The Holy Grail of investments – Part 3

The problem of survival

In two earlier posts, I outlined the problems of the little guy trying to survive in the stock and bond markets. The problem is that markets are notoriously variable, even turbulent at times, and difficult to predict. This must be so because if the markets were predictable, the efficient markets theory would be reality, and there would be no practical point in investing/dis-investing. Stock and bond prices would reflect the best information then available, and on average investment returns ex ante and ex post across all asset classes would be equalized. The historical experiences of individual investors would differ, but this can be attributed to plain luck or lack of it.

Despite the markets’ inherent unpredictability, still, some rules of thumb have worked historically.

A basic strategy

One rule was discussed in my first post. There, I thought the general rule was that stocks and bonds pretty much feed on each other. Bond markets are much more difficult to predict, whereas stocks generally follow bonds. Thus, stock market investing is easier. Stocks go down, with a lag, after bonds go down. So the basic strategy is to Buy and Hold stocks when bonds are quiet or interest rates have gone down. The exception is when bonds fall (or yields go up) sharply, which means stocks will likely fall. At this point, survival demands selling stocks and parking funds in cash until bond prices rise (or yields fall). Historically, the times when one should be in cash are not often and not for very long.

What if stocks lead bonds?

The general rule and exception above are not always good, so I also thought that stocks can lead bonds, in which case there is no easy survival rule. How do you anticipate the unpredictable? The consolation is that the problem applies to all investors. It’s every man for himself, and luck is perhaps the one great determinant of success. Under these circumstances, the efficient markets theory is a good rule of thumb that can however be modified if you can anticipate what Keynes’ called ‘animal spirits’ in a modern economy. This is a variant of the ‘fear and greed’ rule: Buy when everyone else is afraid; sell when they’re greedy.

A third way

Is there a ‘third’ way? I suggest there is, but it’s not easy to implement. The third way is to divide the market into manipulative ‘big boys’ and the rest, the ‘lemmings.’ The big boys play a legal game of ‘follow the leader.’ They use the classic mass media tools – nice suits, fancy office, authoritative gurus on the payroll, getting themselves interviewed on Bloomberg, putting out market letters to ‘preferred’ clients, etc. – to make us think they know what they’re doing. (They know, but not in the way that you might think.)

A typical play is for a big boy to discover a new story about a particular stock or commodity. For example, a new story going around nowadays is that the United States will once more be a major petroleum producer because of shale oil. This means that crude oil prices will be weak for the medium term. This story has implications on individual stocks, and even on bond prices (yields should fall or remain low because inflation of the cost-push side will be weak). The big boys will then quietly buy shale oil producers, bonds, etc., and short the stocks dependent on traditional crude oil production. They then whip up the shale oil story, and during this episode they’re selling to the lemmings.

The lesson from the third way is simple. Do the opposite of what the big boys want you to do. This isn’t easy since the game depends on an ‘after-you-Alphonse head fake’ kind of dissimulation while the big boys acquire their starting positions. But it can’t also be that hard because when the big boys do something people notice and scratch their heads. The trick is to do what they do when the PR mills are quiet and they’re not saying anything yet. But when they say buy, you sell!

There’s a potential pitfall to the third way. The big boys will do their best to hide their tracks and you can be suckered into the wrong play if you misread them. But so long as you can think like the big boys you should be okay. Just don’t over-do it because you’re after all riding on their game. If enough of the little guys pick up on what the big boys do, the third-way game is also history.

Summing up

Investing does not require a Ph. D. in finance or economics.  It does require a sense of history, an appreciation of Keynes, and knowing when people are ‘play-acting.’  It is easier discussed than successfully done.

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