“No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word.” ― Nassim Nicholas Taleb, Fooled by Randomness
Back in 1992, a woman named Julie Larm found out her eldest son had cancer. As any concerned parent would, she wanted to find out what caused her child's cancer particularly since she had four more children and wanted to avoid the same fate for them. She started a group called the Omaha Parents for the Prevention of Cancer. Through their amateur investigative work they became convinced that power lines were causing the cancer. They saw clusters of cancer cases overlapping with places where there were power lines, and they made up their mind.
Nobody can fault Mrs. Larm for her tenacity in trying to ensure children of her community are protected from cancer. Unfortunately, their efforts were largely misdirected. They were suffering inadvertently from something called the Texas Sharp Shooter Fallacy which gets its name from a drunken Texan who used to shoot at his barn after imbibing.
Obviously, with diminished faculties his accuracy was poor. However, if you shoot enough times, purely by chance, you will get clusters. Now, if you paint a target around one of those clusters it simultaneously makes the Texan look a steady sharpshooter and distracts from the other bullet holes indicating his lack of skill. Mathematician Kit Yates described this fallacy as "the bastard child of confirmation bias and hindsight bias".
Despite having the best of intentions, the parents were wrong about what was causing the cancer. Physicists and others examined the potential mechanisms for the electromagnetic waves to cause cancer, and there simply isn't one. These mothers, as well intentioned as they were, were making the same mistake people made when they complained about the Apple playlist not being random because they got an artist two or three times in a row.
The human perception of randomness is inaccurate most of the time. Actual randomness tends to cluster and power lines tend to be in populated areas, so it is most likely that these clusters of cancer cases around power lines were completely due to chance.
That's the thing about randomness, it doesn't feel to random to us. If you look at the three above datasets, the one on the left is the truly random one. The two on the left are features of organic lifeforms purposely spacing out to avoid consuming the same resources. That is, they are not random at all. Yet most people will select the least random of the three as their choice for what is random. This is but one way we are debilitated in our decision making when it comes to money. We constantly crave a narrative to put events neatly into.
When you think of our approach to investing here at www.punkrocktraders.com, we want to bet the Texas Sharp Shooter. We want to look at his target, and look at the bullet holes around it, and say, I'll bet you $100 you can't hit the bullseye! Markets make this metaphorical ability a reality. The fear and confusion of others can be capitalized on.
The Fed Is Your Friend and Recession is Unlikely
Yesterday in this column, we discussed how much of the economic apprehension in surveys wasn't really adding up. I postulated that a lot of economic views had become perverted by political ones. What we discussed yesterday and what we discussed today shows that people can believe entirely false things with great conviction. And they can also take views complacently, which they feel are socially acceptable. Both these facts when applied to markets create an opportunity for alpha.
Recession fears have been very high for a long time, and due to anomalous data from COVID certain indicators have been wrongly predicting recession for quite some time. Yet the economy remains strong and one of the largest threat to continued prosperity, inflation, has been all but declared dead as a major risk by the Federal Reserve. It may be lost on many who don't closely observe the Federal Reserve just how bullish and dovish the last Jackson Hole speech was, but I will contend that it is the most dovish speech in the history of the event.
There has been some fluctuations in growth and many of the normal correlations that industry professionals and economists use to gauge where we are in the economic cycle were, to put it simply, smashed by COVID. It's important to remember that the effects on behavior and their secondary effects on economic activity of the pandemic are far more powerful than most or all the economic catalysts that preceded it.
It's impact is still being felt. And here in lies where we bring our power line metaphor full circle. A large cadre of Wall Street is still convinced that fluctuations in money supply caused inflation rather than the largest economic catalyst of our age. I strongly disagree with the former notion and I think events subsequent to COVID largely support my stance.
The recession predictions have simply been terrible. And we had a bear market in the stock market based on the 'fact' that we were going to have a recession and we never did. I think the economy is a lot stronger than most people think partially because the pandemic cleared out so much dead wood, but also because government intervention during the economy was largely successful and seems to have helped the lower income quintiles boost their earning power as they had time to reconsider their productive capacity in many cases. There is a lot good going in the economy, yet the fear itself is helpful when you think about it.
When so many people are fearful of a recession or think one is happening when one is not, they actually tend to engage in behavior that prevents a recession from happening. The behavior leading up to recession is optimism and ebullience that leads to a widespread level of financial overcommitment, which then causes a recession. When people realize they or their businesses have been overly optimistic they spend less, they cut jobs, and they don't invest in their business.
However, when they are fearful of recession they don't over extend themselves. They are frugal. They keep their books in good order and don't overspend. And when demand doesn't peter off like they expected, they have expanded margins. They might even need to hire someone to help with the unexpectedly high levels of volume.
So, I am of the opinion that recession is unlikely and that the economy is much stronger than consensus affords. This has been crucial to my trades shorting the $VIX. Recently, in a piece on Tuesday I urged folks to buy the $15 September 18th put options on the $VIX. As of yesterday's close, in only two days they appreciated 132% from the price I recommended them at on Tuesday. It is looking like it will have a good day today as well. I may send out a sell alert later.
But much more significant than just short-term trades based on the market's strong fundamentals, whether or not we are in recession has great bearing on whether or not the market is likely to have good performance over the next period. As you can see, if we are not in recession, then performance is materially better following the beginning of a cutting cycle than if we are.
When you parse out seasonality further, as my former colleague from Fundstrat Matt Cerminaro has done brilliantly, you can also see that whether we are in an election year or not also has a great bearing on performance during elections years. So whether we are in recession or not, or imminently approaching it, has great bearing whether or not stocks perform well over the next few months. I have postulated that the volatility event from August 5th should allow us to forego some of the typical seasonal volatility in September, and this was crucial to my successful VIX trade. If you didn't sell already, today might be a good time to lock in gains from this trade. We'll discuss next week what we are going to do with our gains to help build long-term wealth.
