Friday, December 23, 2022

PWA 2022 Year-End Letter, Part 1: Still Icy Waters For Now, But Warmer Temps (in spots) on the Horizon

We'll begin this year's final message with a look back at the market metaphors we explored in last year's Year-End Letter, Part 1.

But first (as in previous Part 1s) we'll list what we believe 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. A willingness to buck prevailing market trends (diverge from the crowd) when the risk/reward setup inspires it.

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

8. A flexible and open mind.

9. Utter humility.
And as I stated last year:
Having been intimately involved in financial markets for the past 38 years, and being a fisherman at heart (observant of flows, weather patterns, water (liquidity) levels, temperature, obstacles, and so on), I tend to find investing metaphors virtually everywhere I look.

Every once in a while one of those metaphors turns into an analogy, which turns into a narrative during client meetings, which ultimately turns into a blog post.

Here we'll have a little fun with two that describe how we view the very serious work we do:
Here I'll copy and paste from last year, and, in blue, I'll comment on last year's results and update our view of present conditions:

Measuring the Ice

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, and you see a huge crowd 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." 

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!"

I 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 experience (been taking folks out onto the ice for 37 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 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.

Well, the ice indeed broke in 2022... While "drowning" in investment terms is subjective to one's overall resources/assets, and risk tolerance, suffice to say that -- unless the market literally shoots to the moon over the next few trading days -- it was a brutal year for many... Particularly for those loaded up with the stocks that occupy the Nasdaq Composite Index, which, alas, are the names that were the most popular among many investors during the previous bull market:
YTD 2021
Nasdaq Composite Index: -32.49
S&P 500 Index: -19.80
MSCI World Index: -19.69

The real shocker came to those who invested with the notion that bonds are always safe alternatives to stocks.

Bloomberg's Long Treasury Bond Index: -27.09

As for PWA clients; I wish I could report that we stayed high and dry in 2022, but, alas, I can't... I can however say that our measure of the ice heading into last year had us diversifying accordingly to the extent that -- for those 100% invested in our core allocation (i.e., with nothing idiosyncratic influencing their allocation [tax constraints, position preferences, etc.]) -- we were able to mitigate more than half of the S&P's decline and more than two-thirds of the fall in the Nasdaq, year-to-date.
Ironically, it wasn't the options hedging that made the difference -- although our SP500 puts saw quite the rally when the stock market got particularly dicey over the summer, and we netted nice gains on the put positions we traded on foreign equities when we became resolutely (short-term) bearish on that space during the spring -- it was the fact that the vast majority of our positions (commodities-oriented, Latin America and US economically-defensive equities in particular) performed measurably better than the major averages... All netted, our cost for options hedging year-to-date comes in at what you can think of as a cheap insurance premium of 0.85%.

As for our present view of conditions, while we don't believe we're out of the icy water just yet -- and, for the moment, we anticipate that'll it'll get even colder before things begin to warm up -- we indeed see bluer skies on the not-too-distant horizon... Although, as you'll read in the remainder of this year-end message, we think the skating will be far better on ponds the vast majority of investors neglected during the previous bull run.

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 do us severe long-term harm -- which, in our view, is essentially not the case today...

The ice of course represents financial market conditions, and the rambunctious skaters represent the average investor who never measures the ice (like this unfortunate fella),

and the student/customer represents our clients' portfolios...

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

Nothing to add to the next one:

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 high school 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 livable 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 livable probability rate.

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

#4s: I can't think of a worst-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 #3s to be #2s. 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 few days, will take us deep into the market/economic weeds.



  1. GM Marty! Today's blog is the Best Reading that I had out of all the books I read in 2022. You hit it right on the nail. Your message is well received and completely understood, especially for #4: "the emotional imprint from that early "success" may indeed last longer than his or her capital." Thank you my friend for the wisdom.

    1. Wow! Thanks for your feedback Sam! I'm so glad that you're finding value herein!

  2. #4!!!! 'Like Father like Son' You left me perplexed...trying to match up the metaphoric characters! I am a visual person and loved the images. Merry Christmas!