Playing the odds

[5 min read]

If there was a 50/50 chance of losing money, would you take the bet?

The uncertainty of the outcome can excite some and frighten others. We all assess risk differently.

However, with human nature being what it is, the herd tends to run together.

In 1979, psychologists Amos Tversky and Daniel Kahneman developed the Prospect theory…an experiment in seeing how people choose between probable alternatives that involve risk where the outcomes are uncertain.

Their studies found that we (as a collective) are inclined to loss aversion.

Why?

Because losses leave a deeper emotional scar. The pain is more than twice the pleasure of a gain…

Our aversion to loss was evaluated based on a series of exercises where the outcomes were uncertain.

Successful investing, according to the investment industry, is about ‘time in the market’. Increase the odds of long-term capital appreciation by staying the distance.

That’s certainly been the case since the early 1980s.

There have been a number of setbacks (market corrections and recessions) that have temporarily derailed capital growth. However, normal transmission (thanks to the Fed) resumes, and markets go in search of higher highs.

The industry message of ‘time in the market’ is designed to remove the uncertainty (our inherent bias towards loss aversion) involved in the investment process.

But what if the investment ‘certainty’ — created from market action over the past 40 years — has actually taken us to a point of greater uncertainty?

Could we be at an inflection point where the market now changes character and behaves in a completely different manner?

Perhaps it might revisit the mid-60s to early 80s…a period when ‘buy and hold’ investors went through a world of pain.

If (or when) the trend changes from exponential to excruciating, the pain could be even greater than that identified in the Prospect theory.

Why?

People have become accustomed to gains…expecting more with each passing positive year…

As a society, we’re not mentally prepared for an extended period of disappointment.

And there is one other significant factor.

Millions of boomers have their retirement hopes resting firmly on the share market putting in a repeat performance. Should that not happen, retirement dreams will be shattered. Many boomer retirees will be bitterly disappointed.

How probable is a change in trend?

Since 1915, the Dow Jones Index (on an inflation-adjusted basis) has progressed in a staircase fashion — riser followed by tread.

Extended periods of stagnation are not the exception the investment industry would have you believe.

What’s the next pattern in the above chart?

The current riser continuing forever OR a tread pattern?

And if it’s a tread pattern, look at all previous treads…they fall first and then recover.

In 2007, hedge fund manager Michael Burry — made famous in the movie The Big Short — identified a looming change in trend. He was ridiculed and sued for his contrarian stance.

After he was proved correct (and made hundreds of millions of dollars), he closed his fund and became a private investor.

Burry recently reactivated his Twitter account, Cassandra. Here’s what he had to say…

‘People always ask me what is going on in the markets. It is simple. Greatest Speculative Bubble of All Time in All Things. By two orders of magnitude. #FlyingPigs360.’

And:

‘All hype/speculation is doing is drawing in retail [Mum and Dad investors] before the mother of all crashes. #FOMO Parabolas don't resolve sideways; When crypto falls from trillions, or meme stocks fall from tens of billions, #MainStreet losses will approach the size of countries. History ain't changed.’

Is Burry going to be right again?

Yes.

Why?

Nothing goes up or down forever. Every cycle rotates from positive to negative. That’s just the natural order of life. The only unknown is when the rotation occurs.

As an investor, you have to play the odds. At present, the odds of a trend change are high. Therefore, your exposure to shares should be low.

However, the past four decades have conditioned us to expect more of the same.

Collectively, we believe asset prices will continue to rise, even though they’re already well above the long-term average.

Reversion to the mean can be mean

Global debt has been ramping up since 1980. As interest rates fell, debt levels rose.

On an inflation- and population-adjusted basis, global debt ballooned more than threefold over the past 40 years.

That money had to go somewhere. And that somewhere was asset prices.

In the world’s largest economy, that asset price inflation is evident in the US’ household net worth as a percentage of GDP.

Over the past 70 years, US household wealth has hovered around three- to four-times the size of the economic activity supporting this wealth.

Since the mid-1990s you can see the Fed’s fingerprints are all over this chart.

Bubble after bubble after bubble has been blown to create the so-called ‘wealth effect’.

The gravitational pull — associated with mean reversion — is evident in the two previous asset bubbles.

Asset prices, after a period of deviation, deflated back towards the long-term average…only to be turned around again by the Fed’s stimulus efforts.

If anyone thinks the ‘greatest speculative bubble of all time in all things by two orders of magnitude’ can disconnect from the underlying economy indefinitely, then they’re in for a very painful lesson.

The reason why wealth levels (asset values) are drawn to the average is simple…household income (money spent in the economy) can only afford to price assets at a reasonable multiple of that income. Debt can pump prices up for a while, but then the debt bubble bursts and prices revert to the mean.

Things get stretched during periods of excessive exuberance, low interest rates and abundant liquidity…but these periods prove to be temporary, never permanent.

The industry’s time in the market mantra — designed to massage away fears of uncertainty — has gained traction during a period that’s truly unique in market history.

This is a period that’s unlikely to be repeated anytime soon…unless of course, we have another baby boom AND start with high rates, a low debt level, AND end with ultra-low rates and a high-debt level.

The truth is, the dynamics that enabled central banks to blow three consecutive bubbles (of ever-increasing size) are no longer there.

The capacity to exponentially expand private sector debt levels is gone.

The capacity to take interest rates lower — making debt cheaper — is all but exhausted.

And more importantly, due to the emotional trauma associated with loss aversion, the public are unlikely to, once again, be co-opted into the central banks’ ‘grand growth experiment’…at least not in the numbers required to reflate asset levels beyond the ‘everything bubble’ marker.

The only certainty with this market is the certainty of loss.

Based on the odds being firmly against the future being anything like the past decade, I’ve developed my own Prospect theory.

The prospect of this period of excess ending well for the vast majority of people is on par with ‘a snowball’s chance in hell’.

Regards,

Vern Gowdie,
Editor, The Rum Rebellion

Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.