In Search of the Obvious

Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.
-- George Soros

One of the most interesting implications of this idea is that an investor is paid in the market not just for being correct--as most people think--but for being different. To make more money than average, you have to do something different from average. Being correct doesn't hurt, but being different is what pays the bills.

This is because most investors crave certainty and are willing to open their wallets for it, even if what they are getting is only the illusion of certainty. As a result, they almost always overpay for assurances about the future. This is exactly what Warren Buffett meant when he wrote that "you pay a very high price in the stock market for a cheery consensus."

Almost as a rule, investments that appear certain to succeed or market theses that seem certain to unfold are overvalued, while investments that have only a possibility of success are frequently undervalued--even if the potential payoff of the second group is far greater than that of the supposed "sure thing."

An exploitable anomaly, seemingly. So how can we put this idea of betting on the unexpected into practice?

Legendary hedge fund manager Michael Steinhardt used a mental model that he termed "variant perception." It sounds esoteric, but it translates roughly as "a different opinion."

In his autobiography No Bull, Steinhardt explains that he wanted his analysts to know four things about any investment opportunity:

1) the idea
2) the consensus view
3) the variant perception
4) a trigger event

This outline presents us with a strange challenge. How do we determine the "consensus view" on whatever subject we are looking for? In short, what is the "obvious"?

This may seem like a simple question to answer, and in many cases it is. In 1999-2000, it was obvious that internet stocks were going up. In 2005, it was obvious that home prices would rise forever. If it ever becomes obvious that stocks are going to go down forever, it will be time to buy them aggressively.

Still, when you apply the question to the flux of day-to-day market activity, it gets quite a bit more elusive. What is the "obvious" belief right now to be bet against? Bulls would say that everyone obviously expects the market to go down. Bears would say that everyone obviously expects the market to return to its previous highs.

To complicate matters further, the "obvious" belief may pointed in the right direction but not going far enough in that direction. For example, if it is obvious to most that we are in a mild recession (and it seems to be), the solution is not necessarily to buy stocks in anticipation of a recovery. It could instead be to batten down the hatches in preparation for a particularly bad recession.

All of this, combined with the seemingly weekly shifts in the consensus about what is "obvious," makes it a tricky time to be using this approach. Still, if the past is any guide, the markets will settle down into a new set of "no-brainer" ideas that we can then fade. I think we'll know them when we see them, but commodities and China seem set up to become good candidates at some point in the future.

Bear Gets Marked to Market

It's amazing what having one of the most powerful investment banks in the world vaporize can do to focus your attention. Accomplishing much more in two business days than I ever have, Bear Stearns (BSC, if you dare) has fallen from over $60+ a share to what will probably be around JP Morgan's buyout price of $2.

I have to travel tomorrow (great timing, huh?), so I won't get to devote the time to this interesting situation that I would like to. But I did want to fire off some quick thoughts that were on my mind.

Please note that I've linked to some old posts here, and I have to cite George Bernard Shaw in my defense: "I often quote myself. It adds spice to my conversation."

Besides, the largest economic forces at play frankly don't change all that quickly. And for the most part I still believe everything I've posted about over the last nine months or so (that is: financials are dangerous, small-caps are dangerous, the dollar is being massacred, emerging markets are more dangerous than advertised, etc.) I don't get (or more accurately, steal) very many good ideas, but if another one comes across the desk, I'll keep you apprised.

• We're now around 1275 on the S&P, a level I (and many others) think is very important. A break below here to the downside would be worrisome, since we could touch off a series of stops, accelerating a decline.
  

Of course, if we suffer a cascading meltdown, I will be sitting glumly in a plane somewhere, hungry and wishing I were short.

• Drawing from the often-remarked-upon similarities between this market and that of the early 1970s (as that market came to terms with inflation and financial instability), I've recently been thinking of this market in terms of the two-stage decline in the 73-74 bear. By this line of comparison, we're around March of 1974, in which a break through support at 90 started a new cascading phase of the bear market. Similarly, if we break below 1275 on the S&P, I will be forced to act off of the idea that we have moved into the second phase of a runaway bear market. I'm expecting this sort of an acceleration to the downside, but am ready to be proven wrong.
  
• Keeping with the title of this post, it looks to me like the JP Morgan buyout of Bear is effectively a mark to market of Bear's assets. The next question everyone has to ask (and, frankly, should have asked themselves a while ago) is: what are appropriate market values for other peer banks? You already know my opinion on Goldman. One thing I have always wondered is why assets that are supposed to be marketable yet have no market value have a book value of higher than zero. I suppose if I worked for a bulge-bracket firm it would make sense to me.
  
• Along similar lines . . . a friend and I were discussing recently how there really hasn't been any panic in financials, despite the brutal declines we've seen thus far. We're still in the Oprah, hand-holding "thank God everything's going to be OK" stage. Well, to butcher an old saying, every panic contains a grain of truth. It may be that our bit of bad news has just arrived. Could the more thoughtful individuals out there who are holding stock in other i-banks start getting pretty hot under the collar?
• I still think the Fed is checkmated. If they cut further (which they will, of course), gold will continue to climb. But the shock of cuts is wearing off, and I don't expect the inevitable "surprise" cuts to provide the same boosts to the upside as previous ones. The market could therefore continue to decline even with further cuts, particularly if those cuts begin to threaten the US price level. Anyway, remember that stocks fell during a substantial part of the Greenspan Fed cuts after the dot.com crash.
• If I were inclined to be bullish, here's what I'd ask . . . if it's true that pessimism is as rampant as some accounts suggest, could this all be simply the process of putting in a bottom?
• Anybody else wondering what the effects of the Bear collapse and the other turmoil could have on the world's $500 trillion+ derivatives market? As a point of comparison, the world bond market is estimated to be $45 trillion and the world stock market is estimated to be $50 trillion. No, that is not a typo. And yes, I realize that all of those positions are perfectly hedged and therefore we have nothing to worry about . . . if you believe in the perfect hedge.
• Finally, financials and market reality, before and after:

An Important Test

A quick update . . .

After the recent rally, we're now at what I see as a very important test. We're about to find out if the Fed's huge injections of liquidity have indeed ended this bear market, as many seem to believe.

As far as I can tell, this rally is still pretty much textbook bear market behavior, and the long-term path of least resistance remains down.

Along these lines, the chart below implies that there are swarms of sellers in the 1400 range waiting in the wings to dump their stock into another leg up. Any new rally is going to have to work through this pretty serious supply overhang.


Stranger things have happened, of course. Look at 1998, for example, when the markets broke and then reflated with the help of well-intentioned central banks.

Because of precedents such as 1998, as well as the Fed's popular (though not official) mandate to keep equities from declining even at the cost of the purchasing power of the currency, it's absolutely essential to have circuit breakers in place so that if you're wrong you don't lose all your money if you're short.

I've been thinking about how to decide when this move will stop being "textbook bear market action," and when to admit that City Hall (Bernanke, Paulson, Bush) has won. And I still think that if the S&P seizes a position above 1400 and can prove that it can hold it, I will be forced to reconsider my strategy.

If this were to happen, it would be a frankly surprising show of buying power and one that would have to be respected.

In the interest of full disclosure, though, my humble opinion is that we look very well set up here for a potential retreat in the next week and eventually a retest of the 1275 lows on the S&P.

But the market's gonna go where it's gonna go . . .

Oh, and if you were wondering whether this sort of central bank behavior (panic 3/4 point rate cuts when the markets drop, encouraging new debt to solve a debt crisis, etc.) is good for the world in the long term, the answer is no.

A final note: if we do claw back up into the old trading range, the amount of new credit it's taken to pull us out of this natural market downturn is almost certain to inflate another huge bubble, possibly more than one. There's no telling for sure what it'll be, but those who guess correctly beforehand will make armloads of money.

I'll let you know where I think these bubbles might be if another leg up starts looking like a real possibility.

Otherwise, see ya at 1275!