Areté blog | Do you feel lucky?
Areté blog | Do you feel lucky?
Crosscurrents and diverse opinions are the commodities of the day. At one extreme, earnings are great, momentum is great, the Fed has your back, so you should leverage up on stocks and options. At the other extreme, valuations are excessive, speculative fervor is unrelenting, and liquidity is tightening so you should scale down risk.
All this makes for an unsettling environment for many long-term investors. Yes, the market seems extended, but what is going to change things? On the other hand, does it matter? Stocks keep going up regardless of what notion of “risk” is being bandied about. How can investors get comfortable enough with the chaotic landscape to position their portfolios for long-term success?
Mixed messages
One of the more pernicious characteristics of the current landscape is the availability of substantial rationale for both extremely positive and extremely negative outcomes. On the positive side, companies have just reported good earnings and we are now in a period of seasonally strong performance. Unemployment continues to decline and Covid is dissipating, at least in the US. Further, retail investors are actively involved and are pumping a lot of money into stocks and options. The bottom line is you don’t have to agree with every element of the thesis to understand how some people can be optimistic about stocks.
Of course, there is also a case to be made for being pessimistic about stocks. Valuations are egregiously high which means future returns are likely to be significantly negative once sentiment turns south. If inflation sticks around, it has the potential to ravage the winners of a prolonged disinflationary environment. Add to this mix an increasingly hostile regulatory environment and economic and geopolitical risks from China and elsewhere, and its not hard to understand why some protection might be a good idea.
Anyone who harbors such concerns has good company. Scott Minerd from Guggenheim made the case as succinctly as anyone:
“There is no way that we have engaged in the scale of asset purchases in the pandemic where there’s going to be a policy which ultimately is going to be perfect and not cause some sort of interruption to asset prices or something else that would be destabilizing. I think that would be in the realm of practically miraculous.”
How did we get here?
So, investors are probably right to be worried, but what should be done? How should tradeoffs be made? In order to answer those questions, the insight by Matt Levine at Bloomberg (and captured by Katie Martin at the FT) provides a useful starting point:
In other words, the notion of applying logic and evaluating fundamental information in today’s market is not working. Prices are set on the margin and the marginal buyers just don’t care about those old school ways.
Good follow up questions include, “Why are so many people buying out-of-the-money call options on the basis of a dog picture?” and, “What does this imply for other investors?”
Raoul Pal from Realvision sent out a tweet thread that goes a long way to answering these questions. The following quote captures the overall argument.
“They are a new generation of investors. 86 million millennials got financialized in the US last year. They hit their prime investing ages of their 30’s.
They have debts, no savings, no hope from the grind. They are poor [sic] than any 30 year old in the last 70 years.”
Weaving the various pieces together, Pal describes: “These young people had been let down by us all. Why should they play by our rules when they could make their own?” As a result, Millennials feel as though they have “nothing to lose”. Since 10% returns will do nothing to level the playing field for them, they believe they must take on “MASSIVE risk”.
This sense of being let down isn’t just some bit of Millennial whining either. A recent Economist article on social mobility shows generational opportunity has been declining for decades, Millennials are just suffering the worst of it thus far:
“What economists call absolute mobility—the probability that a child will grow up to earn more than their parents—has dropped precipitously. In a paper published in 2016, entitled ‘The fading American Dream’, a team of social scientists found that Americans born in the 1940s had a 90% chance of earning more than their parents had earned at the age of 30; for those born in the 1980s, the chance of that had dropped to 50%.”
This explains quite a bit. It explains why many younger adults feel a sense of resentment and it explains why at least some of the resentment is directed at Baby Boomers. After all, Boomers were, and in many cases still are, in charge as the American Dream has run off the rails. As Pal says, “This is ALL about culture”.
It also explains why many younger adults have a strong sense that traditional paths to career progress and investment success will not work for them. It’s a different world. Slow and steady will not make it any longer. You have to take big risks or resign yourself to a life of drudgery and mediocrity.
In this light, it is much easier to understand why trading in meme stocks, the prodigious use of options, and other speculative behavior is so prevalent. In part it is an expression of desperation to attain the same quality of living as earlier generations. In part it is an expression that something very different needs to happen.
Turn Four
In order to understand what these dynamics imply for longer-term investors, it helps to consider them in the context of history and demographics as Neil Howe recently did in a webcast with Adam Taggart. Howe recognizes generational progress has stalled (i.e., fewer adults are out earning their parents at the same age) and that trust in many institutions is eroding.
The progressive weakening of economic growth and eroding effectiveness of institutions are classic indications of the type of crisis Howe calls a “Fourth Turning”. Another indication is increasingly competitive fights for the spoils of the economic “pie”. We can see this in the form of generational disputes about the redistribution of wealth. These characteristics put us somewhere in the middle of the Fourth Turning.
The typical path of a Fourth Turning is for conditions to worsen to the point at which a major crisis erupts. Historically this has involved a fighting war with a common enemy. Such a severe conflict is needed to provide the impetus to finally dispense with old, failed institutions as well as to create new ones that are fit for the new social order.
Playing the hand that is dealt
As a result, it is perfectly understandable why a number of people would be frustrated: They have been short-changed in terms of societal and economic benefits. Many are responding by making bets on story stocks, memes, and whatever else. By any other name this is gambling and has a very low chance of providing personal success.
Importantly, such risky bets embrace rather than reject many of the factors that have caused inequality. While such bets may accord some sense of rebelliousness, they are most likely to leave many financially crippled which will make inequality even worse and do nothing to effect meaningful change.
Other investors are pursuing a different path that also involves high risk but with a clearer objective of instituting change. Crypto enthusiasts are a good example of this camp. A main part of the thesis is that the old institution of fiat money is seriously flawed (it is) and needs to be replaced (it does). Such efforts are frequently enabled by technology and are imbued with the revolutionary spirit of “changing the world”.
Still others are happy being passive investors comfortably parked in ETFs that track major indexes believing they are safe. They aren’t. The belief was somewhat justified when the largest index components were extremely profitable. With Tesla now a top five position in the S&P 500 and AMC Entertainment the largest component in the Russell 2000 index, index investors can no longer be so dismissive of speculative behavior. The game has come to them.
Each of these positions suffers from a degree of arrogance. Gamblers falsely believe they have a better than average chance of beating the odds. Crypto enthusiasts and other “changers” falsely believe they have created “the” answer. Both confuse the expression of frustration and revolutionary spirit with an effort to create a robust and effective solution. The motive is right, but the method is wrong, or at least incomplete. Passive investors, meanwhile, fail to see how the structures and dynamics that have provided them great benefit have also served to make conditions even more unequal and unsustainable for others.
Implications
After an unbelievable run in stocks since the pandemic lockdowns a year and a half ago, and after a big burst over the last several weeks, many investors are beginning to wonder if stocks are getting stretched. Should long-term investors load up or lighten up?
Going back to Neil Howe’s work provides helpful context. A Fourth Turning ends when the crisis resolves and then transitions into a new awakening. Interestingly, the successful completion of a Fourth Turning crisis requires contributions from each generation because each one brings unique skillsets and perspectives.
As such, Baby Boomers will contribute vision and big picture views, Gen Xers will contribute leadership and will be critical for getting things done, and Millennials will contribute a culture of cooperation and community-mindedness. Although war is not the only way a crisis can resolve, it does provide the impetus to set aside differences for a common cause.
As a result, until a crisis arises that is severe enough to unite people against a common challenge, it is fair to expect conditions will continue to deteriorate. This means even crazier and more confounding market behavior. It means progressively more competitiveness within society. It means more hostility between people.
The bad news is there will be no easy way to get ahead. The life cycle of actionable narratives will continue to shrink until they become vanishingly short. As successful as the Fed has been maintaining its support of the market, that will go right out the window when a severe crisis arrives. For example, if China were to invade Taiwan, Fed jawboning about transitory “this” or smooth market functioning “that” isn’t going to help stocks at all.
The good news is, as unpleasant as a Fourth Turning is, it is merely a waypoint to a better place in the cycle. There will be better times. There will also be a fundamental re-construction of ineffective institutions and a re-ordering of society. When Raoul Pal says, “Everything will change”, he is right – and in ways even more expansive than many imagine. It is quite possible, for example, that the Fed may be reconstituted or replaced by an entirely different monetary authority.
Do you feel lucky?
One thing that is clear amid the chaotic market conditions is that several of the main coping strategies are not designed to weather a Fourth Turning. Making incredibly risky bets will result in major losses for the majority of participants. Betting on very specific answers to existing problems often fails to incorporate lessons from history or to consider important elements of society. Ignoring everything and hoping to ride out the market before it crashes unnecessarily makes investing a race against time. The only real question in regard to these strategies is, “Do you feel lucky?”
By contrast, long-term investors can step outside of the day-to-day market machinations, observe the path of broader historical and societal changes, and prepare for them. That involves surviving the Fourth Turning in as good a shape as possible and anticipating a brighter, and very different future.