Aren’t people funny sometimes?
Well, for the handful of you who have been on a desert island since late January, we have news: volatility is back! Not to make light of things…the last two weeks have been a bit shocking and not humorous. But as John Bussel, our co-Chief Investment Officer, said in his letter a week ago, the lack of market “corrections”1 we experienced in 2017 was unusual, as equities seemed to register small gains almost every day. This kind of downturn is actually pretty normal and happens almost every year.
Two things make this time seem worse. The first is the speed — it seems that there used to be significant lags built into trading activity sometimes, so adjustments up and down would generally (not always!) take a little longer. The other difference is that the numbers are bigger now; 100 points is less than half a percent of the Dow these days — so if the Dow moves 1%, that is over 250 points, which feels bigger. So big numbers happening fast make:
Actually, there is a third item making things seem scary: they are happening now. Now is always more impactful, especially because we do not know what tomorrow will look like, and we wonder if this is over or will continue. One day at a time — it seems bigger and more terrible than it will when we look back a year from now.
But we thought the economy was doing really well — why is the market dropping all of a sudden?
Funny how unpredictable these things are. Everyone asks, “What is causing this?” The answer is not known. All the many millions of participants in the markets — in their collective wisdom2 — know things that we as individuals do not, and it will always be so. Pundits have opinions, and we all can see facts on the ground, such as a strong or weak economy, but all that is priced into the market already. What moves the markets is what is coming next, things we do not know yet — and may never know.
Flaws in human thinking
In hindsight, things make sense and even appear obvious, but we often don’t see them coming ahead of time. It is a pattern in human thinking we would do well to contemplate, because failure to firmly grasp that can lead to thinking errors and mistakes.
We saw a good example of this in the real estate-driven market crash of 2008. In a previous letter, we referred to “The Big Short” by Michael Lewis. This is the story of two of the very few people on the planet who figured out what was coming and were able to make a great deal of money trading to take advantage of the opportunity. Great book and pretty good movie, too — might be worth another look. Two strange observations:
1. Despite the compelling logic — which led the two protagonists to conclude that mortgage-backed securities had to fail — very few people saw it, and smart people all over the planet invested billions of dollars in them. How could they be so blind?
2. In hindsight, it seems obvious to us now, so much so that we fool ourselves into thinking we will see the next one coming. But we won’t! These things have happened throughout human history and will continue to surprise us.
Mr. Lewis wrote another great book we have mentioned before: “The Undoing Project,”3 which is about two pioneers in the field of human thinking who spent their lives studying substantial, persistent patterns of flawed thinking. These patterns are so strong that they persist even when you are fully aware of them! They believed — to oversimplify only a little — that the truly rational person cannot hope to function rationally, perversely enough; the best one can hope for is to remain aware of your flawed thinking and avoid relying on your own judgement in many things!
That would certainly seem to describe our thinking and feelings about markets. Even the most professional of us experience the emotions, ideas and even convictions that can destroy our portfolios if we let them. Which is why we plan ahead and build discipline into the process — without a plan and the discipline to stick with it, we are lost.
Let’s conclude by remembering the worst two weeks to start a year, in January 2016 — how dark things appeared and how differently they turned out. In 2016, things got better quickly; in other cases, the markets continued to decline (e.g., in 2008). What comes next is never obvious and is often quite surprising. Be of good cheer — this too shall pass.