Mark Yusko Hits a Four-Bagger
My friend Mark Yusko, founder and chief investment officer of Morgan Creek Capital Management, is a phenomenon; and when you read his third-quarter letter, excerpted in today’s Outside the Box, you’ll see what I mean. His missive (a 72-pager!), has two main parts: a “Letter to Fellow Investors” and Morgan Creek’s “Third Quarter Market Review and Outlook.”
Now, I could subject you to the latter, but the former is a heck of a lot more fun. It’s an amazing disquisition that takes us deep into the weeds on the subjects of Isaac Newton, Yogi Berra, and Willy Wonka. As you savor Mark’s encyclopedic knowledge and obvious love of baseball (and just about everything else), you may begin to understand why he’s such an effective hedge fund manager. Energy like this is hard to top!
And of course, Mark isn’t just spouting off; he’s calling on the aforenamed greats (among others) to help us “solve the puzzle” of today’s increasingly screwball market. As he says,
As we stand here today in November examining the data, Darkness did not Fall and Gravity did not Rule on the equity markets, so what do we make of these results? Has the Universal Law of Gravity (valuation) been repealed? Have the global Central Banks finally discovered Babson’s anti-gravity machine, or is QE the symbol for the new element Upsidasium?
Let’s look back over the past year and see if we can call on a few heavyweights to help us with these questions and then we’ll introduce a couple of new characters to our serial to help us solve the puzzle.
(And those of you who want to go for the double-header and take in Morgan Creek’s “Third Quarter Market Review and Outlook,” too, you can do so right here.)
I have known Mark for well over a decade, and we finally got our schedules in sync so he could become a regular part of the Strategic Investment Conference. Not only does he give a boffo presentation on his best ideas each year, he also helps me by moderating and being on panels. When there is somebody as bright as Mark in the room, you want to get him in front of the audience as much as possible. Last year, I gave a short presentation, as most of the conference attendees are readers, and so they are already familiar with my main themes; and then Mark came on and began to pull out questions and themes and comments for the better part of the session – which attendees told me they enjoyed immensely. He is both entertaining and informative and has the ability to bring out your ideas and thoughts – he and I trade both newsletters and ideas.
Mark will be just one of the heavy hitters at my upcoming Strategic Investment Conference, next March 6–9 in San Diego; and for the next eight weeks in Outside the Box, I’m going to feature some of the other stars in our lineup: Niall Ferguson, George Friedman, Lacy Hunt, Grant Williams, and several more.
But if you want to see them pitch, catch, and hit in person (and hey, maybe even get them to autograph your hat), you’d better hustle, because we want to fill up our seats early this time so we can focus on making SIC 2018 our best conference yet (which it always is – but we do have to work at it!). And if you register in the next two days, by Friday, December 15, you can take advantage of early-bird pricing! Here’s the link.
OK, I think I’ll hit the send button and let you dig into Mark’s remarkable prose. And I do need to get back to my own knitting. Have a great week!
Your loving all the historical analogies analyst,
John Mauldin, Editor
Outside the Box
Letter to Fellow Investors
By Mark Yusko, Morgan Creek Capital Management
Excerpted from “Q3 2017 Market Review and Outlook”
Full PDF here
Full PDF here
It’s déjà vu all over again and #pureimagination.
When we released the Q2 Letter in August, we knew with absolute certainty that a week later on August 21st at 10:15 AM PDT darkness would fall on America and millions of people during the total solar eclipse. On Sunday night, we packed up the car and headed west to Tennessee (the forecast was for clouds in South Carolina and we didn’t want to take any chances) to find a spot in the Path of Totality so we could witness the magic of Black Monday (the trip with Will was a blast and the experience was indeed pretty magical). What we didn’t know for sure was how the eclipse might impact the capital markets (we shared a few theories in the letter), but we had posited a thesis in January that equity markets might be following a path similar to the 1929 Bubble and that perhaps the eclipse might usher in a #SeptemberToRemember similar to the Babson Break that catalyzed the Great Crash. We had laid out details of how the scenario might play out in our #WelcomeToHooverville Letter and we did see a large number of similarities between the events of 1929 and the events of 2017. That letter was the first of a three-part serial (now four-part) that tied together some observations about why we believed U.S. equities were overvalued and how the wisdom of Roger Babson’s warning in September of 1929 might be critical again today. In the first installment, we discussed #BabsonsBrilliance, and learned of Roger Babson’s obsession with Sir Isaac Newton and his Universal Law of Gravity (so obsessed was Babson that he spent his later years, unsuccessfully, searching for a way to defeat gravity). We learned in the second installment about how, in the end, #GravityRules and how Sir Isaac (despite being one of the most intelligent humans to ever walk the planet) shared the fate of being a Not So Intelligent Investor along with Ben Graham, as they both lost their fortunes by chasing stock market Bubbles (Newton in the 1720 South Sea Bubble and Graham in the 1929 DJIA Bubble). We learned in the third installment about how Newton discovered the Law of Gravity and reflected on some other Newtonian wisdom that we thought might apply to investing. We also discussed how eclipses played an interesting role in Newton’s work (movement of heavenly bodies Newton studied to create his great theories), changed his legacy (Einstein’s theory of Relativity that expanded Newton’s static theories was proven using an eclipse) and brought us right up to the point at which darkness was to fall on August 21st. While we believed that markets did bear a striking similarity to the 1929 Bubble period and we wrote “For now, we think it is wise to prepare and be ready for when #DarknessFalls” we did leave ourselves the flexibility (like all good scientists, economists and investors) that “Should the data change, we will change our minds and formulate a new hypothesis.” We believe in the wisdom of Lord Keynes (that we have related in Letters past) who, when confronted by an audience member in one of his lectures who challenged him for saying something different from a similar lecture a few weeks earlier very matter-of-factly replied, “When the facts change, I change my mind. What do you do, sir?” Newton would say that the data speaks and that the outcome (not your belief) is the truth. “A man may imagine things that are false, but he can only understand things that are true, for if the things be false, the apprehension of them is not understanding.” We expounded on the point, saying “The data is what it is and you cannot make it what you wish it to be. In investing, the outcomes are what they are (the company executes or it doesn’t) and we can’t understand an opportunity to be good (imagining the falsity of a negative outcome to make it positive), but human beings are prone to this behavior in investing and we must guard vigilantly against those urges.” As we stand here today in November examining the data, Darkness did not Fall and Gravity did not Rule on the equity markets, so what do we make of these results? Has the Universal Law of Gravity (valuation) been repealed? Have the global Central Banks finally discovered Babson’s anti-gravity machine, or is QE the symbol for the new element Upsidasium?
Let’s look back over the past year and see if we can call on a few heavyweights to help us with these questions and then we’ll introduce a couple of new characters to our serial to help us solve the puzzle. As the first picture at the top of the Letter connotes, “As the story goes, young Isaac (the Sir comes later) was having tea under an apple tree when and apple struck him on the head and he had the epiphany “what goes up, must come down” which led to his formulation of his notion of gravity.” We also wrote how “Newton’s eureka moment was in his deduction that there must be some “force” acting on the apple to bring it toward the earth and his hypothesis that this force must act on the apple no matter how high the tree.” The key point was that the force worked no matter how high the object moved from the ground and therefore the essence of equal and opposite took shape. Newton’s Laws of Motion III stated specifically that, “to every action there is always opposed an equal reaction; or, the mutual actions of two bodies upon each other are always equal, and directed to contrary parts.” This construct was Roger Babson’s favorite and forms the foundation on our thesis on Bubbles and Crashes and so we would add a corollary, the bigger the speculative Bubble, the worse the Crash on the other side. We went on to apply this framework to equity markets in discussing how in every Bubble in history (defined as a movement of two standard deviations above Fair Value) whenever the markets arrived at some extreme level above that threshold, they came back down again Earth (no exceptions, it’s never different this time). In the Letter last quarter, we discussed how the eclipse might be related to the Newtonian Laws and that we might finally see the equal and opposite reaction to the action that had inflated the equity bubble to this point. We discussed how in Ancient China eclipses had great life impact, saying “eclipses were believed to be heavenly signs that foretold the future of the Emperor (important to him). The story is told that Chinese Emperor Chung K’ang (2159 – 2146 BCE) learned of an eclipse from the noise in the streets (his subjects trying to drive the dragon away) and was so displeased that his two court astronomers, Hsi and Ho, did not predict the event that he had them beheaded. Their tombstone reads “Here lie the bodies of Ho and Hi, whose fate, though sad, is risible; Being slain because they could not spy, the eclipse which was invisible,” (clearly some serious life impact here). We noted that “Prior to Ptolemy’s work, eclipses were events of great mystery and were considered to be bad omens or messages from angry gods or supernatural forces, but after his work they became recognized for what they were, the simple regularity of the orbits of the Moon and Earth about the Sun.” The key point here is that ultimately, the understanding of the movements of the heavenly bodies came down to an understanding of science and math and that understanding led to a demystification of the events and the subsequent outcomes (or lack thereof) of those events. and the subsequent outcomes (or lack thereof) of those events and the subsequent outcomes (or lack thereof) of those events. Samuel Taylor Coleridge made a case that “being able to accurately predict a future event that follows from hard, mathematical calculations, determines the veracity of science and that this power of prophecy should be the determinant factor in judging scientific progress.” We took a little bit of an issue with the idea that prophecy was simply forecasting something that we know will occur (like an eclipse). We wrote that “To us, prophecy connotes something more, insofar as it conjures up thoughts of the ability to forecast indeterminate events (like market Crashes perhaps) and speaks to the aspects beyond the physical event (particularly when heavenly bodies are involved).”
We discussed last time how Newton believed that in order to make a meaningful impact you had to be willing to venture into uncharted territory, in other words, take a risk, and said emphatically, “No great discovery was ever made without a bold guess.” We believe it is the same in investing, “To make a truly great investment requires an investor to venture away from the warmth of the consensus and make a guess (we prefer to call it a Variant Perception) about how a company will perform in a manner differently (can be better or worse) than most believe and take a position contrary to the masses.” There are those in the investing world who spend great deals of time trying to determine the outcomes of markets in the future and Wall Street is replete with individuals who get paid huge sums of money (despite very suspect track records) to prognosticate, predict and prophesize on where markets are headed in the future. Based on Coleridge’s standard, the “science” coming out of Wall Street would not stand up to scrutiny (would definitely lack veracity) despite plenty of mathematical calculations, quantitative models and supposedly hard data being utilized by Analysts, Managers and Strategists. Many would fall into the branch of investment science called Technical Analysis (drawing patterns on price charts) and while the average investor might decry its use (and disavow any knowledge of this voodoo), we know that many, many, people do look at charts (why William O’Neill is rich) and that “The human mind is prone to looking for patterns and cycles in data, so they are using Technical Analysis techniques nonetheless.” Another branch of investment science (a rather distant branch perhaps) is Astrological Analysis and while many would say that Technical Analysis is for the tin-foil hat wearing people, they might say that Astrological Analysis is the realm of crazy people. As we wrote last time, we would disagree given that “The vast majority of people do pay attention to cycles (business cycles, liquidity cycles, interest rate cycles) and while they may not think of where those cycles originate (and would clearly dismiss the idea that they are caused by the motion of heavenly bodies), there is a great deal of evidence that the Newtonian movement of the Planets and Moon around the Sun has an impact on the markets.” We find support for this view given the knowledge that some of the greatest investors of our generation (Paul Tudor Jones, George Soros, Louis Bacon and Stan Druckenmiller) are avid users of this type of data to help them make better investment decisions.
We wrote last time about one of the Fathers of Financial Astrology, William Delbert (W.D.) Gann and discussed how he built a very successful track record in investing and a highly acclaimed business of making market prophecies (many of which came true like his prediction of the Great Crash of 1929 that he made in November of 1928). Born in 1878 in Lufkin, Texas into a poor cotton farming family, Gann never finished grammar school so his primary education came from the Bible, but his life education came in the cotton warehouses where he learned about commodities trading. We wrote last time that “In 1903 (after only one year of trading experience), he moved to New York City to work for a Wall Street brokerage firm, but left soon thereafter to open his own firm, W.D. Gann & Company.” Part of Gann’s life story that was particularly interesting was how his trading philosophy evolved from observing the mistakes made by his clients and, given how poorly the average ones fares over time (buy what they wish they would have bought and sell what they are about to need), this insight is very compelling. We noted that “The core of Gann’s philosophy, however, came from his study of the Bible and he often quoted from the Book of Ecclesiastes 1:9 which said “That which has been is what will be, that which is done is what will be done, and there is nothing new, under the Sun.” Gann believed that all market occurrences had historical reference points and every event had a historical precedent and would eventually repeat itself again and again over time (the theory of Cycles). Gann believed that “to make a success you must continue to study past records, because the market in the future will be a repetition of the past. If I have the data, I can tell by the study of cycles when a certain event will occur in the future. The limit of future predictions based on exact mathematical law is only restricted by lack of knowledge of correct data on past history to work from.” In 1909, Gann published the W.D. Gann Financial Timetable (second picture above) that laid out his predictions of capital markets for the next 100 years (ending with the 2008 Crash, quite prophetic) and that Timetable has been updated and extended by the good people at Time-Price-Research. As we wrote last time, “Gann believed in the 90-year cycle, which also predicted the 1929 Crash, which occurred roughly 90 years after the Panic of 1837 (and calls for the next crisis in 2019). It is interesting that 90 years is equivalent to five Saros Cycles (18 year) and that there would be a linkage between the eclipse periodicity and market panics.” It was quite interesting that the August eclipse was part of the same Saros Series as the eclipses in the summers of 1927, 1945, 1963, 1981 and 1999 given that they were almost all (only 1945 broke the pattern, perhaps due to WW II) followed within two years by a significant economic downturn and equity market correction (1929, 1966, 1983 and 2001). When looking closely at the Financial Timetable it tells us that contrary to our original hypotheses that 2017 was like 2001 or 1929 (on the verge of a big correction), it is more likely to be 1999 or 1927. When confronted with new information, we have to go back to the Scientific Method and consider alternative hypotheses (or maybe find another source to provide some wisdom).
The challenge of having Variant Perceptions is that they will not always turn out exactly the way we anticipate and Newton had some wisdom for us on that, saying “Trials are medicines which our gracious and wise Physician prescribes because we need them; and he proportions the frequency and weight of them to what the case requires. Let us trust his skill and thank him for his prescription.” Translation: making mistakes and, most importantly, learning from them, is how we become better investors. One of our favorite managers says it best, “With each investment we get richer or wiser, never both.” The Scientific Method is a series of sequential steps; 1) identification of a problem (equity markets appear overvalued, #GravityRules), 2) accumulation of data (Price/Earnings, Price/Sales, Market Cap/GDP, etc. all indicate extreme valuations), 3) hypothesis formation (U.S. equity market will follow 2000-2002 or 1929-1930 correction path by fall of 2017, #DarknessFalls), 4) empirical experiments to test hypothesis (observe SPX and DJIA nearing target highs of 2,600 and 24,000), 5) objective interpretation of the data (Gravity still being defied...) and 6) repeat steps until acceptable solution is discovered (modify hypothesis, #Pure Imagination, to be explained below). Investing (like scientific discovery) require a rigorous, systematic approach designed to eliminate subjective biases that allows the identification, quantification and validation of facts from which investment opportunities (scientific laws) can be discovered. We discussed the critical nature of keeping the analysis and interpretation of data free from bias last quarter when we wrote “One of the most important points is not to begin the process with inherent bias or beliefs about your subject matter and to this point, Newton says “We are certainly not to relinquish the evidence of experiments for the sake of dreams and vain fictions of our own devising; nor are we to recede from the analogy of Nature, which is wont to be simple and always consonant to itself.” Newton says very directly that we must focus on the actual hard data from the experiment and that we cannot substitute our own fictions and desires (no matter how much we want to do so) as the data is the data. In other words, investors must be sure not to begin with a conclusion and find data to fit that conclusion (and reject data that refutes that conclusion). Having this discipline is truly one of the hardest things to do in investing (and science). “Newton essentially believed that in science (and in investing) the simplest solution (or investment idea) is the best and we should not create a more complex explanation that is antithetical to the simple outcomes we record.” Simplicity was the hallmark of our protagonist for this installment of the serial. Yogi Berra was well known for his off-the-cuff pithy comments, most often malapropisms (the use of an incorrect word in place of a word with a similar sound, resulting in a nonsensical, sometimes humorous utterance) that became known as “Yogi-isms.” Berra’s seemingly random sayings took the form of a tautology or paradoxical contradiction but often delivered a powerful message and real wisdom. Sports journalist Allen Barra described them as “distilled bits of wisdom which, like good country songs and old John Wayne movies, get to the truth in a hurry.” Yogi described them (as only he could) saying “A lot of guys go, ‘Hey, Yogi, say a Yogi-ism.’ I tell ’em, ‘I don’t know any.’ They want me to make one up. I don’t make ’em up. I don’t even know when I say it. They’re the truth and it’s the truth I don’t know.” Wisdom and Truth are two assets that can help us be better investors and Yogi has some real wisdom for investors, at least we think so, since Yogi was quick to point out that “I never said most of the things I said.”
Yogi Berra was born Lorenzo Pietro Berra to immigrants Pietro and Paolina Berra in the Italian neighborhood of St. Louis, Missouri called “The Hill” on May 12, 1925. His father had arrived at Ellis Island on October 18, 1909 at the age of 23 and made his way to St. Louis to find work. Berra’s parents originally gave him the nickname “Lawdie” as Paolina had difficulty pronouncing Lawrence and Larry. Berra grew up on Elizabeth Avenue across the street from friend (and later competitor) Joe Garagiola and nearby the legendary Cardinals announcer Jack Buck. Given the baseball success of that trio, the street was later renamed “Hall of Fame Place.” Berra began playing baseball in the American Legion league where he received his famous nickname from teammate Jack Maguire. At the movies together one afternoon, they saw a newsreel about India and Maguire commented that Berra resembled the Hindu Yogi in the clip (because of how he sat around with arms and legs crossed waiting to bat) and the nickname stuck. In 1942, a sixteen-year-old Berra tried out for the St. Louis Cardinals, but when he was offered a smaller signing bonus ($250 instead of $500, about $3,600 today) than his best friend, Joe Garagiola, he refused to sign. As the story goes, the Cardinals team president secretly wanted to select Berra, but knew he was leaving St. Louis to take over the Brooklyn Dodgers and wanted to sign him there. As fate would have it, the New York Yankees offered Berra the same bonus as Garagiola and Yogi became a Yankee (and the rest, as they say, is history). World War II interrupted Berra’s baseball career when he enlisted in the U.S. Navy as a gunner’s mate on the attack transport USS Bayfield. During the D-Day invasion of France (Omaha Beach), a nineteen-year-old Berra manned the machine gun on an LCS (Landing Craft Support Boat), was fired upon, but not hit. Historians recounted that “only the steel walls of the boat and the grace of God stood between a sailor and death.” Berra received some grace and survived the assaults, later receiving several commendations for his bravery. Following his Navy service, Berra returned home and finally got his chance to play minor-league baseball with the Newark Bears.
Berra was not an imposing physical specimen (like many of his peers), yet he had a work ethic and baseball IQ that surprised his manager who was very impressed with his talent despite his “short stature.” Berra was mentored by Hall of Famer Bill Dickey and he was quoted as saying that “I owe everything I did in baseball to Bill Dickey. He is learning me his experience.” Yet another example of the critical importance of mentorship and coaching (in baseball, investing and life) and why we like to say that Mentorship = #Edge. We wrote last quarter that “Newton had a similar line when asked about the enormity of his achievements, in acknowledging others’ impact on his work, saying “If I have seen further than others, it is by standing upon the shoulders of giants.” (we should all be so humble, a very important trait in investing).” He was so fond of Dickey that he wore his number (8) on his uniform the rest of his career. Berra was called up to the Yankees and played his first Major League game on September 22, 1946 (interestingly, a Gann Date). Berra was a work horse of a baseball player and saw action in more than a hundred games in each of the following fourteen years. Over the course of his career, Berra appeared in record fourteen World Series, including 10 World Series championships (also a record). Given his tenure with the Yankees during one of their most dominant stretches, Berra set World Series records for the most games played (75), At Bats (259), Hits (71), Singles (49), Doubles (10), Games Caught (63), and Catcher Putouts (457). An interesting aside, in Game 3 of the ’47 World Series, Berra hit the first pinch-hit home run in World Series history off Brooklyn Dodgers (the team that originally wanted him) pitcher Ralph Branca (who also gave up Bobby Thompson’s famous Shot Heard ‘Round the World in the ’51 World Series). Incredibly, Berra was an MLB All- Star for 15 seasons, but played in 18 All-Star Games as MLB had two All-Star Games in 1959-62. Berra won the American League MVP Award in 1951, 1954, and 1955 and amazingly never finished lower than 4th in MVP voting from 1950-57. Berra received MVP votes in fifteen consecutive seasons (tied by Barry Bonds and second only to Hank Aaron’s nineteen). Even with all his accolades, perhaps the most impressive statistic (from an investment perspective) is that from 1949-55, playing on a team filled with superstars such as Mickey Mantle and Joe DiMaggio, Berra led the Yankees in RBIs for all seven consecutive seasons.
Berra was an incredible hitter and he always seemed to deliver the needed hit at the perfect time to help his team win. What made Berra truly outstanding as a hitter was that he was excellent at covering all areas of the strike zone, as well as significantly beyond the strike zone. An opposing Manager called Berra “the toughest man in the league in the last three innings” and one of the greatest pitchers of the era said he would rather face the legendary Mickey Mantle than Berra with the game on the line as he was “the real toughest clutch hitter.” Berra was (statistically) one of the toughest outs in baseball and, just like in investing, if you take care of the losses (outs), the gains (hits, runs, wins) will take care of themselves. Further to this point, five times in his career Berra had more HRs than strikeouts in a season. The pinnacle was in 1950 when he struck out only 12 times in 597 plate appearances (an astonishing 2%, versus the MLP average in the teens); for perspective, Ted Williams (considered the greatest hitter ever) averaged 37 strike outs over his career. In addition to his uniquely wide plate coverage, what Berra was really known for was his incredible bat control. Unlike most hitters who have a particular swing style, Berra could just as easily swing the bat like a golf club to hit low pitches out of the park as he could chop at high pitches for line drives to advance a runner or keep a rally alive. The lethal combination of bat control and plate coverage made Berra the last person any pitcher wanted to see striding toward the batter’s box. On the defensive side, Berra is considered one of the greatest catchers of all-time. He was quick, agile, smart and a great manager of pitchers (so good that Berra caught a record 173 shutouts during his career, ranking him first all-time). Casey Stengel once praised Berra saying “Why has our pitching been so great? Our catcher that's why. He looks cumbersome but he's quick as a cat” (looks can be deceiving). Berra commented on his non-traditional looks once, saying “So, I’m ugly. I never saw anyone hit with his face.” Berra led American League catchers eight times in Games, Chances Accepted (MLB record 9,520) and Putouts (MLB record 8,723), six times in Double Plays (an MLB record), three times in Assists, and once in Fielding Percentage. In the 1958 season, he played an astonishing 88 errorless games and became one of only four catchers ever to field 1.000 in a season. Two other interesting asides, in 1962 Berra caught an entire twenty-two inning game (amazing physical endurance) and he was the first catcher to leave his index finger outside the finger hole in his glove, a style now emulated by most other catchers. Baseball legend Mel Ott perhaps summed up Berra best, saying “He seemed to be doing everything wrong, yet everything came out right. He stopped everything behind the plate and hit everything in front of it”. In a classic Yogi-ism, Berra once quipped, “If I didn’t make it in baseball, I wouldn’t have made it workin’. I didn’t like to work.” The irony here is his performance on the field was a direct result of his strong work ethic, but perhaps the greater takeaway (and we can relate to this one) is that if you do something you love, you never work a day in your life.
Berra retired as an active player after the 1963 World Series, and the Yankees immediately named him to succeed Ralph Houk as Manager. In a strange turnaround, despite a World Series run (lost to the Cardinals in seven games) Berra was fired at the end of the season. Some speculate that it was because of the infamous Harmonica Incident (Berra slapped a harmonica out of a player’s hands on a bus ride after a misunderstanding), but others say it was because the Yankees organization didn’t think Berra was ready to manage. Berra was immediately picked up by the crosstown Mets as a coach. Berra played in four early games the next season and his last MLB game was on May 9, 1965 (interestingly Ben Graham’s and this writer’s birthday) just three days shy of his 40th birthday. Berra coached with the Mets under legendary managers Casey Stengel, Wes Westrum, and Gil Hodges for the next seven seasons (including the 1969 World Series Championship) and was named Manager in 1972 (after Hodges unexpectedly died in spring training). That year (1972), Berra was inducted to the Baseball Hall of Fame and his No. 8 was retired by the Yankees (honoring both Berra and Dickey). The 1973 season was challenging as injuries plagued the team in the first half and, at the All-Star break, the Mets found themselves in last place, nine and a half games back in their Division. In July, a reporter asked Berra if the season was “over,” to which Yogi uttered one of his most iconic lines (and the theme of this Letter) “It ain't over till it's over.” As the Mets’ stars got healthy and returned to the lineup, the team had an unlikely, but impressive, surge and captured the NL East title (despite an 82–79 record). The Mets’ “reward” for the amazing comeback was a showdown with the 99-win Cincinnati Reds (The Big Red Machine) in the NLCS. Sparky Anderson’s club was loaded with superstars and future Hall of Famers including Johnny Bench, Pete Rose, Joe Morgan, Ken Griffey, Dave Concepcion and Tony Perez and most baseball fans would have predicted that the series would be “over before it’s over.” Berra had other ideas, and with his own group of superstars and future Hall of Famers, Tom Seaver, Willie Mays and Rusty Staub, the Mets beat the Reds in five games to capture the NL Pennant. The Mets eventually fell to the Oakland A’s in the World Series in a hard fought seven-game series against another amazing group of future Hall of Famers including Rollie Fingers, Reggie Jackson and Catfish Hunter. Berra's tenure as the Mets’ manager ended just two short years later in August 1975, and in 1976, he rejoined the Yankees as a Coach. Berra’s timing was very good and his coaching must have been good too as the Yankees won three consecutive AL titles and back-to-back World Series in 1977 and 1978. As had been the case throughout his playing career, Berra’s reputation as a lucky charm continued to grow. Casey Stengel commented on Berra’s luck once, saying “He'd fall in a sewer and come up with a gold watch.” It has been said that luck is where preparation meets opportunity and Yogi recognized this in speaking about his teammate Joe DiMaggio once, saying “I wish everybody had the drive he had. He never did anything wrong on the field. I’d never seen him dive for a ball, everything was a chest-high catch, and he never walked off the field.” What can appear to be luck (in life and in investing) is usually the result of hard work, experience and anticipation that puts you in the right place at the right time. We would say Preparation = #Edge.
Berra was named Manager of the Yankees before the 1984 season and he agreed to return for the 1985 season after receiving assurances that he would not be terminated by the notoriously volatile owner of the Yankees, George Steinbrenner. Unfortunately for the Yankees faithful, the impetuous Steinbrenner did not honor his promise and fired Berra after only 16 games (adding insult to injury, Steinbrenner had a junior staff member deliver the news) which caused a rift in Berra’s relationship with the Yankee organization that would stand for 15 years. Berra joined the Houston Astros as a Coach in 1985 and again made it to the NLCS in 1986 (the lucky charm strikes again), but the Astros lost to the Mets in six games. Berra remained a coach for the Astros for three more years and finally retired after the 1989 season. Berra’s managerial career was mixed overall as his regular-season record was only slightly above .500 (484 wins and 444 losses) as was his Playoff record of 9 wins and 10 losses. The pedestrian winning percentage might make the uniformed think that Berra had a mediocre career, but given that he needs all ten fingers and three toes to wear all his World Series’ rings, perhaps George Soros’ wisdom applies here “It’s not whether you’re right or wrong (win or lose), it’s about how much money you make when you’re right and how much money you lose when you’re wrong.” On August 22, 1988, Berra and Dickey were honored as “Legendary Yankees” and were awarded plaques that were to be hung in Monument Park at Yankee Stadium. However, even the honor was not enough to convince Berra to come back to the stadium since he still believed that Steinbrenner had broken his promise. Finally, Steinbrenner traveled to Berra’s home in NJ to apologize and convinced him to return to Yankee Stadium on July 18, 1999 for a celebration of “Yogi Berra Day.” Don Larsen threw out the ceremonial first pitch to Berra in honor of the Perfect Game that the duo produced in the 1956 World Series. In his comments that evening, Berra was pure Yogi, saying “I’m a lucky guy and I’m happy to be with the Yankees. And I want to thank everyone for making this night necessary.” Berra died at age 90 at his home in West Caldwell, New Jersey on September 22, 2015, exactly 69 years to the day after his MLB debut (there is that Gann Date again). The next day, the Yankees wore a No. 8 patch on their uniforms, the Empire State Building was lit with vertical blue and white Yankee pinstripes, New York City lowered all flags in the city to half-mast and a moment of silence was observed by the Yankees, Dodgers, Astros, Mets, Nationals, Tigers, Pirates, and his hometown St. Louis Cardinals. On November 24, 2015, Berra was awarded the Presidential Medal of Freedom posthumously by President Barack Obama who honored Berra with one of his famous Yogi-isms, “Today we celebrate some extraordinary people. Innovators, artists and leaders who contribute to America's strength as a nation. We celebrate Yogi Berra's military service and remarkable baseball career. One thing we know for sure; If you can't imitate him, don't copy him.”
We look to Yogi for some assistance in understanding the disconnect between what the fundamentals are telling us about how the markets should be reacting and how the markets actually are reacting. As he liked to say, “You can observe a lot by just watching.” This harkens back to the Newtonian idea that we have to observe the data as it is and not as we wish it to be. Here we can make the simple observation that U.S. equity markets continue their steady march higher. As prices move higher, all the valuation metrics move higher along with them (since EPS are not growing very quickly) and as we breached the 1929 valuation levels and rapidly head toward the 2000 levels there is growing cognitive dissonance for Value investors like ourselves. Yogi had some wisdom on this point too, saying “If the world were perfect, it wouldn’t be.” There will be times when things don’t seem to make sense and where the markets behave contrary to expectations, particularly when those expectations come from models that make assumptions based on logic and rationality. Lord Keynes once expressed a similar view, saying “Equity markets can behave irrationally longer than the rational investor can remain solvent.” Richard Thaler from the University of Chicago (I was lucky to have him for Organizational Behavior class) just won the Nobel Prize in Economics for his work on Behavioral Finance that helps us understand the point that even if the models can show us the Fair Value of the markets, the actual price of the Index itself is determined by human beings, who are prone to bouts of greed and fear, so the Index will spend very little time near Fair Value (will be much lower or much higher). So, when the equity markets appear to be at head scratching levels that call to mind Berra’s comment that You better cut the pizza in four pieces because I’m not hungry enough to eat six,” we have to step back and contemplate what we are missing (if anything) and consider how far away from our rational expectations the markets can (will) move.
One of Yogi’s more iconic lines was that “Baseball is 90% mental and the other half is physical.” The ratio applies perhaps more to Investing in that it is a purely mental exercise, but there is an element of implementation of ideas that is physical (research reports are written, trades are executed, etc.). In investing, there are lots of baseball terms that are applied to the success (or lack thereof) of investors. Good investments are referred to as hits, really good investments are called home runs, batting average refers to the number of ideas you get right and slugging percentage refers to the amount you make off each idea and when investors are having a rough patch they are often said to be in a hitting slump. The interesting point, though, is that it is not necessarily how hard you think, but rather, how effectively you think, how you can maintain your focus (particularly when things are going against you). We wrote last quarter how Newton always came back to focus, “but not the intense “pressing” (which leads to hitting slumps), but the inner focus of meditation and deep thought that taps into what Michael Steinhardt called “the internal supercomputer that is the subconscious.” There is a Yogi-ism for this, too. Berra would say, “How can you think and hit at the same time?” What he was referring to was once you are in the batter’s box, you have to rely on solid preparation and good instincts (muscle memory in the subconscious) in order to hit a baseball being hurled at you at 90 mph from sixty-feet-six-inches away. Maverick says the same thing to Charlie in Top Gun when she asks him what was he thinking up there when he performed a move she thought was ill-advised and he responds, “You don’t have time to think up there; if you think, you’re dead.” Clearly the stakes are not as high in baseball or investing as in fighter jet dog fighting, but the construct is the same, great hitters, pilots and investors have great instincts (good judgement) that they rely on to make good decisions. One of the interesting points here is the answer to the question, how does one attain good instinct/judgment? The answer is that they come from experience and experience comes from making bad decisions that result from bad instincts and poor judgment.
One of the nice things about baseball is that it doesn’t matter how badly you were fooled (how bad your judgment was) on the first two strikes - until the pitcher gets that third strike past you (either fools you again for a called third strike or you swing and miss), you’re not out. In investing, it is even better because there are no called third strikes, you can be patient and wait with the bat on your shoulder for the perfect pitch. We wrote last time that Newton also believed in this construct and we wrote how he “understood that the most valuable things take time and said that “If I have ever made any valuable discoveries, it has been due more to patient attention, than to any other talent.” Again, with amazing modesty and humility, Newton hits one of the most critical elements of the most successful investors is that they are content to sit and wait for the right opportunity, the right environment, the right structure and the right timing to deploy their ideas.” The good news is that you don’t actually have to be a Newtonian genius (thankfully) to be a great investor and you don’t even have to consistently discover new ideas and make quantum leaps in strategy to deliver superior returns. What you do need is the patience and discipline (two more personality traits on the #Edge list) “to remain focused on identifying and executing a small handful of truly extraordinary ideas that come your way.” Jeremy Grantham has said that all you need is one or two truly great ideas to consistently outperform over time and we would concur that it is much more about quality and timing than volume. Yogi sums it up saying, “You don’t have to swing hard to hit a home run. If you got the timing, it’ll go.” You need to have the trained eye to see that the right pitch is leaving the pitcher’s hand (one you think you can hit) and you have approximately 0.4 seconds to react and swing. But you actually don’t have that much time, since the eye and brain need about 0.25 seconds to receive the image and process, that leaves around 0.15 seconds to react, which is technically impossible because the signal has to get to our muscles. So how does anyone hit a 90mph fastball? The brain makes a series of complex calculations and your body reacts without complete information and relies on all of the wisdom stored in the muscles from previous hits and misses. We discussed last time how “Oftentimes we have to make decisions in investing when we don’t have perfect information, or all the facts that we would like to have before we move forward with an idea.” The key to success in that situation is to be patient, wait for the right pitch, swing smoothly and, like Yogi says, it’ll go.
We have often said that in investing it is critical to start with a Beginner’s Mind, a perspective free from preconceived views about whether an investment opportunity is attractive, or unattractive, follow your analytical process and then make a decision to invest or pass. The most important character trait that allows this type of analysis possible is humility. We wrote last time how Newton had this characteristic and that “despite his incredible intellect and sizeable accomplishments, brought a constant humility to his work, saying “what we know is a drop, what we don't know is an ocean.” Mark Twain made the same point from the opposite perspective saying, “It’s not what we don’t know that hurts us, it’s what we know for sure, that just ain’t so...” Yogi would concur, and was fond of saying, “In baseball, you don’t know nothing.” In baseball, like in investing, there are so many variables that are ever changing you have to approach the game from the perspective of humility, primarily because you have so little control over the elements of the game that can influence the outcome. A bad hop on a routine grounder (an unexpected geopolitical event), a .200 hitter that goes 4-4 because all your pitchers that day were southpaws (a company that unexpectedly blows away earnings estimates), a pitcher with a losing record who suddenly throws a no-hitter against you (the PBoC puts $1 trillion of stimulus in the markets and you are short), or any number of other examples of things that go unexpectedly right/wrong that are unknowable in advance. Yogi also had a great line that would probably be helpful for most investors when he said, “If you ask me anything I don’t know, I’m not going to answer.” It is okay to not know (and even better to say you don’t know), but the hubris of the investment industry is such that most often people feel compelled to give an answer (or make one up) when asked a question. Julian Robertson was a task master in this area and he implored his Analysts never to respond if they didn’t know, or hadn’t done the work, by saying “never fudge the numbers.”
So, how do you move forward if you don’t know? We discussed Newton’s solution last time saying his “approach to this dilemma was incrementalism, start small and look for confirming information before making a sizeable commitment, “tis much better to do a little with certainty & leave the rest for others that come after than to explain all things by conjecture without making sure of anything.”” We also discussed how another of the greatest investors of all time, George Soros, would apply the same reasoning and “would try ideas in small amounts and look for the market to confirm whether he was right in his original assertion. He also was adamant about never being certain of anything and having the discipline to admit when you were wrong and step to the sidelines (the opposite of the average investor who needs to prove they are right so they keep averaging down). Soros has said, “I am only rich because I admit my mistakes faster than everybody else.” Being able to admit when you are wrong is critical to long-term success in investing and doing it sooner, rather than later, is even more profitable over the long run. Another key to long-term success in investing is having a solid investment plan, an investment policy statement or set of rules and a discipline that you follow religiously to keep the emotion out of investing that leads to sub-optimal returns. Yogi says it very simply, “If you don’t know where you’re going, you’ll end up someplace else.” You need to have explicit goals with respect to types of returns you are looking to achieve, the kinds of risks you are willing to take (and can tolerate) to get those returns and an outline of the assets and strategies that you will utilize in that plan. Yogi had another line about traveling that we can apply to investing when he said, “You’ve got to be very careful if you don’t know where you are going, because you might not get there.” If you don’t have very clear objective and goals, it may be very difficult to determine where you are along the path and you might not find your way to the destination at all. The brilliant writer Lewis Carroll made a similar comment that “If you don’t know where you are going any road will get you there” and perhaps it is not a coincidence that his story Alice in Wonderland was all about what happens when you go down a rabbit hole. There are endless investment opportunities that can be considered, and if you aren’t discerning in which ones you take a swing at, you can find yourself striking out far more often than Yogi did and not achieving the investment results you desire.
Another quip from Yogi that gets us to the primary topic of the Letter, to talk about the Bubble (or lack thereof) that resulted from someone asking him why he never went to Rigazzi’s restaurant in St. Louis anymore, he replied “No one goes there nowadays, it’s too crowded.” The same thing can be said about the stock market today as the conventional wisdom is that this is the Most Hated Bull Market and that investors aren’t overly exposed to equities and there is a lot of cash on the sidelines waiting to invest so the market will push higher. Let’s look at the box score. The facts are that cash in mutual funds is at the lowest point since the Tech Bubble and the ratio of cash in money markets versus assets in the stock market is at the lowest level ever (it is possible that there has been some substitution effect away from money markets as a vehicle). The ratio of financial assets to income has never been higher, exceeding the previous highs from the Tech Bubble in 2000 and the Housing Bubble in 2008, prompting the NY Times and Jesse Felder (@JesseFelder) to christen this the Everything Bubble. So, it appears that everybody is actually still going to the restaurant, hence why it is so crowded, and perhaps why Yogi also quipped, “It was impossible to get a conversation going, everybody was talking too much.” There is indeed a lot of talking going on about the equity markets today as the airwaves are filled up seventeen hours a day with Talking Heads extoling the virtues if investing in stocks and the hardly a day goes by without the Tweeter-in-Chief sending out another tweet about the new all-time high in the stock market (which he takes full credit for despite the #NoFecta). It is actually nearly impossible to have a conversation about the equity markets because people are so busy buying ETFs and Index Funds so they don’t miss out of this epic bull market (only a few months away from being the longest bull market in history). The FOMO (Fear of Missing Out) is incredibly strong right now and while it does feel very much like the Bubble leading up to 2000, it is hard to pinpoint specifically whether we are in 1999 or 2000 (since we clearly aren’t in 2001 as we originally hypothesized).
That feeling like we have seen this somewhere before is the title of the Letter, “It’s like déjà vu all over again.” Yogi said this in referring to watching Mickey Mantle and Roger Maris hit back-to-back dingers in multiple games over a number of seasons with the Yankees in the 1960s. We have discussed over the past year how the S&P 500 is overvalued on every possible measure and how some of the measures (like Price/Sales) had reached levels we have never seen before. Yogi said, “It gets late early out here” and when we look at the quantitative data we would have to agree (and have made the case all year) that it is indeed getting to be late in cycle and that now as we are very close to the 2,800 and 24,000 targets for the SPX and DJIA it “should” be time for a normal correction.” That said, the toughest thing about Bubbles is that they go on longer than most investors would think and, in fact, usually rise at an exponentially faster rate as we get close to the crescendo. Jeremy Grantham quantified this for us a couple weeks ago at his annual meeting in Boston when he said that the last twenty-one months of a Bubble usually rise 50% (seems impossible, but that is what the data says). By this calculation, the final leg of the Bubble began in March of this year when the Indexes broke through two standard deviations above Fair Value (2,400 and 21,000), so we could see a continued inflation of the Bubble until the end of 2018 that would take the SPX to 3,600 and the DJIA to 31,500 (seemingly stunning numbers). Berra has a Yogi-ism for this too, saying, “Congratulations. I knew the record would stand until it was broken” and these levels would eclipse the Bubble peaks of 2000. At first glance (and many people’s first reaction, including our own to this point) would be that this is impossible because valuations would be far too extreme and that the markets would have to collapse under their own wait before that point. But Yogi has an explanation for why it could be different this time, saying “The future ain’t what it used to be.” In other words, with near zero interest rates, ever expanding Central Bank balance sheets and record levels of financial engineering (abundant leverage and stock buybacks), the present (and near future) are clearly not like the past periods (1929 and 2000) when valuations reached similar extreme levels. As the caption in Yogi’s picture above says, when it comes to Bubbles, “It ain’t over till it’s over.”
But hold on you say, how can we go from dire warnings of Darkness Falling to projections of new record valuations and nearly two more years of a Bull Market? We have told the story in past letters of how Sir Isaac Newton invested in the South Sea Company that turned into the first stock Bubble (actually term was coined writing about the event) and “lost nearly his entire life savings and prompting him to famously quip “I can calculate the movement of stars, but not the madness of men.” It is said that for the rest of his days he forbade anyone to utter the words South Sea in his presence.” Bubble are curious things and greed (FOMO) clouds investors’ judgment causing them to do things that seem like madness. We aren’t saying that the melt-up will happen, we are saying it could happen (even Jeremy said it was only a little better than 50% chance) based on looking at the current data free from the bias that 2017 was most similar to 1929 or 2000. In truth, it requires some serious willing suspension of disbelief to get to the extremes that would be required for the Ultimate Bubble to occur and that is where our second protagonist enters the story. Willy Wonka (pictured on the far right above) is a fictional character based on the 1964 novel Charlie and the Chocolate Factory by Roald Dahl that was later adapted in 1971 as a musical fantasy film Willy Wonka & the Chocolate Factory. Wonka is the proprietor of a large global chocolate company who comes to the realization that with no heirs and an appreciation that he “can’t go on forever” organizes a contest to find an honest child that he can secretly bequeath the Chocolate Factory. Wonka hides five Golden Tickets (gold always seems to figure into these types of movies) in chocolate bars and invites the five children who find the tickets to come tour the factory and win a lifetime supply of chocolate (not giving away his true intention of finding an heir). Wonka says that he couldn’t trust the company to an adult who might “ruin the wonder” of his life’s work and he needs to find someone who will carry on Wonka’s candy making secrets and protect his beloved Oompa Loompas (the workers in the factory). A poor paper boy, Charlie Bucket, finds the last Golden Ticket and goes on the factory tour with his Grandpa Joe, along with four incredibly spoiled and rotten kids who represent the problems of gluttony (Augustus Gloop), addiction (Mike Teavee), privilege (Violet Beauregarde) and greed (Veruca Salt), who all end up being disqualified from the contest by violating Wonka’s rules during the tour. In the end, Charlie proves his honesty and is chosen by Wonka to inherit the Chocolate Factory and bring his whole family to live happily ever after. So, what does Willy Wonka have to do with investing and Bubbles? My good friend Grant Williams (who writes the amazing Things That Make You Go Hmmm..., found at @TTMYGH) gave a presentation at a conference recently titled Pure Imagination and used a number of Willy Wonka’s quotes to make the point that equity valuations have reached a place so outside of normal that they can only be rationalized by pure imagination. The music in the presentation has been stuck in my head for the last week and there was a particular slide in the presentation that made me realize that perhaps our warnings about #GravityRules and #Darkness Falls were a little “Early.”
In the movie, Willy Wonka (played by the amazing Gene Wilder), resplendent in his purple top coat, orange top hat and cane, croons the following lines “Hold your breath. Make a wish. Count to three. Come with me, and you'll be, in a world of Pure Imagination.” As the same music plays during Grant’s presentation, he shows slides that take us to this world, 1) U.S. GDP has been falling steadily since 1947, 2) the past decade of GDP growth has been 1.4%, less than half the previous five decades, 3) how corporations have been the only net buyers of stock since 2009 (financial engineering). The song continues “Take a look, and you'll see, into your imagination. We'll begin, with a spin, traveling in, the world of my creation. What we'll see, will defy, explanation.” We see some additional slides about how bankers have created a debt Bubble of Pure Imagination, 4) that global debt has grown from $86T in 2002 to $217T today and is now at close to 4X GDP, an all-time record, 5) how total Central Bank assets have grown from $1T in 2009 to $6T today, 6) how Student Loans have soared from $200B in 2009 to $1.1T today, 7) how the velocity of money peaked in 2000, was cut by one-third by 2008 and is now down (80%) from the peak, 8) how the M2/SPX ratio has gone from 800 in both 2000 and 2008 to 1,800 today. The next verse continues “If you want to view paradise, simply look around and view it. Anything you want to, do it. Want to change the world? There's nothing to it.” More slides that show paradise, 9) the S&P 500 at levels far in excess of the 2000 and 2008 Bubble peaks, 10) a slide that shows that Elon Musk can do anything he wants as Tesla continues to raise debt and equity despite having a valuation per car sold 125X greater than Ford despite only having 5% as many sales, 11) European High Yield Bond yields below U.S. Treasury yields, 12) Canadian home prices 2X the U.S. average and Australian home prices 2X Canada, 13) Argentina being oversubscribed for newly issues 100-year bonds (despite 6 defaults in the last 100 years) and the USD falling (95%) in purchasing power over the past 100 years. And the final verse, “There is no, life I know, to compare with, Pure Imagination. Living there, you'll be free, if you truly wish to be.” 15) U.S. Market Cap/GDP at 133% versus an ATH of 141% in 2000, 16) the Median Price/Sales of the S&P 500 50% higher than the previous peaks in 2000 and 2008, 17) U.S. Net Worth to Median Disposable Income at the highest level ever, 18) M2 to Savings Ration at 2X the highest level ever in 1987 and 3X the levels in 2000 and 2008, 19) Margin Debt balances at the highest levels ever. Clearly investors feel free to live the way they truly wish to be and risk is an archaic concept that has been erased in the world of Pure Imagination.
Many of these numbers look so extreme they bring to mind another Wonka quote, “For some moments in life, there are no words” because a rational investor would be struck speechless looking at all of the data pointing to such incredible extremes and would (justifiably) conclude that an imminent correction is just around the corner. But Wonka says, “A little nonsense now and then is relished by the wisest men” and continues that “Where is fancy bred? In the heart or in the head?” These comments harken back to Sir Isaac lamenting he could not calculate the madness of men and lead us to perhaps the most important Wonka quote of them all, “Oh, you should never, never doubt what nobody is sure about.” We know that consensus is most frequently wrong in investing and the antithesis of consensus would be “what nobody is sure about” as it is always the thing that no one is thinking about that is most likely to occur (and cause the most stress in the system). There is almost nobody who believes that the U.S. equity bull market has a long way to run (there are a few) and perhaps this is now the Variant Perception (all the “smart money” has moved to the correction camp) and Yogi will turn out to be right about things not being over. Wonka has a line that conjures up global Central Bankers today when he says, “We are the music makers and we are the dreamers of dreams” and so long as they keep handing out Everlasting Gobstoppers (special Wonka candy that you can suck forever and they never lose their flavor) and Fizzy Lifting Drinks (soda pop that fills you with bubbles so you can actually fly) the equity markets will continue to look like the test chamber where Charlie and Grandpa Joe found themselves flying around within (recall the top of the chamber had a giant fan that threatened to cut them to bits...). Wonka sums it up saying, “Bubbles, bubbles everywhere, and not a drop to drink... yet.” The key word being yet.
So, when does the fun end and the bubbles begin to burst? Wonka has a great line as all of the guests watch poor Augustus Gloop stuck in the vacuum tube that purifies the chocolate river (which he has fallen into by being gluttonous trying to drink the chocolate) waiting to be shot like a bullet up the tube when the pressure builds up, saying, “The suspense is terrible. I hope it will last.” Investors are enjoying the ride and don’t want the fun of rising equity prices to end and they are willing to ignore the potential perils of the downside, for now. There is a scene in the movie where the entire group boards an odd-looking boat for a journey to another part of the factory. As the boat enters a tunnel, suddenly the walls are filled with disturbing images and if feels like the boat is accelerating at a rapid pace (the last parabolic move of the Bubble). Wonka starts reciting the following lines as the as suspense grows, “There’s no earthly way of knowing which direction we are going. There’s no knowing where we’re rowing or which way the river’s flowing. Is it raining? Is it snowing? Is a hurricane a-blowing? Not a speck of light is showing so the danger must be growing. Are the fires of hell a-glowing? Is the grisly reaper mowing? Yes, the danger must be growing because the rowers keep on rowing and they’re certainly not showing any signs that they are slowing!” Then, just as suddenly, the boat emerges from the tunnel and you can see that the entire “journey” was only a few meters. It was all an illusion. So, when will this journey end? We did think the end was nigh but there was one slide at the end of Grant’s presentation that got us thinking that Jeremy may be right and there could be one last cathartic move up in the coming quarters. The slide showed the S&P 500 divided by the price of gold and what it shows is that the current level is about (60%) below the 2000 peak and about equivalent to the levels in 1997. Perhaps the illusion is what Yogi Berra referred to when he said, “A nickel ain’t worth a dime anymore.” Perhaps the devaluation of the Dollar (reflected in the dramatic rise in the price of gold since 2000) has created a nominal rise in equity values and there is significantly more upside to go to get to a Bubble in real terms. Nominal increases have a funny way of playing with the mind, consider that both Venezuelan and Zimbabwean stocks are up a lot this year and you wouldn’t want to be invested in either place. Is it possible that the explosive increase in price of Bitcoin is signaling a stealthy hyperinflation in the dollar? Or maybe the Fed has turned the equity markets into a Wonkavator. What’s a Wonkavator? Willy describes it to Charlie in the final scene, saying, “It's a Wonkavator. An elevator can only go up and down, but the Wonkavator can go sideways, and slantways, and longways, and backways, and squareways, and frontways, and any other ways that you can think of. It can take you to any room in the whole factory just by pressing one of these buttons. Any of these buttons. Just press a button, and zing! You're off. And up until now, I've pressed them all, except one...This one. Go ahead, Charlie.” Charlie presses the button and the Wonkavator surges upwards and crashes through the glass roof of the Chocolate Factory and magically flies over the town. Are the SPX and the DJIA about to crash through our ceilings of 2,800 and 24,000 and head for the magical peaks that Jeremy calculated would be the Bubble for the ages? Should we never doubt what nobody is sure about? Something tells me we will be revisiting these questions frequently in the next couple of quarters.
Turning back to Yogi, he has some additional wisdom that helps us think about the contentious issue of active versus passive investing and the purported death of hedge funds. Since 2009, the simple strategy of buying a capitalization weighted index fund or ETF has beaten the majority of active managers and hedge funds, prompting the media and many investors to declare the death of active management and hedge funds (for the fourth time in my career). We believe firmly that it’s not different this time and that this cycle shall pass (just as all the others before) and Active Management and Hedge Funds will outperform again (as they have done for half the time over the last forty years). Yogi had a couple of equally pithy quips that describe the current environment for Active Managers and Hedge Funds when he said, “Always go to other people’s funerals, otherwise they won’t come to yours” and “I’m lucky. Usually you’re dead to get your own museum, but I’m still alive to see mine.” The reality is that there is no such thing as Passive (despite all the claims of its superiority), but every strategy is active on some level, the only thing that changes is the speed of the changes. For example, one of the members of the S&P 500 Committee (the group that decides which companies go into the S&P 500 Index) spoke at a conference right before me last week and said that during his twenty years on the committee 400 of the 500 names turned over (Slow Active). ETFs that follow rules are actually active as well (many trade very frequently), they call themselves passive because they are “Rules Based” (free from human decisions, although a human did create the rules and tweaks the rules when they aren’t working...). Capitalization and Price weighting are simply a form of a momentum strategy (you buy more of things as they go up in price) and momentum strategies do better (versus Value strategies that buy more as prices go down, buy what is on sale) when Central Bank liquidity is plentiful and that has clearly been the case since 2009 in the QE Era. The flip side is that when CB liquidity is ebbing, Value strategies outperform and we can have decades like 2000 to 2010 where Active Management and Hedge Funds outperformed Index Funds and Passive dramatically (but that is clearly ancient history and forgotten). But Yogi provides us with some insight as to why this particular cycle has been even more contentious than normal.
When you lose a baseball game (or any other game or contest for that matter) there is a right way and a wrong way to talk about the experience. Yogi once quipped “You wouldn’t have won if we’d beaten you” and it turns out that this tact is likely to spur negativity and confrontational attitudes. When Yogi was a player he was sometimes, how should we say it, overconfident, and was prone to comments such as “Slump? I ain’t in no slump... I just ain’t hitting” or “I never blame myself when I’m not hitting. I just blame the bat and if it keeps up, I change bats. After all, if I know it isn’t my fault that I’m not hitting, how can I get mad at myself?” Not taking responsibility for your performance is a sure way to engender negative feelings and the Active Management and Hedge Fund industry has, unfortunately, uttered a few Yogi-isms like these in recent years as the gap between Active and Passive has grown wider. Making excuses is a tough way to win friends and influence people and it tends to lead to feelings of resentment, kind of how Yogi referred to pitchers, saying “All pitchers are liars or crybabies.” When you aren’t hitting, it is pretty clear to everyone that you aren’t hitting (the box scores don’t lie), and when a manager or a strategy is out of favor, it is pretty clear to everyone (the performance numbers don’t lie). There are a couple of options, you can blame the bat (Central Bank largesse, Algorithms, Leverage and stock buybacks, etc.) or you can take responsibility for your actions. When Yogi became a manager, he matured and discovered the wisdom of how to say the right thing (like Kevin Costner giving tips to Nuke LaLoosh on how to talk to the press in Bull Durham) and was more likely to say “I tell the kids, somebody’s gotta win, somebody’s gotta lose. Just don’t fight about it. Just try to get better” or “We made too many wrong mistakes.” Taking responsibility defuses the argument and changes the tone of the debate. As Yogi said “It ain’t the heat, it’s the humility.” People don’t like arrogance and they respect humility. A baseball season is very long, 162 games, and it turns out no team has ever won them all (the 1906 Cubs and 2001 Mariners won 116). Every team goes through tough patches where their game plan isn’t working, the individual players aren’t sharp, or sometimes the opponent just simply plays better than you on a particular day (or over a series). The good news is that you don’t have to win them all to get to the World Series. Investing is the same as no strategy wins in every environment and there will be times when a manager or strategy goes into a slump. You have two options, you can complain about the environment (blame the bat) or you can put your head down and work harder to get better. We favor the latter and believe wholeheartedly that Humility = #Edge.
Everyone, not matter how talented they are, will go through tough times. As Yogi pointed out, “Even Napoleon had his Watergate.” The greatest players in every sport (and legendary investment managers) will have untoward outcomes along the way. Yogi spoke about Sandy Koufax (one of greatest pitchers ever) in this regard saying, “I can see how he won twenty-five games. What I don’t understand is how he lost five.” Koufax was an astonishing talent. His career was cut short by arthritis, but in his six years he won three Cy Young awards and was the first MLB player to throw four no-hitters. When Koufax was “on,” he was nearly unhittable (keyword “nearly”) and what Yogi was referring to is that despite his enormous talent, some combination of events led to him actually losing games from time to time. Even the most legendary investment managers have had their losses, times when people said the world had passed them by (Robertson and Buffett in 2000) or that their strategy was no longer viable (Klarman and Dye in 2000), but in every case the cycles turn and talent wins. The real problem is that just when a strategy is about to have its best performance there will be the fewest number of investors in that strategy. Investors have a terribly bad habit of buying what they would have bought (chasing hot performance) and selling what they are going to need (fleeing the out of favor strategy). Yogi talked about this with respect to fans’ reactions to losing streaks saying, “If the people don’t want to come out to the ballpark, nobody’s going to stop them.” The same applies to investors in specific strategies, they will shun the strategies that have recently done poorly and only show up when their team is winning. Rewind to 2009, where were all the investment dollars flowing, into Index Funds and Passive? No, on the contrary, into Hedge Funds and Active because they had outperformed in the downturn. When everyone counts you out, that is right about when things are going to turn (so long as the talent is there and the strategy hasn’t changed). When the 1973 Mets were 9 1/2 games back toward the end of the season Yogi described his team, saying “We were overwhelming underdogs,” but despite everyone giving up on them (including the fans) he was confident in his team because, as he said, “We have deep depth.” He had confidence that they could (and would) come back and win the title, which they did.
Shifting to Hedge Funds specifically for a moment, Yogi had some thoughts on what makes certain baseball players superior hitters, saying “He hits from both sides of the plate. He’s amphibious.” The ability to go long and short, to take advantage of both undervalued and overvalued securities is a superior way to manager capital (just like switch hitting is a superior way to be a great hitter, and make big money in the major leagues). We wrote last time that “colloquially, “to a carpenter with a hammer, everything looks like a nail,” but if that carpenter is placed in a situation bereft of nails, he comes to a standstill and cannot act. An Index Fund, or a SmartBeta Fund, or an ETF, where there is no judgment, but rather just a mechanistic predisposition to act in a certain way (how they have been programmed) are limited to having success in only one environment and should the environment change they will challenged. Active Managers and Hedge Funds have the ability to use judgment and reason to nimbly maneuver” so they really can hit from both sides of the plate. We expect that after an extended period of underperformance (a serious hitting slump), forward returns (both absolute, but particularly relative to traditional strategies) over the next decade will be much more favorable for hedged strategies. Putting it in quantitative terms, if we strip things down to the most basic level (stocks, bonds, Long/Short Equity, Absolute Return) and utilize the GMO forecast returns (using a 2.2% Inflation/T-Bill rate) for traditional assets (could use First Quadrant of AQR too as they are all nearly the same) and the long-term historical returns for hedged strategies (which is likely conservative given they have just had a seven-year period of below average returns), we get the following expected returns. Long-only equity strategies are expected to produce essentially no nominal return (T-Bills – 2%) in the Developed Markets and T-Bills + 3% in the Emerging markets and Fixed Income strategies are expected to produce T-Bills - 1% (expectation that yields will rise) in the Developed Markets and around T-Bills + 1% in the Emerging Markets. Long/Short Equity Hedge Funds should generate T-Bills + 5% in that type of environment (similar to 2000 to 2010) and while we think the returns could actually be higher, better to under promise and over deliver. Absolute Return Hedge Funds should generate around T-Bills + 3%, which is nothing super exciting, but superior to all of the traditional asset expected returns. Many today are solely focused on reducing fees and believe that paying up for the talent in Hedge Funds is a bad idea. Yogi quipped similarly that “Why buy good luggage, you only use it when you travel?” We will take the other side of this argument saying you place your valuable possessions in your luggage so paying up for safety and security makes sense, the same is true with your most valuable possession (your wealth), doesn’t it make sense to have it managed by the most talented people (just like in baseball, the best people are compensated the highest)? If it was the bottom of the ninth with two outs and the bases loaded, wouldn’t you (as the manager) send up your star (highly paid) hitter rather than the rookie (lowest paid player)? When the game is one the line, we will go with talent every time. We wrote last time that “the vitriol against Hedge Funds is as extreme as it was back in 2000 and one thing we know from having been involved in the Hedge Fund business for twenty-five years is that the lean periods of returns are followed by strong periods of returns, usually on about a seven-year cycle.” We also wrote how vividly we remember how no one perceived a need for hedging back in 2000 (every month set a new record for funds flowing into Index funds). So let’s go to the scoreboard, we know that the next decade was a disaster for investors who piled into those Index Funds and Passive strategies while investors who chose to put the bat in the hands of Hedge Funds made double-digit compound returns (they knocked it out of the park).
We wrote last quarter how Newton said, “Plato is my friend, Aristotle is my friend, but my greatest friend is truth.” We might say that Gravity is truth and that no matter how hard people try to escape it, or rationalize it away, it is constant and unrelenting. In investing, there are many who attempt to rationalize valuations when they escape the normal orbit around fair value, coming up with complex explanations for why we are in a New Paradigm or why it is different this time (Sir John rolls over again).” Newton understood a couple things very well related to the challenge of dealing with a Bubble, 1) no matter how much force you exert on an object (not matter how high you drop the apple from the tree) it will return to earth as the truth of gravity takes over and 2) every Action has and equal and opposite Reaction. For every Bubble, there is a Crash. Predicting the timing is hard, but the outcome is always the same. We also noted how Newton shared some wisdom on communication, saying that “Tact is the art of making a point without making an enemy.” We understand that it is our job “to deliver our views based on the weight of the facts, not on the hopes and dreams of what we wish might happen. The challenge of calling a Bubble is that you run the risk of losing your credibility, your clients and your job, or as Jeremy Grantham calls it, Career Risk.” Willy Wonka would add that “So, shines a good deed in a weary world.” It has been challenging to hear about the reasons to be cautious and watch the markets continue to grind higher. We have spent the last few months examining the weight of the evidence and have reviewed the reasons in this letter why it might be 1927 or 1999 rather than 1929 or 2001 and believe that a balanced approach to the markets remains warranted. Yogi is right on when he says, “Its déjà vu all over again” and “it ain’t over ’til it’s over,” but we still maintain that Roger Babson’s prophetic words (particularly the second half) are important for investors to heed today. “I repeat what I said at this time last year and the year before, that sooner or later a crash is coming which will take down the leading stocks and cause a decline of 60 to 80 points in the Dow Jones Barometer (it was 381 at the time). Fair weather cannot always continue. The Economic Cycle is in progress today as it was in the past. The Federal Reserve System has put the banks in a strong position, but it has not changed human nature. More people are borrowing and speculating today than ever in our history. Sooner or later a crash is coming and it may be terrific. Wise are those investors who now get out of debt and reef their sails. This does not mean selling all you have, but it does mean paying up your loans and avoiding margin speculation. Sooner or later the stock market boom will collapse like the Florida boom. Someday the time is coming when the market will begin to slide off, sellers will exceed buyers, and paper profits will begin to disappear. Then there will immediately be a stampede to save what paper profits then exist.” It is not the time to sell everything and retreat to cash, but avoiding speculative fever, shifting toward Active and Hedged Strategies will prove to be a winning line-up and just may get us all to the World Series of investing in the years ahead.
A brief comment on the #BuffettBet. Ten years ago, Warren Buffett made a $1 million bet (the winner’s charity would receive $1 million) with Hedge Fund-of-Funds manager Ted Seides that the S&P 500 would outperform a basket of five FOFs. As we near the end of the wager in December, Mr. Buffett will indeed win the bet and a charity of his choosing will get the proceeds (which are actually closer to $2 million because Buffett and Seides put the money in BRK.A during the Financial Crisis). With all the hoopla about another victory of Passive over Active/ Hedge Funds, people forget that the S&P 500 was behind (way behind) for the first five years of the bet. Some might say that had it not been for QE taking the volatility out of markets over the past few years the outcome might have been different. But the outcome is the outcome and a passive index fund beat the basket of hedge funds over the past decade, but not for the reason that everyone thinks. It wasn’t the fees that sank the Active Managers, it was the style bias toward value that has been trounced by momentum since 2009 (remember the S&P 500 is a momentum strategy because of the capitalization weighting it buys more of what is working and less of what is not, the anti-value strategy in fact). The other drag on Hedge Fund performance was the change in short selling as interest rates fell over the decade. When the wager began, interest rates were nicely positive and managers were paid a “short interest rebate” when they borrowed stock to go short and as cash rates fell to zero, that rebate turned into a “cost of borrow” and turned from a tailwind to a headwind. These are explanations, not excuses, Mr. Buffett and team S&P 500 beat Ted and team Hedge Funds fair and square.
So, as the end of the bet drew near, I decided to try and challenge Mr. Buffett to the #BuffetBet2.0 and tweeted that I challenged him to the same bet for the next decade.
Becky Quick showed my tweet to Warren during an interview she did with him at the Berkshire Annual Meeting and he said to her that he would make the bet again. The next day, October 3rd, the top headline on CNBC.com was “After winning bet against hedge funds, Warren Buffett says he’d wager again on index funds.” The article went on to say that Warren believed that passive investing works in any market environment, therefore he'd be willing to wager again against active investing for the next 10 years. He was quoted as saying, “The S&P 500 will absolutely kill every one of the fund of funds. Passive investment in aggregate is going to beat active investment because of fees." It seemed very clear to me that he was willing to accept the wager so I called Warren to try and seal the deal. One of the most amazing things (among many) is that Warren Buffett answers his own phone after 5:00 (when his assistant goes home) so when I called, he answered. We had a very nice discussion about the wager and he commented that he thought ten years might be a little long given that he was 87 years old. I commented that I fully expected he would best Roy Neuberger who went into the office every day until 94 and managed his own money until 101 (finally passed at 105) and Warren added that his friend Irv Kahn managed money until he was 107. He asked me what I had in mind, I said to replicate the terms of the last bet (with one change that I would pick a basket of ten Hedge Funds) and he said to send him something in writing and that “he would entertain my proposal.”
Not gonna lie, I interpreted that comment (mistakenly) as we had a deal and I was pretty excited. I think this is a critical issue right now and I believe it is a very dangerous time for investors to be putting money into index funds (particularly the S&P 500) and that the #BuffettBet would continue to keep the conversation about Active/Passive, Value/Growth, Hedged/Long at tip of mind in the coming years. Unfortunately, a few days later, I received a letter from Warren saying that because of his age, he didn’t think he could make a wager of ten years and since he believed this was the proper measurement period he was going to decline my proposal. That made sense and I was disappointed, but understood that perspective. Then I read the rest of the letter and he said two things that left me a little bewildered, “I think the Protégé bet proved the point and has stimulated a re-evaluation of professional management,” and “There’s no doubt in my mind, however, that the S&P 500 will do better that the great majority of professional managers achieve for their clients after fees.” Here we beg to differ. The Protégé bet proved the point that active management underperformed during a period of excessive central bank liquidity (as it has done cyclically for decades), but we weren’t talking about the past, we were talking about the next ten years, starting from the current valuations.
Historically Active has won about half the time (Value bias) and Passive has won half the time (Momentum bias), so winning the last bet has nothing to do with the next bet (just like winning a baseball game yesterday doesn’t get you a W today). The second comment was the more troubling one, though, as if you don’t want to accept the bet because of your age, fine, understood, but you can’t then make the claim that had you made the bet, you have no doubt that you would have won, that is why bets exist (and why they play the games). Don’t get me wrong, I have nothing but the utmost respect and admiration for Warren Buffett as an investor, all I am saying is he made the challenge, I accepted the challenge and I wish he would have made the bet. Time will tell who wins and we will go ahead and pick our basket of Hedge Funds and we will track the wager as if there was real money on it starting on 1/1/18. Who knows, maybe Jack Bogle will take Warren’s position, he is a very young 91 and no one loves Index Funds more that Jack.
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