My dear reader,
I have moved the newsletter to Substack, though I will retain my website for “best off” posts. My aim is to provide a weekly newsletter that is always of the highest standard in terms of writing quality, the aesthetics of any visualizations I use, rigour of argument, depth of research and a self-flagellating desire to seek out the truth even at the risk of contradicting myself, a newsletter that fully expresses my personality. That, dear reader, is my commitment to you. Consequently, in some ways, I will defy various norms -”to oneself be true-, but the pursuit of empirically grounded and logically sound analysis of capital cycles and market behaviour will always be my North Star.
Leading up to my next, weekly newsletter on capital cycles, I decided to share a few old thoughts on more philosophical issues surrounding extreme events and uncertainty, that in some ways challenge the conventional wisdom in their optimism over the foreseeability of the future, without giving way to a determinism free of the randomness that Gregory Chaitlin and Nassim Taleb have so rightfully urged us to keep sight of. This is a five-part series and I hope it proves useful.
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May you have a profitable day.
1. “The Way of the Samurai is found in death. Meditation on inevitable death should be performed daily. Every day, when one’s body and mind are at peace, one should meditate upon being ripped apart by arrows, rifles, spears, and swords, being carried away by surging waves, being thrown into the midst of a great fire, being struck by lightning, being shaken to death by a great earthquake, falling from thousand-foot cliffs, dying of disease or committing seppuku at the death of one’s master. And every day, without fail, one should consider himself as dead. This is the substance of the Way of the Samurai.” Hagakure, by Yamamoto Tsunetomo
2. As a wave crashes into a sandcastle, scattering and washing it away, Covid-19 has crashed, scattered and washed away old certainties. The post-World War II economic expansion whose apogee was the Great Moderation, a period of ostensibly eternal growth and prosperity, where gross domestic product (GDP) was robust and steady, and inflation, unemployment and volatility were low, and to the minds of policy makers, economists, and investors “controlled”, was burnt to ash by the Great Recession. In place of this panglossian paradise, investors today behold an age in turmoil, old and new threats charging at the gates. A survey of economists by FiveThirtyEight points to a dramatically uncertain future -what many believe is that the Great Lockdown presages the greatest economic decline since the Great Depression-; forecasts on fatalities and when a vaccine will become available harken toward a long resolution to the greatest pandemic since the Spanish Flu of 1918; the importance of preparation for the many threats that we face has seldom been so evident -so urgent has the task of estimating our threats become, that, in lieu of a Worldwide Threat Assessment of the US Intelligence Community for 2020, Politico published a “Domestic Threat Assessment”-; core earnings continue to decline, accelerating a trend rooted in the pre-Covid-19 era as New Constructs and O’Shaughnessy Asset Management have shown; the unequally shared health risks and economic burdens of Covid-19 have highlighted the historic levels of inequality in the twenty-first century and a polarization of society so stark that how Covid-19 is perceived is split along partisan lines; economic problems ignored in the last decade intensify; the fracturing of the US-centric iteration of the world system accelerates as China adopts a more assertive foreign policy and the United States increasingly treats China as a hostile rival; meanwhile, governments across the world undertake unprecedented measures to shore up the economy; the way we work has changed in ways that will have profound consequences for the economic landscape; companies spend less and less time on the S&P 500; competitive advantages have become transient; and our old complacency has collapsed before the spectacle of uncertainty. Seldom has so much happened so quickly and with such consequence. Even as waves redound, Covid-19 will be defeated, sandcastles rebuilt, new certainties erected and …many will forget the lessons of 2020.
3. In his memo, “Uncertainty”, Howard Marks defines investing as the art of allocating capital to options that one thinks will benefit from an uncertain future and where success is measured against the performance of some absolute or relative benchmark. Marks goes on to say that the fundamental and I think irreducible uncertainty of the future makes forecasting devilishly difficult and often, as now, well-nigh impossible, making the challenge of out-forecasting the crowd of investors against whom one is effectively competing, extremely daunting. Of things unknown and unknowable, there are many.
A look at forecasting models of Covid-19 shows how hard it is to forecast fatalities a month from now; so to paint an accurate picture of the world in 2021 is impossible, because a theory of history -and of the future-, is inherently imperfect: firstly, because of facts and numbers we do not know but which we may come to know, what is known as “epistemic uncertainty”; secondly, because even if furnished with all the experimental data it is possible to gather, every emotion, every glance, all the economic, scientific, and social data imaginable, it would still not be able to explain everything and predict everything, because of the irreducible randomness that is inherent in historical processes, what we call, “aleatory uncertainty” -the union of all sets of knowledge is not equivalent to reality-; thirdly, because our perceptions drive our actions which impact the future, a shoelace process of history, so that the future is a constantly evolving predictive target, rather than a linear chain of fact to fact to fact; lastly, because cognitive biases impede our ability to understand the world regardless of how much information we have.
It is not enough to know long-term historical trends: historical processes are the work of a blind archer, they do not converge around some limit, they are Cauchian, have have many small movements and wild swings, results are not spread out smoothly –in 2018, Amazon, Netflix and Microsoft made up 71% of returns on the S&P 500; in the 1980s, 40% of gains came from just 10 days of trading on the S&P 500-, markets do not adhere to our time horizons -consider interest rates, which, when 10-year yields on US Treasuries were 2.5%, seemed low, but compared to Japan (0.56%), Germany (1.24%), or Singapore (2.3%), among other examples, were relatively high, or consider those rates against the long view of history: in the 1930s, according to A History of Interest Rates, the average was 2.98%, in the 1940s, 2.54%, in the 1950s, 2.99%; the normal of our short-term view is not the normal of the market, when we speak of mean reversion, against what mean? 100 year?
4. We have a hankering for certainty. Among the goals that drive the human brain, one is a need for certainty. The brain craves certainty and using the same neural networks, as it craves food, sex and other primary drives. Information in a time of uncertainty is like a feast for a hungry man. Uncertainty creates a threat or alert response in the limbic system that results in diminishing ability to focus on other things. Uncertainty hurts, certainty is soothing, and we yearn for it even when we are better rewarded by staying uncertain. The Ellsberg paradox: we prefer to bet on the outcome of an urn with 50 black and 50 green balls, rather than on one in which an urn has 100 balls whose proportion of black-to-green is unknown. Our aversion to uncertainty is ingrained in us. “Better the devil you know”, we say.
Uncertainty makes our brains ill-at-ease because it hurts its ability to make predictions. The brain makes predictions by inferring patterns from data, storing them as memories and using a combination of those memories are present events to predict future outcomes. Above all things, the brain is a pattern-seeking, memory creating, prediction-maker. When certainty arises, we feel rewarded and we want more of it. From organizing our playlist, to playing chess, we have a craving for certainty that makes itself felt everywhere. This drive for certainty is at the heart of an industry of experts whose forecasts are bunk but who still manage to rake in fortunes appearing in prestigious newspapers and TV shows and social media. This industry feeds what Scientific American Mind called an “information addiction”. Certainty, that rush of dopamine we get when we receive new information, makes us feel good, even though it may not be good for us all the time.
5. Having noted that contrarian forecasts must be right in order to be profitable and the difficulty of consistently making correct contrarian forecasts, it is clear that whether one takes the view that markets are always wrong but because of herding, a prevailing bias can impose itself on it; or that markets are mostly sort-of–right, except on the few occasions they go wrong, the opportunities for being contrarian and profitable are rare. How are we to navigate uncertainty?
6. Forecasting on the Good Judgment Project 2.0’s research project developed by Philip E. Tetlock and Barbara Mellers, has rewarded and punished me with an experience of how difficult forecasting is and how so few people, “superforecasters”, consistently out-forecast the crowd. In his book, Expert Political Judgment, Tetlock evaluated the predictions of experts in various fields and measured them against well informed non-experts and found that there is an inverse relationship between the confidence an expert has about a prediction and its accuracy and that the difference in skill between the prognosticating expert and a well-informed non-expert is negligible. The ghastliness of expert predictions does not end there: the predictions of experts performed with as much accuracy as randomly chosen bets, and many would have performed better by simply evenly splitting their probabilities between a base rate -a projection of the status quo into the future-, and the worst and best case. The experts proved as good as a monkey throwing darts at a board. “We reach the point of diminishing marginal predictive returns for knowledge disconcertingly quickly. … In this age of academic hyperspecialization, there is no reason for supposing that contributors to top journals—distinguished political scientists, area study specialists, economists, and so on—are any better than journalists or attentive readers of the New York Times in ‘reading’ emerging situations.” Let us throw fuel at the fire: recently, Epsilon Asset Management published a study that revealed that hedge funds’ “best ideas” did not do better than their other positions. Like a bee that has gathered too much honey, experts are weighed down by their own expertise. There are those who see in science something absolute, and definite, but even in science there are uncertainties, provisional truths, one must see science from a Lakatosian perspective – Peters and Ceci’s work on the peer-review process shows that even the most vaunted journals would reject their own work if resubmitted and decades after their findings, their conclusions about the fallibility of the peer-review process are still relevant.