Friday, December 18, 2020

PWA 2020 Year-End Letter, Part One: The Eagle, The Ice, and The Basketball

2020, a year to forget, but one we never will, is coming to a close…

Being that folks come here for insight into markets and economies, we’ll only touch on politics and pandemics in the context of markets and economies.

This year’s final message will come to you in several parts. Part One will focus on how we here at PWA metaphorically view the investing process.

But first we'll list what we know to be the essential characteristics of the world’s best portfolio managers -- the traits we everyday strive to embody:

1. A passion for macro economics and market history

2. A firm understanding of intermarket relationships

3. A firm grasp of global macro and geopolitical developments

4. An obsessively strong work ethic

5. The ability to transcend his/her ego and political preferences

6. An understanding of and appreciation for the uncertainty of markets

7. A flexible and open mind

8. Utter humility

Having been professionally involved in financial markets for roughly two-thirds of my existence, I tend to find investing metaphors virtually everywhere I look.

Every once in a while these metaphors turn into analogies, which turn into narratives during client meetings, which ultimately turn into blog posts.

Here are three that describe how we view the work we do:

The Eagle
Imagine that we've captured a very large beautiful eagle. And imagine that we've affixed to it electrodes that monitor its key vitals: Such as its heart rate, its blood pressure, its blood oxygen level, etc.; as well as its wing-beat patterns and its trajectory as it ascends to -- and descends from -- various altitudes.

Now imagine that once each week we gather and put into a model all of this data that inform us as to the present general health of our giant bird.

Sitting here in the present (January 2018), as we turn on our monitors we of course acknowledge that our eagle has indeed soared its way to altitudes that it hasn't previously experienced, but, frankly, that's not our concern.

Again, our concern is its general health and whether, given our findings, we believe it can weather the headwinds and storms that it may encounter at virtually any altitude.

In essence, is our eagle in a good place? Is it strong? Under turbulent conditions would it simply descend to a calmer altitude (say, to a few thousand feet [read Dow points] below) where it would glide around until the winds subside, then resume its previous pattern and ascend to yet greater heights?

Or is it exhibiting a level of stress that would have it collapsing in the face of a sudden storm; tumbling to substantially lower altitudes where it would require an extended period of recuperation to build back the strength, stamina and confidence necessary to at first retest the previously failed altitude, then potentially break above and reach for yet greater heights?

In the latter instance we'd need to determine what steps to take (what reinforcements we might deploy) to mitigate the potential damage that a rapid fall from such an altitude might levy upon our eagle.
Of course our eagle symbolizes general economic conditions, our proprietary macro index (paragraph 2), the financial markets, and, in the final paragraph, our clients' portfolios.

Measuring the Ice (October 2020)

So, you’re going ice skating on a popular lake, and I happen to be the guide you’ve hired to instruct you and to show you a good time.

As you approach the lake you find me waiting for you, and you notice tons of folks having the times of their lives; cutting, sliding, skidding, kids romping all over the ice.

We have a seat, you lace up your blades, you rise up and I say "stand still a minute, we're not quite ready yet." I then proceed to strap onto you a life vest with a pulley on its back, through which I thread a rope then toss it over the thick limb of a nearby tree.

You say to me, "Marty, what the heck are you doing? If I even get onto the ice before dark I'm not going to have much fun the way you've got me all bound up!"

Me say to you, "Well, you know, I got here early so I could measure the thickness of the ice and take the outside temperature. And, unfortunately, while I understand how it looks on the surface, with all those folks having such a great time, I checked my notes from my own personal experiences (been taking folks out onto the ice for 36 years), as well as my studies of literally centuries of related history, and, well, virtually every time the ice was this thin and the weather was this warm the ice ultimately broke. And, sadly, many of the skaters who were out there completely unprotected sank to the bottom, some never recovered.

Now, I honestly can't know for sure if the ice is going to break this time as well, but I do know that the risk is very high that it will. And, frankly, I'm just not willing to take you out there completely unprotected.
Not that we won’t enjoy our time on the ice, but as long as it remains this thin we’ll do so with a layer or two of protection against drowning.
Of course, if/when a big freeze hits and the ice thickens back up, I'll happily release the binds and we'll have ourselves a ball. I love skating fast on thick ice when the odds suggest that our falls won't kill us -- which is absolutely not the case today, believe me!"
The ice of course represents macro conditions and financial markets, the rambunctious skaters represent the average investor who never measures the ice, and the student represents our clients’ portfolios.

Said protection typically consists of complementary asset classes that are uncorrelated to stocks, as well as a strategically designed, and sized, options hedging strategies…


Four Types of Investments

I play a lot of basketball, and, as my son and the dudes I play with will attest, I like to attempt three-pointers.

In that success enhances the enjoyment of virtually any endeavor, I knew from the start (my late start [not surpassing the 5'5" mark till after highschool and, thus, being a wrestler during my formative years]) that if I was to score enough to justify my itchy trigger finger, I had to learn good shooting fundamentals.

While I'm fully aware that 100% from the field is infinitely beyond my reach, I know that if I can stay in rhythm, if my form is sound and if I practice good shot selection, my odds of maintaining a respectable enough percentage to keep me from being the lowly last pick come time to select the teams increase dramatically.

Different players bring different talents to the game. There's a young man we play with, we'll call him Bartholomew (just in case he happens to stumble upon this blog post) who possesses exceptional ball-handling ability and plays the point beautifully. Surprisingly, however, his outside shooting leaves much to be desired. So much so that when he launches a three his teammates cringe; hoping the ball finds nothing but air.

Now why would his own teammates want Bart to miss his shot, in embarrassing fashion no less? Because they know that if he drains it, their odds of winning will decrease exponentially.

You see Bart believes that a shot that goes in has to be a good shot. Therefore, when he makes one he believes that he suddenly possesses the fundamental makings of a good shooter -- and good shooters shoot. So he shoots and he shoots and he shoots and, in reality not having mastered good shooting fundamentals, he misses and he misses and he misses and, alas, his team loses.

We can sum up basketball shooting as follows. There are:

1. Good shots that go in.

2. Good shots that miss.

3. Bad shots that miss.

4. Bad shots that go in.

#1's are great.

#2's are fine, unavoidable, and possess a liveable probability rate.

#3's, while costly, are the most predictable and, therefore -- being costly -- should be readily avoided.

#4's -- as explained above -- are an utter curse!

Here's my point:

We can sum up investing in precisely the same fashion. There are:

1. Good investments that make money.

2. Good investments that lose money.

3. Bad investments that lose money.

4. Bad investments that make money.

#1's are great.

#2's are fine, unavoidable, and possess a liveable probability rate.

#3's, while costly, are the most predictable and, therefore -- being costly -- should be readily avoided.

#4's: I can't think of a worse case scenario than a new investor hitting a #4 right out of the gate. The perverse feedback from that experience could absolutely send him/her to the poorhouse -- as he/she might think that he/she's discovered a high probability investing method and chalk up the subsequent string of losses to rotten luck.

I.e., believing what are in reality #3's to be #2's. The emotional imprint from that early "success" may indeed last longer than his or her capital.
Our ultimate goal as a firm is to do the deep macro and micro work that has us only making what we believe to be fundamentally good investments on behalf of our clients’ portfolios...

Well, folks, the easy part’s over… The rest of our letter, coming to you in sections over the next two weeks, will take us deep into the market/economic weeds.

Thanks for reading!

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