The "Market" knows nothing

The "Market knows" is a phrase you hear bandied about Wall Street all the time. The "Old Timers" use it so commonly it has become Wall Street lore. It is ingrained in the minds of all junior traders, analysts and Portfolio managers from the day we get our first desk. They use it ... when they cannot explain what is really happening. Even more so, the media push "common wisdom" like that because it's pithy and a perfect soundbite for media. It is a way to create fear & greed, without appearing to do so. Fear, greed and uncertainty are what drive people to watch more, buy more and spend more. It creates the proverbial "monster in the closet" scenario.

As parents, you may have been there. You kiss your child on his head after reading his goodnight story, but he seems a bit unsettled. You turn off the light and you hear him call for you. You return and he complains that when you turned the lights out he saw a monster in his closet while the door was ajar! You try to convince him it's just his pile of clothes from that day. But, unconvinced, he is certain it is a monster...and he can't sleep...until you turn the lights back on. So is the "market knows" phrase to investors. It is a crutch that ALL of us have been guilty of saying and "relying on" from time to time...no more. The Market does NOT "Know".

I have had my suspicions for many many years (decades?) that this was utter nonsense. Each time we had a major market event the news would come out and "explain" to the masses "why" the market did what it did that day and why we were in a "New Bull" or "New Bear" market. These retrospectives are always so convincing. They sell papers, clicks, subscriptions and yes, even management fees....

But it IS NONSENSE. Let me explain......

Let's just start with one clarification. This is not the whining of a Bear that has been run over by the April/May Thundering Bull of  Spring 2020. We have had this market called pretty well, thought that March was a classic panic and have managed through this mess to good outcomes, in spite of the terrible situation that Coronavirus brought on us all. But this particular market rout and rebound have clarified this gnawing question for me immensely.

In February the market was a tired bull. The signs were building up. The S&P earnings trajectory was flattening out.  We had been dealing with an inverted yield curve. The Bull market that began in 2012 (not 2009, but that's another story) was getting a bit long in the tooth. It had it's positives to be sure, but in fact, it was susceptible to a correction. It just turned out that this was not just a cyclical correction or bear phase. It was the Mother of all wrapped up in one. It was an economic collapse caused by a health crisis (with some politics thrown in). Why the "Mother of"? Because we have never had an event where within three weeks we went from ebullience to a full on economic collapse where 1/3 of the country was filing for unemployment while we were locked down like prisoners in our own homes because it was not safe enough to go outside. Meanwhile the news and internet was filled 24/7 with literal horror stories of death, destruction and disease. It may have well been the apocalypse! No wonder the market reacted the way that it did. We were not just fearing for our portfolios...we were fearing for our very existence! Or so we were told......

2020 was the worst crash of the modern era on a price/time basis. Even the Great Depression did not fall as swiftly as this one did. It was also the third major bear market since the turn of this century...and that began only 20 years ago, and all three made it to the top 10 Bears since 1920. So, most of current Wall Street has built their careers fighting out of deep Bear Markets. This created a "recency bias" that was so powerful, that the instant reaction was to just sell. Other factors certainly factored in as well, such as the bubble in passive investing. Don't get me wrong, Passive Indexing can be great, and certainly deserves a spot in many allocations. But it has become a bit of a monster in it's own right and it certainly is no panacea for market irrationality. It's easy until it's scary. This was not a small part of the problem because it is simply a directional trade. If I own the SPY I am only making a judgement on the direction of the overall market (UP) and thus by extension the economy. So, if the news cycle is so bad that it is clear that we are going into a recession and bear cycle AND the market is crashing, of course I should sell. Again, that is the ONLY reason one owns a passive index...because it is supposed to go UP (with diversification). What could go wrong?!? Obviously a lot. And everyone became an expert market strategist!

When all of that collapses simultaneously, you get a panic, a crash like we had in February and March.

So those passive investors sold because the market was going down- and that is what they do. The CTA's who run immense & directional books sold because they are trend following machines, and that is what they do. The Quants, a different breed of systemic trading who base their models like lemmings on the same factors as one another sold. So, when negative momentum hit the  Quants, they sell - because that's what they do. Oh, and the advent of Machine learning based systems and AI trading? Guess, what, all sold-because that is what they do. So, what did that leave? Active managers (whether small fries of the pros).

While the year is not over this one is still not in the record books, but I will go out on a limb  and say that when this is all said and done the active managers and hedge funds will likely be the ones who will have won this battle. We have and are seeing many good investment managers that have weathered the storm very well. Active in our world has far outpaced Passive so far in 2020. Long/short has reasserted it's value again just when it was supposed to. Maybe this is the realization that Passive IS IN FACT THE DIRECTIONAL TRADE and active management, while often underperforming in a raging bull, will usually serve you well during periods of uncertainty.

Why is that? Because the market does NOT KNOW ANYTHING but everyone acts like it does, even the pros. They will tell you it knows EVERYTHING. Don't ever forget that if someone - ANYONE - is talking about the market or any investment on TV or in print, they have an agenda. You likely do not know what it is and their "view" should almost never matter to you. Just look at the Bill Ackman story from March. He rants on TV about his view of the end of the world. It was intense TV- scary in fact. Almost made for TV it was so good. But was it relevant? Did it matter to you? If you acted on it you certainly are far far worse off. But he's a billionaire you say? Yea? so what?

I hear common wisdom all the time that, well the market is not "acting well" "someone knows something". Oh, I love this one ....the Burton Malkiel special, the market is a random walk and the market knows more than you...." The market discounts all news ", the efficient market hypothesis, or my absolute favorite, the right price is "whatever the market says it is". Really? well, what if the market is wrong? Have you ever seen a stock rise or fall by a large percent in one day on no material change in the business? It happens every day. The market is wrong often and sometimes by a wide margin. How often have you seen a stock price move dramatically after earnings? That is the market adjusting to having been wrong. This concept that someone or the market ALWAYS knows something that you don't thus you should buy if they are buying or sell if they are can be incredibly dangerous to your long run returns.

It now appears that the market was wrong in February. It was wrong again on March 23. Again, today back over 3,000 SPX my guess is the market is wrong. If you changed your view and flipped it over and began viewing the market as always wrong, you might focus more appropriate risks and maybe even what drives stock prices. What is the outlook for that one company, manager, strategy? So, when that stock hits the inevitable air pocket misses a quarter and drops 20-40%, the only way to know what to do is to know the company. Know the investment deeply. It could be that you should sell, but it could just as easily be the better decision to buy more of it? Just look at Warren Buffet.

As much as I honor his history and track record, one cannot deny that he has under performed for a decade. Of particular interest is the last two bear markets, Dec 2018 (SPX-20%) and March 2020(SPX-36%). During both of those bears, while swift, he did no material buying. In fact, in 2020, as we all know he was a net seller. He had some "mere mortal" bad trades. like buying and selling the world's largest airline for a 60% loss- all in a one month period. To be followed by puking much of his GS and other bank stocks near the lows.....AND THIS IS BUFFET, WARREN BUFFET! He is supposed to be the guy that "knows", and he didn't. If the Market Knows, then he MUST know, no? NO!

What about AMZN it round tripped from 2100, to 1650 and now 2500? all within a three month period? At which price DID THE MARKET KNOW? Home Depot at $240, 140 0r $240 again, at which price was the market "right"? Or JNJ at $140, 108 or the new high of $157- same question?? Yes, these could be viewed as just market moves or volatility, but the bigger question is this....Was the market right? Even the 20% correction/bear, whatever you want to call it in Dec 2018 was similar. It shook out many good investors. Did it "know" anything? No it didn't.

So, let's stop pretending that the market knows and better yet, stop reacting to the fear (and greed) created by your sense that the market "knows" and get back to knowing what you own and why you own it. More importantly, what is your strategy and is that strategy the right one for you? If that is the case, you will avoid reacting to the fear mongers on the Street and in the media who just love it when investors lose money......Then we can turn the lights on just to realize that that monster in the closet may just be a pile of clothes....

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