Dealing with the Turkey Problem
(Author’s note: Given the short week, I thought I would update last year’s Thanksgiving message, as it was one of my most popular posts. I hope those of you who missed it last year will enjoy it as much as last year’s readers. If you remember the column, please move on to the Market Update portion for the latest on the financial markets.)
This week we will no doubt see photos in the press of President Trump announcing the annual pardoning of a lucky turkey. Unfortunately for most turkeys, but fortunate for most of the rest of us, this Thursday, the fate of the average turkey is not to be pardoned.
Last year at this time, I spent a good part of a week in a very small workshop with Nassim Taleb, author of many of my favorite books on risk (“Fooled by Randomness,” “The Black Swan,” and “Antifragile”). It was an awesome workshop that helped me refocus on the reasons for risk management.
In the latter two books, Nassim describes “The Turkey Problem”:
For a thousand days, the butcher feeds the turkey. With each passing day, as he steadily grows in size, the turkey becomes more convinced of the butcher’s benevolence and the probability of an ever-brighter future. Then the day before Thanksgiving arrives, the turkey gets a surprise.
The poor turkey falls prey to an issue that we all have to deal with in our daily lives. Humans have necessarily evolved into creatures that survive by taking a few events and generalizing them into a prediction of the future that they think they can reliably act upon.
We touch a stove and are burned, so we don’t touch a hot stove again. A forecaster examines a stream of earnings reports that looks like the turkey’s first 1,000 days and predicts that the next quarter will be even better.
While such “inductive” reasoning serves us in many tasks, it does a very bad job of preparing us for surprises to come. Like the turkey on the day before Thanksgiving, the surprise comes abruptly, and the result can be shocking. One can learn overnight that the hand that feeds you can literally be the one that also wrings your neck.
Our goal should be to avoid being the turkey.
How can we do that in investing? We all rely on the past to help us cope with the future. But most of us rely too much on the recent past. We need to use more data.
Stock market strategies should not be based on the last five years, for example. It’s been a bull market for most of that period. Any strategy that’s worth its salt must be tested through at least a full cycle of rising and falling markets. Better yet, strategies should be tested through the two bull and bear cycles stretching back to the 1990s at the very least, as in our Illustration Generator. The turkey did not know what was coming, but the butcher with a larger perspective did.
Even when we have a lot of data, it is never enough. The turkey had a lifetime of data!
In the fall of 1987, when we moved all of our clients to the safety of money-market funds, there had never been a day in 100 years of stock market history when the stock market had fallen 25% in a single day. Yet, there were events that had signaled a negative stock market environment in the past that had not been as extreme.
You act on such signals even though you can’t predict that they will lead to a day as bad as a drop of nearly 25%. That’s why we provide tools such as the Crash Test Analyzer (you must log on to our website and be a financial adviser to access the tool) and our market environment indicators.
When we test a strategy, we can examine on a more micro level how various asset classes respond. A burn from a slight touch of a stove allows us to decide that putting one’s hand in a bond “fire” is not a good idea. And a strategy that does worse than its benchmark on a small down day can tip you off that it is going to have even more trouble with a major decline.
Of course, even this is not enough. Sometimes you are just surprised. “Every strategy works until it doesn’t,” is our oft-spoken mantra. The turkey’s strategy of daily eating at the feed trough always worked … until it didn’t. The only solution to this dilemma is to diversify.
While high fences and the clipped wings of the turkey prevented it from diversifying its risk, investors are not so limited. Instead, they have the freedom and ability to not put all of their eggs in one basket.
Traditionally, this has been accomplished by creating portfolios made up of multiple asset classes. The hope is that when most go down, some will go up.
But in the last two major market declines, almost all asset classes plummeted. Bonds and gold have been the exceptions. Yet, looking into our future, with bond yields rising, it’s possible that they will not deliver as much protection as in the past. And while gold often shines in a downturn (like now), few investors or advisors seem able to muster the 25% investment that would have given maximum protection in past declines.
Diversifying into a number of uncorrelated, actively risk-managed strategies is a sounder, more robust way of dealing with surprise. These strategies are usually not related to a single asset class, as they can dynamically switch or rotate into defensive positions when the environment warrants it.
A portfolio of these strategies can provide a more robust solution to “The Turkey Problem.” The key is uncorrelated strategies. If you choose strategies that “flock together,” all moving in the same direction most of the time, they are not likely to be uncorrelated. If you don’t choose recent losers with the winners, you will probably have a portfolio of all losers when the next bear market begins.
Remember, when constructing investment portfolios, you are creating your portfolio for what lies ahead. The risk you are preparing for is not in the past. Like with the turkey, the real risk is in your future.
Market Update
The present stock market chart looks like the Turkey Problem chart. The only difference is that the turkey chart ends with a peak the day before Thanksgiving, while it appears the S&P 500 reached the chopping block back on September 30. On that day the index hit an all-time high. But since then we’ve fallen 6.6%.
Last week it appeared that we might have turned around and could go into rally mode. The index rallied for two days, and if it had passed the level hit on the day of the last red arrow in the above chart, we would have taken out a previous peak value after hitting a higher low (the point of the green arrow). Instead, with today’s (11/19) action at midday, it appears that we are close to confirming the downturn. This happens when we have two peaks at ever lower levels since a high and three dips to ever lower values.
We were looking good going into today, as the green-arrow dip was higher than the lowest red arrow. But today we are close to taking out last Thursday’s intraday low. We’ll have to see if the market can rally in the afternoon to avoid closing below Wednesday’s close of 2,701.58. With the S&P 500 trading at 3683 as I write this at 2:15 p.m. on Monday (11/19), a 0.7% rally in the remaining two hours seems unlikely, given the severity of the turndown today, but, of course, it is possible.
If that comeback is realized, it would be very positive for stocks. However, if it fails, the attention then must shift for the bulls to the index low hit back on October 29 (2,641.25 close, intraday low of 2,603.54). Will it stop the falling trend (as often happens at previous market low points), or will that continue? It does not appear that the NASDAQ will be stopped today by its October 29 low (7,050.29, 6,922.83 intraday).
The bounce in stock prices that we suggested in our October 29 Market Update did come to pass, and it is entirely possible that, if we can survive between now and Tuesday without breaking below the October 29 lows, a Thanksgiving bounce could move us higher.
Traditionally the Wednesday before and the Friday after the Thanksgiving holiday sees prices move higher. While the chart below discloses exceptions to the rule, the chart does definitely show an uptrend historically for an investor who only invests during those two days.
This seasonal advantage is not present either today, the Monday before Thanksgiving, or next Monday. Both of these Mondays historically have been down more than they have been up. And as we pointed out in past Market Updates, a market with a Republican Senate and Democrat House has not been positive for stocks for the first two weeks of December.
The intermediate-term indicators for Classic, STF, and Market Leaders, like the chart analysis above, are close to delivering a sell signal for the first time in over a year. The short-term indicators have already flipped to sell, although one has reversed (but it is likely to be whipsawed back to a sell given today’s action).
Our market environment indicators remain the same as last week. The All-Terrain measure continues to provide support for a return to a bull market mode, while the Volatility measure has suggested increased volatility, albeit with a chance for a renewed market rally.
Economic reports continue to disappoint more often than not. But a few of our recession indicators are suggesting such an event within the next 12 months.
The world economies are slowing down and their stock indexes are mostly already in bear market territory (20% or greater decline). This is markedly different from the U.S., where we are only slightly down from recent highs and our economy shows few signs of slowing.
One area of concern here, though, is the housing industry. Unfortunately this often leads the rest of the economy. It is slowing down as it absorbs the higher interest rates imposed by the Federal Reserve. While I am in the camp of those who do not believe the Fed will raise rates much higher, if they do, it would be dire news for stocks. The collapse in homebuilder stocks this year (down over 30%) may be a preview.
Friday we retraced some of the gains in rates, but as in the past, nearing the short-term low point has only caused them to reverse direction and soar. Today at the opening this happened again. However, with the ensuing decline in stocks that began this morning, rates are now falling. They have even set a new short-term low as I write this. The decline in stock prices today has sent both bonds and gold higher in the usual flight–to-safety trade.
Despite this, our Strategic High Yield Bond strategy is selling bonds today and moving to money-market funds. The Strategic High-Yield Growth strategy had already moved similarly some time ago. High-yield bonds sometimes act like stocks and at other times like bonds. The sharp decline in stocks has finally translated into weakness in high yields.
Probably the greatest area of concern is earnings. Yes, I know, we just finished earnings reporting season last week and the average stock saw growth in the 20%-plus area. But these gains are on the back of the Trump tax reductions. After adjusting to that, it does not appear likely that earnings will be able to manage much above 9% growth in 2019.
This matters greatly to stock investors. Although the 9% growth would be solid and during most times very bullish, historically stocks have moved in the direction of changes in the rate of growth, not the absolute growth percentage. This is demonstrated in the chart below.
The inevitability of this selling pressure is quite concerning.
I’m not suggesting that a “day before Thanksgiving” event is nearing for the stock market, only that we need to use all of the tools at hand—maintaining an active vigilance with our investment portfolios, and using time-tested and dynamic risk-managed strategies in a strategically diversified portfolio—to protect our investments not from the risks of the past, but from those that are always in our future.
From all of us here at Flexible Plan, may your Thanksgiving deviate to the max from that of the turkey’s and be full of family, good food, and holiday joy.
All the best,
Jerry