Author: Rocco Huang
Covestor model: Tortoise and the Hare
Many friends ask my opinions about the economy, ostensibly because of my prior job as an economist. However, when it comes to investing, I am macro-aware but not macro-driven. I react to what happens in the economy, but I don’t forecast.
Wall Street economists like to use the term “on the other hand” when forecasting the economy just in case they are proven wrong later. It's a good career strategy.
I am not going to beat around the bush here. I don’t need to. I am not forecasting the economy. I am just now-casting (i.e. trying to find out what has happened) and therefore my reputation should remain intact even if I am wrong.
There are a group of economic indicators that I watch closely, including the Purchasing Manager Index (PMI) (in all major economies), non-farm payrolls, PCE (Personal Consumption Expenditure), Average Weekly Earnings, etc. I also watch financial market indicators including equity market performance, yield curve, credit spreads, etc.
Based on these indicators (without disclosing my method), I believe that we are currently more likely than not crawling into a double-dip recession. Consumption is not picking up because employment and wage is not doing the push. For a consumption-based economy like the US, this is a death penalty. There are no growth engines left in the world as Europe, Japan, and China all have their own problems to deal with.
Accordingly, I continue to hold sufficient amounts of cash.
I am sure you will have a problem with my choice of words. What does “more likely than not” mean? Isn’t it as useless as “one the other hand”? And why don’t you hold 100% cash if you think a recession is coming?
Puggy Pearson, one of the greatest professional gamblers, used to say: “There ain't only three things to gambling: knowing the 60/40 end of a proposition, money management, and knowing yourself."
The “money management” and “knowing yourself” parts answer the “why not 100% cash” question.
(1) Money management. Very likely I can be wrong. One holds 100% cash only if he’s 100% sure that he’s got a crystal ball to see the future. I don’t, and accordingly I don’t bet the farm. What if the market rallies up?
(2) Knowing yourself. My comparative advantage is not in timing the market. Period.
The “Knowing the 60/40 end of a proposition” advice has been my favorite quote. Even the best poker players get an edge of only 51/49. Yet they turn that tiny edge into millions of dollars. It is not luck. It is simply the law of large numbers. In fact, if you make large number of bets with a 51/49 edge, you should make billions. The fact that we haven’t seen a billionaire poker player, but plenty of millionaires, probably suggests that their edge is smaller than 51/49, but greater than 50/50.
If you are disciplined enough to make a bigger bet when you feel that your edge is smaller (e.g., when you are dealt a poor hand) and a smaller bet when your edge is larger, assuming that your “feel” is, more likely than not, correct, then you can make even more money in the long run. Few are disciplined enough, otherwise there should be more than one Warren Buffett on this planet.
The quants like to say “have an edge, and bet often”. If you have an edge, you can achieve much higher a risk-adjusted return (or Information Ratio, in industry jargon) if you apply it systematically to many independent bets than if you concentrate in just one bet. There are at least 49% odds that a poker champ will lose to an amateur if they play just one hand.
How does Pearson’s advice translate into my decision to tilt my portfolio according to a “more likely than not” view about the odds of an oncoming recession?
Well, if the odds are more than 51% that we are going to have a recession, then I prepare based on this view, even if 49% of the time I will turn out to be wrong. If I stick to this strategy often enough, I will be better off.
Explaining this logic the most persuasively is a poker-related story told by Paul DePodesta (of MoneyBall fame). He’s the Vice President of player development and scouting for the New York Mets - see the story on DePodesta’s blog:
Many years ago I was playing blackjack in Las Vegas on a Saturday night in a packed casino. I was sitting at third base, and the player who was at first base was playing horribly. He was definitely taking advantage of the free drinks, and it seemed as though every twenty minutes he was dipping into his pocket for more cash.
On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: "Dealer, I want a hit!" She paused, almost feeling sorry for him, and said, "Sir, are you sure?" He said yes, and the dealer dealt the card. Sure enough, it was a four.
The place went crazy, high fives all around, everybody hootin' and hollerin', and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: "Nice hit."
I thought, "Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn't justified just because it worked."
The moral of his story is that casinos really love Blackjack customers who ask for hits when already having 17 with the first two cards, even if the next card may be a four from time to time. In our context, it is not wise to be fully exposed to the market when the odd of a recession is “more likely than not,” even if the market may indeed goes up the other 49% of the time.