Variant Perception

Variant Perception and How the Market Is Always Wrong

“The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.” ~ George Soros

Soros understood a fundamental truth about markets. He knew that they’re very good at pricing the “now”. Meaning, markets typically discount a future that’s non-dynamic and looks a hell of alot like today. This is what he means by, “biased view of the future”. He’s saying that markets overweight the present when they’re discounting the future (this is called recency bias).

Our team at Macro Ops agrees.

This is why it pays to be a contrarian — a smart contrarian, to be specific. Traders who can identify the largest mispricings (instances where the market is the most wrong) make the most money.

Michael Steinhardt (hedge fund legend) said this on the importance of contrarianism in his book No Bull:

I defined variant perception as holding a well-founded view that was meaningfully different from market consensus. I often said that the only analytic tool that mattered was an intellectually advantaged disparate view. This included knowing more and perceiving the situation better than others did. It was also critical to have a keen understanding of what the market expectations truly were. Thus, the process by which a disparate perception, when correct, became consensus would almost inevitably lead to meaningful profit. Understanding market expectation was at least as important as, and often different from, fundamental knowledge.

As a firm, we soon found that we excelled at this… Having a variant perception can be seen benignly as simply being contrarian. The quintessential difference, that which separates disciplined, intensive analysis from “bottom fishing,” is the degree of conviction one can develop in one’s views. Reaching a level of understanding that allows one to feel competitively informed well ahead of changes in “street” views, even anticipating minor stock price changes, may justify at times making unpopular investments. They will, however, if proved right, result in a return both from perception change as well as valuation adjustment. Nirvana.

To attain trading “nirvana”, we have to determine four things. Here’s Steinhardt again (emphasis is mine):

I spent much of my time listening to investment ideas that covered the full spectrum of the marketplace – a range of industries about which, in many cases, I knew little. I became a very careful listener. For me to be effective in understanding these ideas and monitoring them over time, I constructed a system that overcame the necessity of specific knowledge across a wide range of industries. In short, I asked the right questions by seeking the variant perception inherent in each idea.

 A summer intern reminded me years later of the advice I had given him on his first day at work. I told him that ideally he should be able to tell me, in 2 minutes, four things: (1) the idea; (2) the consensus view; (3) his variant perception; and (4) a trigger event. No mean feat. In those instances where there was no variant perception – that is, solid growth recommendations within consensus – I generally had no interest and would discourage investing.

Learning to understand what we at MO call “market narratives” is critical to becoming a smart contrarian. If you’re placing a bet that the market is wrong, then you better have a good grasp on what the market is thinking and what its expectations are (the consensus view). And then your alternate narrative (what you think will likely happen) has to differ from the dominant narrative enough to where it justifies you putting your hard earned money at risk.

Being a dominant trader is all about playing the game at a higher level than others. Keynes said it best in his “markets as a beauty contest” analogy:

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

Ask yourself, what level of thinking are you playing the game at?

Do you understand market narratives?

Are you a smart contrarian?