The Black Swan

“Something is rotten in the state of Denmark” ~William Shakespeare

Let me start this piece off by saying that I am a strong believer that investing in great companies through the stock market is the single best way to generate long-term wealth. It’s given me the best job in the world, as the very nature of my work is to simply buy great businesses when they are cheap, then sit back and let others do all the work. This is the basis of fundamental investing, and to say it lightly, I’m a huge fan. I’ve based my principles by being student of the greatest investor of all-time, Warren Buffett, who posits that finding amazing businesses is the first key, but one should only invest in them when they’re on sale. In one of his most famous quotes, Mr. Buffett said, “Buy when the streets run red with blood.” In stock market terms, red always indicates the downside. It’s important to note, that inside of Mr. Buffett’s investment powerhouse Berkshire Hathaway, that he is currently sitting on over $130 billion in cash. Again, that’s one hundred and thirty billion dollars in cash, which is a considerable amount of dry powder. 

Over the course of the twenty-one years that I’ve spent professionally investing in the markets, studying its patterns, and learning from those who have seemingly mastered it (Warren Buffett, Peter Lynch, Ray Dalio), I’ve seen its violence first-hand. Within months of getting my securities license in November of 1999, the internet bubble burst, and the market crumbled. Then, in September of 2008, an unforgettable event occurred on September 15th, when Lehman Brothers filed for bankruptcy. Over the next four months, the Dow fell by 54%, costing American investors $12.8 trillion. 

Which brings us to today, where we sit at the top of the market, which is just off of its all-time highs. Many times over the past eleven years - the longest bull market in U.S. history - I’ve been asked, “Do you think it could get as bad as it did in ’08?” And many times, because I don’t want people to worry, or be plagued by unnecessary fears, I’ve answered, “Probably not.” But let me be clear, I absolutely believe that it can get that bad if not worse. 

The one thing that we all hold as a firm truth, is that no-one has a crystal ball, and timing these things perfectly, and consistently, is virtually unimaginable. There is no credible science or system that makes timing the markets possible, and while one may get lucky, what I want to focus on is this: Today, there is a much better chance that the stock market will go down, than it stands to go up forever, despite what the last 11 years may indicate.

Just like our personal lives, there are always ups and downs, and since we haven’t had many downs for investors over the past eleven years, I believe that complacency has set in again, and that is inherently dangerous. Much in the way the parent of a straight-A student is ultimately shocked when their child screws up, investors often experience shock when the good times cease to roll. I have been that father, lulled into complacency, but I’m not that kind of investor. Because I have a fiduciary responsibility to the clients whose assets I manage, my job is to avoid this false sense of security, to ferret out the risks, anticipate speed bumps, and steer portfolios around them. The best advice I've ever received applies to parents as much as it does to investors: ask lots of questions, don't put your head in the sand, and trust your gut.

In the financial world, the term “Black Swan” event is used to characterize an unforeseen occurrence, otherwise known as the “shoe that flies in from left field”. In 2008, we had just this sort of event unfold when Lehman Brothers collapsed, and in 2001, we had the tragic attacks of 9/11 which precipitated a slide in the stock market. Both of these things are examples of shocks to not only the financial system, but shocks to our emotional states. Especially in the short-run, emotions are the driving factor in the stock market, where you either have fear that drives selling, or greed that drives buying. We are by nature either pessimistic or optimistic about the future, and rarely if ever, completely neutral or apathetic. Investors, whether small (mom & pops) or large (hedge fund & pension plan managers), are all human, and it’s the “Black Swan” event that can easily turn a collection of the most optimistic hearts, into an ocean of panic. In the words of my grandpa, "When you walk through an orchard, don't forget about the limbs that hold the fruit above you!" It may have served Sir Isaac Newton to ignore this inherent truth, but, well you get the point.

The buzz word today that’s roiling markets (today’s close on 1/31 left the Dow down 603 points) is called the Coronavirus, which has spread rapidly across China, and caused major U.S. airlines (Delta and American) to cancel all flights in and out of the country. While it’s true that the flu in general kills tens of thousands of people a year, this is something much different, and here’s why it matters economically. The largest company in the world, Apple, has a number of its major manufacturing facilities in and around the Wuhan province, which is at the heart of the outbreak. With the entire area quarantined (40 million people), this will undoubtedly have an impact on global trade. Additionally, under the Phase I trade agreement, China agreed to import $40 billion in agricultural goods from the United States, primarily soybeans. This contagion puts these potential U.S. exports in limbo, and undoubtedly add to the pain that farmers in middle America are already feeling.

The U.S. stock market has more than quadrupled in value since the lows of February 2009, and just as it moved up sharply - creating unparalleled prosperity - the move to the downside will be just as violent. Today, we saw a divergence that I haven’t seen in twenty years, with just two names in big tech way up (Amazon and IBM were in the green), and nearly all other stocks that I track were in the red. On days when so much red colors my trading screen, one of the principle assertions of famed “Moneyball” author Michael Lewis’s book “Flash Boys”, reverberates in my head. In this excellent piece on modern day financial markets, he details the inherent risks of computerized trading, which is powered by algorithms and artificial intelligence, and employed at nearly every investment institution that sits inside of Manhattan. These automatic trading systems make up close to 70% of the daily volume of the stock market, with the most prevalent of these machines being devoted to one craft: High Frequency Trading or HFTs. As I’ll save the boring details of this works for another day, know this: these systems only play, and stay active in, the stock market when it goes up. When the market goes down, especially in repeated fashion, these HFT’s hibernate and completely disappear. Because these systems have only come online within the last ten years, we’ve never seen what happens in down markets when the computers sleep, but let me offer my most educated guess: If 70% of trading volume vanishes overnight, then any and all downside that the stock market faces will be accelerated at a rate that we’ve never seen. Lewis posits that these will be “Flash Crashes”, and no matter how you slice it, that doesn’t sound like a ride that anyone wants to take. At amusement parks, wild ups and downs are what we crave, but with our money, they’re the things that quickly make us sick to our stomachs.

In closing, the Dow and Nasdaq rest just off of their all-time highs. They’ve been driven there by a handful of tech companies - Apple, Microsoft, Google, Amazon, and Facebook - whose combined size makes up 17% of all of the value in the stock market. With the heartlands already ravaged by the trade war (farming bankruptcies in the U.S. hit 20% in 2019, the highest rate since the Great Depression), this divergence is not normal. When that “Black Swan” event hits, the chickens will come home to roost, and a lot of seed will disappear in a flash of feathers. In following the man I've modeled my investing principles after (Warren Buffett), we’ve got a slug of dry powder on the sidelines for clients, and have moved out of tech and all things related to China completely. “Be fearful when others are greedy’, said Mr. Buffet. “Be greedy when others are fearful.” 

Here's the link to to Part II: https://www.dhirubhai.net/pulse/black-swan-part-deux-michael-m-knittel/?published=t

Michael Knittel is the lead portfolio manager and Chief Investment Officer at Lagunitas Asset Management. He carries the series 7, 63, and 66 securities licenses, and his firm is an independent Registered Investment Advisory firm that holds client assets at TD Ameritrade and Charles Schwab. The opinions above are his own and should not be construed as investment advice. For more on Michael and Lagunitas visit the link below.

www.LagunitasFinancialPlanning.com