Wednesday, December 6, 2023

PWA 2023 Year-End Letter, Part 1: If A Blizzard Hits, Characteristics of The Best Portfolio Managers, and An Invaluable, Timely, Quote-Fest

As you (clients) know, I enjoy using analogies to explain our view of market and economic general conditions... In the past I've associated our macro analysis with the flight path of an eagle affixed with electrodes, etc., that allow us to monitor its vital functions as it glides across blue skies, sores to high altitudes, and flaps its way through the storms that occasionally cross its path.

Fishing, basketball and ice skating have also inspired some storytelling that has helped me drive home how we approach the task of preserving, protecting and growing our clients' wealth in a manner that has them satisfying their objectives while, ideally, feeling comfortable amid the inevitable ups and downs delivered by world markets.

I stumbled onto the latest during a discussion with a client who loves to go hiking... I explained to her that our approach to taking on risk (and, thus, the potential for higher returns) could be thought of as deciding whether or not it’s safe to head for those vaunted higher elevations -- those levels, while beautifully breathtaking when the weather's beautiful -- where an unanticipated storm could do some serious, long-term, damage to one's physical and emotional wellbeing.

Truly, the more beautiful, or greater, the reward, the greater the risk one must take in reaching it.

Here's me paraphrasing the analogy in a June blogpost

"When, for example, there's a 50% chance of a blizzard over a given time period, and at a certain altitude, you simply don't go hiking up there until the forecast clears... Whether the blizzard* occurs in the meantime means absolutely nothing... Even if it doesn't snow, not hiking up there (given the risk in the forecast) was 100% the right decision."

In an investing context:

"...if one stays consistent and always makes such thoughtful decisions, the odds of one ever going broke are greatly reduced... As, make no mistake, there will be financial blizzards* that will materialize in our future; whether or not one occurs in the coming months remains to be seen, but, as we continue to point out, odds are such that prudence is presently warranted."

*The "blizzard" risk, in terms of the equity markets, on the relatively near-term horizon is one of recession, and the fact that valuations (particularly for the US market) and company earnings estimates are presently assigning it zero odds -- while our model, and the ones of many of the worlds' best economists, highly suggest otherwise.

In the ideal scenario, we remain in the foothills (diversified and hedged) as long as the storm risk looms... If indeed the storm hits, our goal then will be to strap on our snow shoes and slowly begin our ascent when our models signal that it's beginning to abate.

Along the trail we'll encounter those who either didn't see the signs, or ignored them altogether, and who will be desperate to offload their equipment (for far less than they paid for it), and get themselves out of that freezing mess they got themselves into... Of course we'll be more than happy to purchase quality equipment (stocks, etc.), on the dirt cheap, when we're comfortable traversing those ever-desirable higher elevations.

If, on the other hand, the blizzard doesn't hit, that's perfectly okay, for, as our forecast clears, we'll then gladly begin our ascent to higher elevations -- with zero desire to catch up to those who, unwittingly or otherwise, chose to accept what was in fact cripplingly high risk.

I.e., we here at PWA are steadfastly committed to the principle that investing is in no way, shape or form, a race... Our responsibility is to invest our clients' hard earned wealth in a manner consistent with their time horizon, their risk tolerance, and with our overall view of the present global macro risk/reward setup -- with utter disregard for what other asset managers are up to... Except, that is, when we're considering the prevailing market sentiment, the degree of crowding, etc.

In Part 2 we'll offer up the data that justify our still cautious view of conditions, and that suggest that those who are presently stationed at those higher altitudes are strapped with some dangerously heavy (expensive, in market terms) equipment... In Parts 3+ we'll explore what we see as literally a world of opportunity beyond whatever's left in the present cycle.

In the meantime, here's the list of what we believe to be the essential characteristics of the world’s best portfolio managers -- traits we everyday strive to embody -- that we've featured in the past few year-end letters Part 1:

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.

We'll close Part 1 with an apropos for these times quote-fest from one hugely successful, seasoned investor who I believe embodies those characteristics; Howard Marks:
"’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it." 

 "Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can’t know when a stock is too high and therefore resist joining in. And with a market in freefall, they can’t possibly have the confidence needed to hold or buy at severely reduced prices."

"You must be aware of what’s taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this—more than anything else—is what dooms most investors to being victimized repeatedly by cycles of boom and bust." 

 "Understanding uncertainty: The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities."  
"In the tech bubble, buyers didn’t worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the greater fool theory works only until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.
• The positives behind stocks can be genuine and still produce losses if you overpay for them.
• Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy.
• A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.
• “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time … or become far more so.
• Eventually, though, valuation has to matter."
 "When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reason? These are the people Nassim Nicholas Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors." 

"...since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999. That year, underperformance was a badge of courage because it denoted a refusal to participate in the tech bubble.)" 
"The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up." 
"...everything in the investing environment conspires to make investors do the wrong thing at the wrong time." 
"...when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well." 

 "Surely investors who get their statements and find that their accounts made 10 percent for the year don’t know whether their money managers did a good job or a bad one. In order to reach a conclusion, they have to have some idea about how much risk their managers took. In other words, they have to have a feeling for “risk-adjusted return.” 

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