.
We’ve benefited from having a low bar over the last few years. The goldilocks economy, of low growth and low inflation, kept expectations low which made for an easy hurdle. But with the recent tax cuts and a globally synchronized growing economy at our backs we’ve seen earnings growth, and expectations, jump.
Just look at the chart below. Consensus estimates have earnings growth peaking in the 3Q of this year.
Simply put, after this year we’re going to have a HIGH hurdle to clear. And current expectations are for this global synchronized growth trend to continue. Remember, current trend extrapolated ad infinitum… But will it?
While growth here in the US remains strong, as shown below by our composite leading indicator entering expansion territory for the first time in nearly four years. There are signs that the world’s second biggest economy is beginning to limp.
China is in the difficult spot of trying to manage a deleveraging while shifting its economy from a production centric to a consumer focused one. All while trying to maintain financial stability lest the CCP upset the apple cart and drive people into the streets demanding *gasp* freedom.
Because of China’s economic size and especially its hunger for natural resources. It’s importance on the global stage is significant, and only becoming more so.
BofA wrote in a recent letter how, “On close inspection, DM and Chinese growth are increasingly intertwined. While the two series were nearly uncorrelated in the previous cycle, their correlation has increased considerably in the current cycle. Moreover, Granger causality tests suggest that the ECI for China leads the developed-market common factor by four to five months but not vice versa.”
China matters. It sneezes and the rest of the world catches influenza…This is why we should be somewhat concerned by the recent slowdown in the rate of change in the data coming out of China.
The second-derivative shows a trend-shift occurring. Chinese liquidity has turned, as shown below by the YoY change in the M1 money supply — which tends to lead China’s PMI by 3-months. And this tightening liquidity is showing up in industrial production electricity usage. One of the few seemingly untainted data points that come out of the country.
And growth in domestic credit to households has rolled over.
Danske bank writes the following on some of the ways this could impact the rest of the world, noting:
The moderate slowdown of the Chinese economy is expected to dampen the global inflationary impact from China further over the coming year with PPI inflation declining further to around 1% by the end of 2018 down from a peak at 7.5% in early 2017. The inflationary impact of reductions in overcapacity is also set to fade, as China has already come quite far in cutting overcapacity and steel prices and other commodity prices have recovered to more ‘normal’ levels.
So here we have new incoming data that doesn’t exactly jive with the current market consensus. But it could potentially have a large impact on the dominant narrative and even cause a complete trend-shift. We have all the necessary information to game various scenarios on how this can play out.
We know that the market is still strongly positioned bullish. It’s extrapolated current trend-growth rates out to the wazoo.
We know that a combination of tax cuts and global synchronized growth last year has given us a boom in earnings this year. This earnings growth should peak in the second half, leaving us with a high hurdle and declining growth going into 2019.
We know that the market has recently anchored to the “reflation” narrative with expectations for much higher inflation becoming a consensus belief (charts below via BofA fund manager survey). As well as one of the top fears or “tail risks” on investor’s minds…
This new dominant belief over rising inflation has driven bond yields higher. And since bonds compete with equities for capital flows. And their rates are used in valuing and assigning a multiple to stocks, the high rate-of-change in yields has caused stocks to sell off.
This creates the interesting scenario — one of many possible outcomes — where a slowing China could be bullish for US stocks; over the near-term, at least. This is because a gradually slowing China (keyword being gradual) would feed into lower inflationary pressures and maybe a more dovish Fed, if not, it’d at least help put a floor under bonds.
And this outcome would then spawn a whole host of other potential outcomes.
A slowing China could extend the Fed’s rate hiking cycle and thus spur US relative market outperformance versus the rest of the world. This would put a bid under the dollar and a strengthening dollar would raise foreign investors total return outlook in US markets. Which could spark a virtuous cycle of money flowing back into the US.
Throw in the likelihood of the corporate share buyback orgy reaching new climatic heights this year and we have the makings for a core renewed driven rally. One that would have many large consequences for the dollar, gold, oil, and emerging market stocks.
Isn’t this game fun?
If this scenario plays out, then the market will double down on its US-centric bullishness and extrapolate, extrapolate, extrapolate. While also failing to see that by doing so it sows the seeds of its own destruction. Let’s return to Soros again:
Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.
If a self-reinforcing process goes on long enough it must eventually become unsustainable because either the gap between thinking and reality becomes too wide or the participant’s bias becomes too pronounced. Hence, reflexive processes that become historically significant tend to follow an initially self-reinforcing, but eventually self defeating, pattern. That is what I call the boom/bust sequence.
Two trends are always interacting with one another, in a reflexive loop. One trend is reality and the other is a misconception of that reality. As global macro traders we need to focus on both. And the best way to view “reality” is by measuring it at the second derivative level.
You now know what the market’s potential misconception is. As well as how growth-trends are unfolding.
There are a number of sizable trends that are about to develop… along with massively asymmetric trades that are soon going to catalyze.
We’ll be discussing all of this in our next Market Intelligence Report (MIR) that comes out next week.