THE DRAGONS ARE IN OUR HEADS

MANAGING FEAR IN A WORLD OF ENDLESS INFORMATION

Last Friday night, my four year old son and I went through our typical bedtime routine. He took a bath, brushed his teeth, and then picked out three books...not one, not two, not four. Always three and he takes his time. Any parent who reads their kids books at night knows this is a classic stall tactic. Eventually though, he climbed into bed with the books. Two were part of his “regulars”, but his third choice surprised me —“Mikey and the Dragons”. The book had been on his shelf for several months, but for whatever reason, he had not chosen it yet. I gave him a puzzled look and asked, “Are you sure?” He just smiled and nodded. 

"Mikey and the Dragons" is a story about a young prince who recently lost his father, the King. For years, the King had kept the kingdom safe from the dragons on the other side of the hill, but with the King's passing, it was now Mikey's responsibility. The young prince was worried he was not up to the task. However, this changed after he found a note his father had written him shortly before his death. It read,

“When I was a little boy, I was also small. I had fear in my heart and didn’t know where to start. I couldn’t imagine going over that hill to face the dragons. But do not worry my son, you will be just fine if you can keep these things in your mind. The dragons aren’t really that big at all. It is only in our minds that we make them so tall. Inside our brains things always get overblown, especially things that are completely unknown.”

After reading the note and feeling inspired, Mikey decided to head over the hill to confront the dragons. 

At this point, my son and I were both expecting the young prince to slay the dragons. To our surprise though, when Mikey made it to the other side of the hill, he noticed something unexpected -- the dragons were much, much smaller than he had imagined. They were overblown. Why? Because they were unknown. 

We finish the book and I turn back to my son, but his eyes are closed. As I sat there in his bed, it dawned on me. We are currently living through a period consumed by fear, largely fear of the unknown. COVID-19 and the contentious political environment are the obvious reasons, but our fears are deeper than that. Fear today seems to be largely tied to our inundation with data. Too many pieces of conflicting data. Too much opinion. Too much misinformation. The result is people do not know what to believe. So what do we do? We data mine. We gravitate to whatever supports our underlying behavioral biases. Pessimists become Cassandras, while optimists become Pollyanna's with little room left in the middle.

The young prince was fearful because of a lack of information (i.e. not knowing what the dragons were like). Investors today are fearful because they have access to too much information. A letter and a trip over the hill solved for Mikey's fear. Could investors benefit from something similar? Quite possibly, but first let's take a look at the evolution of information, incentives, and how both drive markets.

A FATTENING BELL CURVE 

For some context, let's take a look at how the world of journalism and information dissemination has evolved. If you picture the universe of information as a bell curve, fifty years ago it would have looked something like this: 

In this world, the curve was largely populated by the major networks, newspapers, and traditional data sources. People relied on the likes of Walter Cronkite and Edward R. Murrow. The news was fact checked and, for the most part, just the news. Data was available, but it required exhaustive searches -- think libraries, punch-cards, and micro-form machines. It was difficult to aggregate, synthesize, and act on.

With the rise of satellite news networks like MSNBC, CNN, and Fox News in the 1990's, the curve's tails began to fatten. News was now available 24 hours a day, 7 days a week. On one hand, this meant better access and transparency. On the other, it meant more opinions and biases. This gave the networks more power to control to narrative and made it more difficult for consumers to separate truth from fiction. This world looked something like this: 

Fast forward to today. With the complete polarization of the networks, combined with bloggers, bots, and Tweeters, information and data is coming at us from all directions. This means that the average American (and therefore investor) has access to any piece of data or opinion they want. The result is that our beliefs are shaped by who we choose to follow, read, or listen to. As a result, we are currently living in multiple realities. This world looks something like this. 

The "fattening tail" phenomenon has led to some profound changes and a new world for investors.

So why did this happen? Because there has been every incentive for it to happen, or as Ted Koppel astutely commented,

"Journalism is so fragmented now. We have so much journalism. Everyone is in competition for a tiny little fragment of the audience. Whereas thirty to forty years ago we used to be in competition to give people the news that they need, now we are in competition to give people the news that they want."

INCENTIVES

Charlie Munger once said, “Show me the incentives and I will show you the outcome.” He might as well have been speaking about the media. Look no further than CNBC’s ratings during economic turmoil versus more placid economic periods .

More chaos, more eyeballs. More eyeballs, better ratings. Better ratings, more advertising. More advertising, higher revenues. It is that simple. So, how does a network like CNBC get this "flywheel" going? By running BREAKING NEWS headlines every six minutes, projecting images of bears attacking bulls, and making outlandish comments like “Largest Point Drop in Market History” with no mention of the fact that the percentage loss was relatively minor. CNBC is not alone. These incentives are spread across the economy.

In his best selling book, “The Science of Fear”, Dan Gardner unpacks this dynamic well by highlighting the fact that,

“Fear sells. Fear makes money. The more fear, the better the sales. So we have home-alarm companies frightening old ladies and young mothers by running ads featuring frightened old ladies and young mothers. Software companies scaring parents with hype about online pedophiles. Security consultants spinning scenarios of terror and death that can only be avoided by spending more tax dollars on security consultants. Fear is a fantastic marketing tool, which is why we cannot turn on the television or open a newspaper without seeing it at work.” 

Simply grasping this concept, understanding incentive structures, and having an appreciation for how quickly information now spreads can provide an investor with an advantage because these factors are increasingly elevating levels of fear and pushing markets to extremes. Knowing this, is it any wonder we have seen three of the sharpest selloffs in a century occur since the advent of the internet?

HISTORY

This is not a new phenomenon. Look no further than David Dreman’s book “Contrarian Investment Strategies”, published more than two decades ago. In it he wrote, 

“How do we know when a crisis has arrived? The symptoms are anything but hard to find, and usually are downright unavoidable. They appear on prime time news or in banner headlines. In each case, the crisis is the major news of the day. Legions of experts are interviewed, most making dour forecasts of structural damage to the nation. A common theme is ‘things will never be the same again’. Because when the nation, if not the world, is focused on the crisis, the media is in its glory. A crisis sells newspapers, builds ratings, and pedals advertising.” 

Dreman would go on to highlight the case of the Gulf War earlier in the 1990's and the impact it had on markets, 

“In a crisis, most people do not make objective evaluations. Therefore, perceptions that drive stock prices end up taking on a life of their own. Look no further than how the U.S. media portrayed the 1990 Gulf War by focusing overwhelmingly on the devastating problems the U.S. faced and how it would lead to oil shortages and severe economic losses.”

So, what happened? In the third quarter of 1990, equity markets experienced the fourth worst selloff of the post-war period. Was it justified? Clearly not. Instead of it being a prolonged military conflict that caused severe economic damage, the U.S. military drove the Iraqi military out of Kuwait with extreme ease and minimal loss of human life. As for those oil shortages or economic losses. You guessed it. They never materialized. 

Today, given the current backdrop, these types of scenarios are only magnified. Therefore, the fear is as well. So how can we combat it? Maybe a letter of our own would help.

THE LETTER

Earlier this year, my brother and I went to listen to the author of “Mikey and the Dragon” speak at the Warner Theater in Washington D.C. Now, I bet you are wondering why two nearly 40 year old's would go listen to a children’s book author speak. Be honest.

But, what if I told you that the author is retired Navy Seal commander, Jocko Willink?

I mean, just look at that guy. If anyone could head over and combat some dragons, it is him. More importantly, as a best selling author and a veteran, there might be no one more equipped to pen a letter today. A letter to investors might go something like this (composed from a variety of his talks, writings, and podcasts): 

“In the 24/7 news cycle that we are on, every news story is THE END OF THE WORLD. Everything that happens is ‘Trump Did This’ or ‘Pelosi Did That’ and it is the end of the world. If Hillary got elected IT IS THE END OF THE WORLD or if Trump gets elected, IT IS THE END OF THE WORLD. Instead of succumbing to this fear, listen to what different people have to say. Try and understand what their perspectives are."

A deluge of information makes it easy to believe the world is full of dragons. Is the COVID-19 pandemic incredibly serious? Yes. Has it been life altering in many ways, especially for those who have lose loved ones? Of course. Has our response as a nation been disjointed and lacking? Yes. Yet, we will get through this. The fact is, the country has repeatedly faced difficult moments. They just seem to be happening at an increasing rate. But is that because they really are happening more often or has this information overload story played a role? Remember when we were on verge of World War III when American forces killed the Iranian general Qasem Soleimani? That was in January….of this year. Today, more than ever, it pays to put things in context, while being more discerning, open minded, and critical of all the news we consume.

If the first part of the letter hits on maintaining a rational perspective, the second part might go something like this,

When there is truly a major problem, say GOOD. When something is going wrong, say GOOD. When things are going bad, there is going to be some good that comes from it. You learned. Unexpected problems? GOOD. We have the opportunity to figure out a solution. That’s it. When things are going bad, don’t get all bummed out, don’t get frustrated. If you can say the word, GOOD, guess what, it means you are still alive. So get up, dust off, reload, re-calibrate, re-engage. Go out on the attack.” 

The fact is, when challenges arise people do not sit by idly. As Jocko said, they "Dust off, reload, re-calibrate, re-engage, and go out on the attack." From restaurants pivoting from dine-in-only establishments to full blown catering businesses, to teachers leading Zoom classes of 20+ young students several times a day, to retailers streamlining their online operations from in-store-only to e-commerce businesses, to auto dealerships doing home delivery and service appointments, to hotels figuring out how to manage their occupancy levels coming out of this crisis, to residential real estate companies accelerating online house tours, to technology companies helping all types of businesses navigate through these difficult times, we have seen a remarkable re-calibration taking place across all parts of the economy. Couple this with monetary support from the Fed and fiscal support from the government and, signs of longer-term optimism were emerging.

TAKEAWAY

Remaining calm in the face of information overload and appreciating American resilience are two good first steps for any investor. In fact, doing so may be two of the most controllable sources of alpha. Look no further than the correlation between VIX levels (the measurement of market volatility, otherwise known as the "fear gauge") and future returns.

Unsurprisingly, as seen in the chart below, each time the VIX hit 40 over the past three decades, it also coincided with a pretty good entry point. Though, as you might have guessed, most equity investors either sat on their hands or hit the eject button at these points.

The bottom line, as my often referenced friend Morgan Housel writes in his piece, "Permanent Assumptions", is we should never forget:

1. The world breaks once per decade. There are so few exceptions.
2. More people wake up every morning wanting to solve problems rather than wake up looking to cause harm.
3. Nothing too good or too bad stays that way forever.
4. History is mostly the story of unprecedented events. This is just another one.

Said another way, no matter how unknown things are, the dragons are never as big as we think they are.