Our Framework For Analyzing Gold

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In March 2019, we pointed out the incredibly tight compression regime in gold, writing:

Volatility in gold as measured by the width of its monthly Bollinger Band is at levels last seen over 17-years ago, in 02’ right before the barbarous relic began its decade-plus run…

Markets tend to work like rubber bands. The tighter they’re wound up, the more explosive they unravel. In other words, compression regimes lead to expansionary ones. The size and velocity of the move often mirror the preceding level of contraction in vol. There are logical reasons for why this occurs (it has to do with positioning and narrative cascades).

The current level of compression suggests something big is coming around the corner. As macro traders, it’s regimes like these where we need to be at the ready. An explosive macro trend is about to be born…

We pounded the bullion table some more a month later, writing:

It seems we have the two necessary ingredients for a major bull market in gold. These are (1) low expected returns for long-term financial assets and (2) a global money stock that is likely to keep growing (potentially by A LOT).

When we combine this with the current low vol regime + the textbook long-term inverted H&S bottom pattern forming, we get a clear trading opportunity….

Looking at the tapes of a number of gold miners I can’t help but salivate. There are a few stocks here that look ready to explode…

The background timing of the current macro environment tells us something big is coming, something that’s not yet fully known or fully discounted by the market…

This means some major trends are on the horizon. And along with major trends come major opportunities to profit.

Gold is just one area I see that’s ripe for exploitation…

And finally, we trumpeted the bullish clarion again in April of this year:

I expect gold will take out its all-time high made in 2011 within the next six months. After that, the sky is the limit.

I have high conviction on this trade over the long-term.

Gold closed the month of June near its highs — a bullish development. And is now less than 7% away from taking out its all-time highs.

You can find the links for each of these timestamped reports here, here, and here.

Alright… enough with the self-congratulatory hubris. That’s not the point of this piece. I share this so you can see how much you can improve your analysis of the metals market when you have a hard and consistent framework for doing so. A framework that I’m going to share a key part of with you right now.

Similar to all other markets we trade, the foundation of our precious metals framework is the “Marcus Trifecta”. A triangulation of the Macro, Technicals, and Sentiment. We’re going to cover the macro.

The macro framework is simple… It has little to do with inflation or “crisis insurance” of any other of the perfunctory narratives that commonly get passed around as wisdom.

Okay… so here it is… our macro framework is: RED. That’s it, what do you think… Pretty good, huh?

Not impressed? Okay, that’s fine, let me break it down for you then. RED is an acronym that stands for.

    • Relative Size
    • Expected Real Returns
    • Demand

Here’s what each of those means.

Relative Size

Less than 15% of the gold mined throughout history is held in investment form. Gold’s total market cap is somewhere in the ballpark of $1-$2trn. While the global capital stock (equity + debt) is in the realm of $250-$300trn. This creates a positively sloped investment demand function. More on that below.

Expected Returns

Read the following from a 1985 NBER working paper titled “Gibson’s Paradox And The Gold Standard”. Here’s the link to the paper (emphasis from me):

Gold is a highly durable asset, and thus, as stressed by Levhari and Pindyck (1981), the demand for the existing stock (as opposed to the new flow) must be modeled. The willingness to hold the stock of gold depends on the rate of return available on alternative assets. We assume that the alternative assets are physical capital with a (instantaneous) real rate of return r, and nominal bonds with (instantaneous) nominal return i = r + P/P = r — Pg/Pg. The real rate of return is exogenous to the model, but subject to shocks. These shocks reflect changes in the actual or perceived productivity of capital as envisioned by Keynes and Wicksell.

The above is just a fancy of way of saying two things (1) since gold is a non-perishable metal and the amount mined each year (new flow) is tiny relative to the existing stock, we should focus on the latter in our supply & demand calculations and (2) the attractiveness of gold is ALL relative and demand only becomes positive when the expected real rate of return offered on other assets (stocks and bonds) is low.

Demand

Demand, not supply, is what matters. Remember, potential demand is many multiples the size of the existing gold stock, which is fairly inelastic. So it doesn’t take much of a change at the margins of asset preferences to cause very big moves in the yellow metal. And as we learned above, this demand or asset preferences are driven by the expected real returns of stocks and bonds. This is why gold tracks the real yield on bonds very closely. When the real yield offered on bonds is trending lower, gold goes up. And vice versa.

This inverse relationship can be seen below in the following matrix via the excellent book Hedgehogging, written by Barton Biggs (the chapter with Peter, the “Gold Guru” is also where I first became aware fo the above NBER paper).

So that’s it… That’s RED. Our fundamental framework for analyzing gold.

The entire thing can be boiled down further into just two key points:

    1. Over the long run (and this is one of Ray Dalio’s “principles” regarding gold, as well) the price of gold will approximate the total amount of money in circulation divided by the size of the gold stock
    2.  And it’s not inflation or deflation that is the principal driver of gold, but the expected real return from other long-term financial assets, particular equities.

Using the above we can quickly discern that there’s a very high probability the bull market in gold will continue for the foreseeable future.

The global money stock has exploded and continues to rise… While the expected real return on financial assets is very low. Even negative in some cases. See GMO’s 7-year forecast as case in point.

Gold obviously isn’t going to go straight up from here. So, if you’re a trader, then you’ll want to pay attention to some key indicators and of course, read the tape.

Here’s a slide from our regular weekly Trifecta Report that goes out every Saturday. In the report, we analyze the four main macro instruments: SPX, UST 10yr Bonds, Gold, and the dollar.

The below slide shows some of the key positioning, sentiment, and seasonal data that we track for gold. As of right now, fund flows, sentiment, and positioning all remain supportive of higher prices. Not to mention, gold is about to enter the strongest 2-months of the year for returns on a seasonal basis.

The tape says we’ll probably see a little pullback over the short-term as stocks get bid up. But, that’ll just offer us another good opportunity to add to our position.

So there you have it. That’s our RED system for analyzing gold. I hope you find it useful. We didn’t even cover silver, which according to our framework, should outperform gold over the coming months.

If you appreciate this kind of first principles research and analysis. And you’d like to join our Collective of traders and investors from around the world, please click the link below to check us out. Our community is comprised of the full spectrum of market participants, from wealthy retirees to hard-charging college students, to a handful of billionaire hedge fund managers who are household names. The one thing we all have in common is that we’re maniacally devoted to mastering this great game.

This devotion shows in our performance. While the market is negative on the year, we are up double digits so far. Not to mention we’ve had to stomach MUCH less portfolio volatility. This is a testament to our ruthless devotion to truth in this game and building an approach from the ground up, starting with foundational principles.

This enrollment period closes this coming Sunday. Afterward, the discounted price will no longer be offered and we won’t be reopening our doors for some time.

I hope to see you in the group. It’d be great to have you on the team. We expect the rest of the year to be a wild one for markets. It’d be a lot of fun (and hopefully very profitable) to tackle them together.

Sign me up for the MO Collective

How To Read Market Sentiment

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On being a contrarian from Michael Lewis’ Liar’s Poker:

Everyone wants to be, but no one is, for the sad reason that most investors are scared of looking foolish. Investors do not fear losing money as much as they fear solitude, by which I mean taking risks that others avoid. When they are caught losing money alone, they have no excuse for their mistake, and most investors, like most people, need excuses. They are, strangely enough, happy to stand on the edge of a precipice as long as they are joined by a few thousand others…

Contrarianism is the most abused and empty platitude in trading and investing. Everybody thinks they’re one, but few are.

And that, by its very nature, has to be the case. Because to be a contrarian is to go against the herd, the majority.

Hedge-fund legend Ray Dalio puts it like this, “You can’t make money agreeing with the consensus view, which is already embedded in the price.”

In case you don’t have twitter (good on you, you’re a better person than I!) or missed my recent thread on the subject of “How To Read Market Sentiment”. You can find the entire thread here. Let me know if you have any thoughts or comments.

Here’s the link to the video

Whether one knows it or not, we’re all playing Keynes’s Beauty Contest. Most dither at the first level completely unawares. Hopefully, this thread helps you see the market for what it really is so you can begin playing the game at the second, third levels, and beyond…

We’re currently working on a report about where we see the MOST one-sided positioning and consensus out of any market around the world. This consensus has created what we believe is an extraordinarily asymmetric opportunity.

Jim Rogers, the famed partner to George Soros during the ole’ Quantum days, likes to say:

The way of the successful investor is normally to do nothing — not until you see money lying there, somewhere over in the corner, and all that is left for you to do is go over and pick it up.

Well, suffice to say, we at MO see a disgustingly large pile of money just sitting over in the corner right now… just waiting for some free-thinking investors to come and scoop it up.

If you’re interested in finding out more then click the link below and join our group while the enrollment period is still open and the discounted rate still applies. I hope to see you in our group.

I Want To Join The MO Collective

Thinking In Essentials

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The other day I shared my thoughts on E.O. Wilson’s quote, you know the one where he writes “We are drowning in information while starving for wisdom. The world henceforth will be run by synthesizers, people able to put together the right information at the right time, think critically about it, and make important choices wisely.”

Here’s a link to it in case you missed it. Anyways… one of the problem sets that we work really hard on solving here at MO is to cut through all the gross noise —  and there’s A LOT of it — in order to tease out the valuable signal. You know, separate the wheat from chaff, synthesize the goods, and all that.

This requires something that we call Ruthless Reductionism, which is really just a fancy way of saying “we work tirelessly to cut away the fat from our process and only use the effective essentials”. In visual form, the process looks like this.

Victor Sperandeo, one of the Trading Greats of the 70’s/80’s era and author of the fantastic book “Trader Vic”, also wrote about the importance  of focusing on essentials. Here’s Vic in his own words (emphasis by me):

“If I had to reduce all the components of my methods to a single phrase, it would be thinking in essentials.

“It’s not necessarily how much you know, but the truth and quality of what you know that counts. Every week in Barron’s there are dozens of pages of fine print summarizing the week’s activities in stocks, bonds, commodities, options, and so forth. There is so much information that to process all of it, and make sense out of it, is a task beyond any genius’s mental capacity.

“One way to narrow down the data is to specialize in one or two areas. Another way is to use computers to do a lot of the sorting out for you. But no matter how you reduce the data, the key to processing information is the ability to abstract the essential information from the bounty of data produced each day.

“To do this, you have to relate the information to principles — to fundamental concepts that define the nature of the financial markets. A principle is a broad generalization that describes an unlimited number of specific events and correlates vast amounts of data. It is with principles that you can take complex market data and make it relatively simple and manageable.

So you could say that taking complex market data and making it relatively simple and manageable is what the team and I at MO do. Not just for our own process but for fellow Operators in our Collective. Our strategies, the tools and indicators we use, the information we aim to share, is tirelessly tested for its efficacy.

For it to get into our toolbox it needs to be able to make us money… We don’t aim to participate in confirmation bias or sensational prediction making here.

I write all this because since we’ve opened up enrollment into our Collective this week. I wanted to share with you the research we sent out to our group over the weekend. So you can take a look for yourself to see if it’s something you may be interested in.

Here’s the link to our Trifecta Report. This report is a macro chartbook that breaks down the: sentiment/positioning, technicals, and fundamentals of the main macro assets we track weekly. It consists of all the primary indicators and charts we look at each week for those markets.

It’s meant to offer a quick scroll through so you don’t start the week unprepared. It goes out every Saturday along with this Stock Alerts report put together by my teammate Brandon. This report shows the most actionable technical chart setups that he’s tracking each week.

And then on Sunday, I sent out this short Market Note discussing the two opposing macro forces at work in markets, currently.

This is just a sampling of what goes out over the weekend. Much more is included with entry into the group. Anyways, if you’re tired of reacting to the financial new click-bate’ery and want to cut out the noise, increase some zen in your investing life, then come and trial us and see if we’re a fit.

Click Here To Read More About The Macro Ops Collective

Synthesizers Win

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“We are drowning in information, while starving for wisdom. The world henceforth will be run by synthesizers, people able to put together the right information at the right time, think critically about it, and make important choices wisely.”

– Edward O. Wilson

It is mind-blowing to think about how much information is available now versus 20 years ago, or even just 5 years ago. And yet part of the problem is a data deluge. It is incredibly tempting to be distracted by useless information… or to pay undue attention to the wrong information… or to self-select news sources and get trapped in an echo chamber… the potential pitfalls go on and on.

As the flow and volume of information increases, the ability to parse and sort that information becomes an ever more valuable skill. There are parallels here to the way grandmaster chess players process chessboard information versus amateurs. While the amateur has to painstakingly work through a complex situation — analyzing, say, ten different possibilities in detail — the grandmaster uses a process called “chunking” to reference a library of patterns in his head, then immediately zeroes in on the one or two pattern matches that are relevant.

This creates both a speed advantage and a depth of analysis advantage: Having cut away the subpar lines of play more quickly, the grandmaster can either move more quickly (saving time and energy) or invest a savings of time and energy in deeper, more nuanced analysis of the two moves that matter. The natural synthesis process increases speed, accuracy, and efficiency simultaneously, thus allowing for compound investment of the surplus.

An accumulation of small advantages in the information processing space can strengthen and reinforce itself, in small subtle ways, until finally becoming indomitable. The ability to put together “the right information at the right time,” thus allowing the ability to act with conviction before a window of opportunity closes, is in some ways the essence of trading.

What are you doing to enhance your “synthesizer” skills? Are you distracted by low-value information, or focused on high-value information? Do your data streams drown you… or act as a rich source of nourishment? Do you have a reliable means of strengthening conviction — or diluting pre-existing conviction as appropriate — based on what the information flow tells you?

I talk about the exact process we at MO use to separate the wheat from chaff in this short video I put together, which you can watch here. I cover a number of important concepts, most of which I haven’t seen discussed anywhere else. Now, more than ever, it’s critical to have a process for bypassing the noise and getting to the signal. Give the video a watch if you want to learn exactly how we do that.

The Narrative Pendulum

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Fractalized sine waves are encoded into the very fabric of our reality. Like the Golden Ratio and the second law of thermodynamics, they appear throughout the universe on nearly every level of scale and function. It’s no surprise then that they underlie the structure of our market.

This makes intuitive sense because a sine wave is just a continuously swinging pendulum. And crowd dynamics naturally follow the path of a pendulum. Swinging from one local extreme to another. 

The market is in effect a large complex information transmission system. All acting participants make bets using their particular knowledge set which then in aggregate sets the market price. This, then, provides new information for the actors to incorporate into their decision-making process so they can then make new bets. Thus, creating a neverending feedback loop of information, assessment, action, new information.  

These infinite feedback loops, when combined with group psychology and crowd dynamics, necessitate the constant back and forth we see in markets.

Each rally sows the seeds for a reversal and each reversal sows the seeds for a rally. Ad infinitum. 

Michael Mauboussin discusses how this dynamic creates a neverending process of market trends and crashes in a paper titled “Who Is On the Other Side?”. In it, he shares work done by economist Blake LeBaron which animates this concept using an agent-based model (here’s a link to the original paper). 

The model is computer generated and the “agents” are imbued with decision-making rules and objectives similar to those that drive market participants (i.e., make money, try not to lose money, don’t underperform the average for long periods, etc…) 

Here’s a section from the paper (emphasis by me): 

LeBaron’s model replicates many of the empirical features of markets, including clustered volatility, variable trading volumes, and fat tails. For the purpose of this discussion, the crucial observation is that sharp rises in the asset price are preceded by a reduction in the number of rules the traders used (see exhibit 5). LeBaron describes it this way:

“During the run-up to a crash, population diversity falls. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market. The economic mechanism here is clear. Traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies. In the Walrasian setup used here, this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity. 

“Because the traders were using the same rules, diversity dropped and they pushed the asset price into bubble territory. At the same time, the market’s fragility rose.”

 

Really grokking this concept and understanding how this plays out in markets is critical to learning to play this game at the second and third levels and beyond. It’s the fundamental difference between being a reactionary self-proclaimed contrarian that routinely gets steamrolled by price-trends. And an effective contrarian, who knows how to read something I call the “Narrative Pendulum”, which allows you to get on and stay on the right side of the trend. 

I talk about this concept in-depth in a recent video I put together. If you’re interested in giving it a watch just click the link below. It’s free and doesn’t require anything on your end, other than just an hour of your time. But I promise the information is illuminating and will change the way you view and interact with markets in more ways than one.

Video: How To Read the Swing of the Narrative Pendulum

I’d love to hear your feedback after you’ve given it a watch. Just shoot me an email at alex@macro-ops.com with any Q’s and comments you have. I look forward to hearing from you!

Sifting For Asymmetry

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The market moves off stories. These stories are based on both the underlying fundamentals and people’s perceptions of the underlying fundamentals.

Our job as traders isn’t to try and predict where the market is going (that’s a fool’s game). Rather, it’s to identify areas of potential asymmetry.

We like asymmetric opportunities as traders because they allow us to be wrong a lot, and still make a boatload of money. And that’s the key to this game. Finding asymmetric opportunities and also creating them through trade management.

The majority of the time, assets and markets, reflect a wide range of stories (ie, people’s perceptions of the underlying fundamentals). This means the market is pricing in a wide range of potential future outcomes. When that’s the case, there tends to be little asymmetry in the price.

Asymmetry is born when a story becomes popular (ie, consensus) and it prices an asset/market to only reflect a very narrow range of outcomes.

Humans are really bad at predicting the future. Probably why Mark Twain said, “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

This is why it pays to be a contrarian.

The following three things help with identifying asymmetry.

    1. Understand the popular models/beliefs: Know the popular economic models, theories, and beliefs that people use to assess the market and understand the world. This allows you to get a feel for how the market will react to and interpret certain data and events.
    2. Know the stories: This is more art than science and it’s helped by having a firm grasp on the above. But read constantly, study the headlines, and develop a feel for the stories that are driving prices. Bruce Kovner calls this “listening to the market.”  Dominant stories are actually pretty easy to spot, the problem is is that we’re likely to believe in them too. Stories only become consensus because they’re convincing.
    3. Understand how the economic machine works: Markets and economies are complex systems. It’s impossible to “know” how things will unfold, which is why prediction is pointless. But, even complex systems follow broad-based principles. Knowing these first principles and understanding how the economic machine works a little better than the average market participant allows you to identify dominant stories predicated on faulty models/beliefs. Market prices based on faulty think = mispricings and asymmetry.

It’s not about trying to predict the future. It’s about being aware of many probable outcomes and comparing those to what the market is over/underpricing. You want positive EV, high expected value opportunities, which is (Probability of Winning) x (Amount Won if Correct) – (Probability of Losing) x (Amount Lost If Wrong).

It’s a different approach to markets than the way most do it. It’s an inversion of conventional thinking. Most try to predict where the market is going… they play the “game of being right”. We compare where the market is, to a range of where it could be, and focus on how we can be wrong a lot but still get paid.

Ray Dalio, put it best when he said, “You can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.”

The Perils of Too Much Information

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The other day I was flipping through Tim Ferriss’ book “Tribe of Mentors” and came across this great section from Adam Robinson. For those of you not familiar with Adam, he’s a rated chess master, founder of the Princeton Review, and now a global macro advisor to some of the world’s most successful hedge funds and family offices — amongst many other impressive things.

What Adam writes about markets in the book is pure gold. It needs to be read by everybody, printed out and taped above your trading desks and then tattooed across your forearms. It gets at a central truth of markets and what we can do as traders (aka. professional uncertainty managers) to best exploit it.

Without further ado, here’s Adam:

“Virtually all investors have been told when they were younger—or implicitly believe, or have been tacitly encouraged to do so by the cookie-cutter curriculums of the business schools they all attend—that the more they understand the world, the better their investment results. It makes sense, doesn’t it? The more information we acquire and evaluate, the “better informed” we become, the better our decisions. Accumulating information, becoming “better informed,” is certainly an advantage in numerous, if not most, fields. But not in the counterintuitive world of investing, where accumulating information can hurt your investment results.

“In 1974, Paul Slovic—a world-class psychologist, and a peer of Nobel laureate Daniel Kahneman—decided to evaluate the effect of information on decision-making. This study should be taught at every business school in the country. Slovic gathered eight professional horse handicappers and announced, “I want to see how well you predict the winners of horse races.” Now, these handicappers were all seasoned professionals who made their livings solely on their gambling skills. Slovic told them the test would consist of predicting 40 horse races in four consecutive rounds. In the first round, each gambler would be given the five pieces of information he wanted on each horse, which would vary from handicapper to handicapper. One handicapper might want the years of experience the jockey had as one of his top five variables, while another might not care about that at all but want the fastest speed any given horse had achieved in the past year, or whatever.

“Finally, in addition to asking the handicappers to predict the winner of each race, he asked each one also to state how confident he was in his prediction. Now, as it turns out, there were an average of ten horses in each race, so we would expect by blind chance—random guessing—each handicapper would be right 10 percent of the time, and that their confidence with a blind guess to be 10 percent.

“So in round one, with just five pieces of information, the handicappers were 17 percent accurate, which is pretty good, 70 percent better than the 10 percent chance they started with when given zero pieces of information. And interestingly, their confidence was 19 percent—almost exactly as confident as they should have been. They were 17 percent accurate and 19 percent confident in their predictions.

“In round two, they were given ten pieces of information. In round three, 20 pieces of information. And in the fourth and final round, 40 pieces of information. That’s a whole lot more than the five pieces of information they started with. Surprisingly, their accuracy had flatlined at 17 percent; they were no more accurate with the additional 35 pieces of information. Unfortunately, their confidence nearly doubled—to 34 percent! So the additional information made them no more accurate but a whole lot more confident. Which would have led them to increase the size of their bets and lose money as a result.

“Beyond a certain minimum amount, additional information only feeds—leaving aside the considerable cost of and delay occasioned in acquiring it—what psychologists call “confirmation bias.” The information we gain that conflicts with our original assessment or conclusion, we conveniently ignore or dismiss, while the information that confirms our original decision makes us increasingly certain that our conclusion was correct.

“So, to return to investing, the second problem with trying to understand the world is that it is simply far too complex to grasp, and the more dogged our attempts to understand the world, the more we earnestly want to “explain” events and trends in it, the more we become attached to our resulting beliefs—which are always more or less mistaken—blinding us to the financial trends that are actually unfolding. Worse, we think we understand the world, giving investors a false sense of confidence, when in fact we always more or less misunderstand it. You hear it all the time from even the most seasoned investors and financial “experts” that this trend or that “doesn’t make sense.” “It doesn’t make sense that the dollar keeps going lower” or “it makes no sense that stocks keep going higher.” But what’s really going on when investors say that something makes no sense is that they have a dozen or whatever reasons why the trend should be moving in the opposite direction . . . yet it keeps moving in the current direction. So they believe the trend makes no sense. But what makes no sense is their model of the world. That’s what doesn’t make sense. The world always makes sense.

“In fact, because financial trends involve human behavior and human beliefs on a global scale, the most powerful trends won’t make sense until it becomes too late to profit from them. By the time investors formulate an understanding that gives them the confidence to invest, the investment opportunity has already passed.

“So when I hear sophisticated investors or financial commentators say, for example, that it makes no sense how energy stocks keep going lower, I know that energy stocks have a lot lower to go. Because all those investors are on the wrong side of the trade, in denial, probably doubling down on their original decision to buy energy stocks. Eventually, they will throw in the towel and have to sell those energy stocks, driving prices lower still.”

Stanley Druckenmiller’s first mentor Speros Drelles — the man Druck credits with teaching him the art of investing — would always say that “60 million Frenchmen can’t be wrong.

What Drelles meant by that is that the market is smarter than you. It’s smarter than me. It’s smart than all of us. This is why its message should always be heeded. 60 million Frenchmen can’t be wrong…

Markets are incredibly complex which is why there’s a measurable downside to accumulating too much information, as we saw with the horse bettors. It can lead to confirmation bias and overconfidence as Adam points out.

I read a study a couple of years ago. I want to say it was done by the shared research site SumZero. I’ll have to see if I can find the link and add it to this post when I get a chance. But what this study found was that there was a significant difference in performance between short sub-500 word stock pitches and long 10-page+ writeups.

The short and sweet stock pitches outperformed their longer-winded brethren by a country mile.

German psychologist, Gerd Gigerenzer, calls this “The less-is-more Effect”. If you’d like to really dive into this then I highly recommend picking up his book “Gut Feelings”. But, essentially what the less-is-more effect refers to is that heuristic decision strategies can yield more accurate judgments than strategies that utilize large amounts of information. The way I think about this in trading and investing is that if you need 20-pages of notes to convince you to put on a trade then you shouldn’t put on the trade.

Rather, a seasoned trader should have a framework for what constitutes a good trade and a bad one. This framework is focused on the key drivers — the few essential pieces of information needed to make an informed positive expectancy bet. This should be able to fit on the back of a napkin. Literally.

Remember this the next time your scrolling through a 334 slide deck on why Herbalife (HLF) is a zero or reading through a “Macro Strategists” 75-page report on what he thinks the market is going to do over the next 3-months.

Ruthless reductionism and Occam’s Razor may make for cold bedfellows but they’ll help keep you from shooting yourself in the foot. Which, if you can avoid doing, will put you a few steps ahead of your peers.

So remember… Respect the market, seek to get just enough information, and keep things simple but no simpler (to bastardize a popular Einstein quote).

Be Fire and Wish for the Wind

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“Wind extinguishes a candle and energizes fire.

“Likewise with randomness, uncertainty, chaos; you want to use them, not hide from them. You want to be the fire and wish for the wind. This summarizes this author’s non-meek attitude to randomness and uncertainty.

“We don’t just want to survive uncertainty, to just about make it. We want to survive uncertainty and, in addition — like a certain class of aggressive Roman Stoics — have the last word. The mission is how to domesticate, even dominate, even conquer, the unseen, the opaque, and the inexplicable.”

– Nassim Taleb, Antifragile

AB Comments:

What does it mean to “be fire and wish for the wind” from a trading perspective?

First, consider the market strategies that get put out like candles. Selling naked puts against the S&P 500 index, for example, is a well-documented means of doing well temporarily, then extinguishing one’s trading account. So too with “reaching for yield” strategies in which steady-eddie returns are generated in periods of quiet via the use of questionable leverage. Volatility comes along and blows out the P&L candle.

Strategies that benefit from outlier moves, and thrive on the exploitation of tail risk, would be the fire in Taleb’s metaphor. Trend followers and other long gamma traders “wish for the wind” of heightened volatility and fat tail price movements.

Another way to wish for the wind (i.e. embrace volatility) is to develop trading capabilities, if not a full-scale methodology, that can profit in bearish environments. Because so many managers are long-only, it can be quite valuable, from both an OPM and absolute return perspective, to have the ability to thrive in bear markets (or at least to generate solidly positive returns, while the majority of investors get hammered).

This concept applies in life too. Some people are weakened substantially, or even see their candle “blown out” entirely, by the winds of adversity. Others get stronger — more resilient and powerful — in the presence of setbacks and challenges. The wind makes their inner fire burn hotter.

How resilient and robust is your approach to trading… and to life? Do you require idealized conditions to thrive… or can you burn almost anywhere? Are you the candle or are you fire?

Markets as a Banana: The MOST Important Fundamental Part 2

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Today’s note is the second part of a write-up I sent you earlier in the week titled The MOST Important Fundamental: The Global Shortage of Safe Assets. If you haven’t already, I suggest clicking the above link and giving the first section a read before diving into this one.

In the following collection of ordered words and well-timed punctuation marks, we’re going to layout the second piece of the all-important global asset shortage puzzle.

By the end, you’ll know why the market is a banana (yes, you read that right, I said banana). And we’ll finish with what this means for the market on both a longer-term as well as a near-term basis.

Enough with the introduction… Let’s hop right in.

Everything in markets comes down to supply and demand. Our jobs as speculators is to figure out the two and see if there’s a mismatch that will lead to a change in prices (a trend). So let’s start by defining demand.

Investors can allocate their savings to three main assets: stocks, bonds, and cash. They make these allocation decisions based on desired returns and tolerance for risk to come up with a portfolio mix — the classic being 60% in stocks and 40% in bonds/cash. Recent price appreciation (not valuation or yield) and general risk appetites are the overwhelming drivers behind this allocation decision. Momentum is the bottom line. Investors are always chasing the trend — nobody likes sitting out of a rising market.

Savings — the amount of money available to invest — fluctuates according to the levels of cash + credit (money) in the system. Since credit is easier to create than cash (any two willing parties can create credit out of thin air with an IOU), credit largely drives the amount of investable money in the system.

Expanding credit equates to more savings to invest. This amount cycles up and down in accordance with our debt cycle framework.

The supply side of financial assets is comprised not just of the total amount of shares or bonds in existence, which is what many people mistakenly believe. But rather, it’s the aggregate market value — the total dollar amount in existence at current market prices — that makes up supply.

The equity market has a flexible supply. If demand for stocks goes up then equity flows will drive up prices,  increasing the total market cap thus creating more supply to equilibrate to demand. It’s a self-correcting system.

The basics of our equity supply and demand model is thus:

    • On the demand side we have:
      1. The amount of savings available to invest is driven by the credit cycle
      2. The allocation mix of investor portfolios is driven by performance chasing and general risk-appetite (both work on each other in a reflexive loop)
    • On the supply side we have:
      1. Supply consists of the total market cap of the asset and this market cap is equal to the number of shares + the price at which they trade
      2. Stocks have a flexible supply in that greater demand leads to a higher market cap and more supply

We can look back through time and see how this model correlates to market returns.

Historically, US corporate share issuance has rarely exceeded 2%. Over the last three and a half decades corporates have been reducing their share count through buybacks and M&A at an average annual rate of 2%.

While the number of shares available to trade has been steadily falling, the amount of money (cash+credit), has been steadily increasing.

Over the last 50 years, the money stock in the US has gone up at an average annual rate of 8% a year.

So…… over the last five decades the supply of equity (available shares) has been dropping at an average rate of 1-2% a year while the total money stock has gone up at an average rate of 8% a year.

Let’s disregard the total market value and investor allocation preferences for a second. Just taking this straight forward mismatch of supply and demand alone, we get a structural supply deficit of approximately 9.5% a year.

You want to guess what the average annual return of the stock market has been over this same period?

Banana…

No, sorry, I mispoke… the banana part comes later. The correct answer is 9.5%… 9.5% is the average annual return of the S&P 500 over the last 50 years. And it’s also the average yearly deficit of equity supply in our stock market supply and demand model.

Coincidence you may ask?

Not at all. It’s just math.

If investors keep their portfolio mix (their allocation preference between stocks, bonds, and cash) relatively constant, then the market value of stocks has to rise at the same level of the supply and demand mismatch caused by share reduction and money creation — 9.5% a year.

Eye-opening stuff, isn’t it?

I hope this changes the way you view the broader market cycle. The GOAT, Stanley Druckenmiller, instinctively figured this out, even if he gets the actual mechanisms at work wrong. But it’s this phenomenon he’s referencing when he says things like:

Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.

So to sum this section up… overtime, the market has to rise because we operate in an inflationary system. A system where the quantity of money is always going up (over the long-haul) and the corporate sector’s aversion to dilution keeps share growth at a minimum to a net negative.

The only way for the market to clear, for supply and demand to balance, is for the total market value to rise, increasing supply to meet demand.

If you were trading back in the early 80s and you understood this market supply and demand model, you would have known with absolute certainty that a massive secular bull was on the horizon. It was mathematically inevitable by that point… the supply/demand mismatch combined with the then-record low allocations to equity made for an unavoidable rally in stocks. And a massive rally at that, which is exactly what ended up happening.

This macro model has been a major reason behind my continued bullishness and definitely was when I first wrote the above report on the topic for members of our Collective back in mid-18’.

If you’d like to read up more on this idea then I highly recommend checking out this 2013 blog post on Philosophical Economics, which outlines in much greater detail, this very idea.

And finally, we can get to my original point which is that the market is a banana.

Not just any banana. But this very specific banana.

Remember this musa acuminata?

Last month some guy — who apparently refers to himself as “artist” — duck taped this ripening fruit to a wall at Art Basel Miami. This piece of “art” was then sold three consecutive times, first for $120,000 and finally for $150,000.

I know, what you’re thinking… what a steal right? Old Warren would surely be proud of that final buyer who most definitely resides in Graham and Doddsville.

Anywho… the banana art was shortly eaten thereafter by some other guy who also calls himself “artist”, and said the act of eating the artful banana was actually art itself.

When I first heard this I thought “my God, that poor banana buyer must be devastated.” Fortunately, I was mistaken — I confess…. I’m a total ignorant when it comes to the highfalutin world of Produce Art.

In fact, according to the Gray Lady, the performance artist’s “stunt did not actually destroy the artwork or whatever monetary value it might have had at that moment. The three buyers who collectively spent about $390,000 on the taped fruit had bought the concept of the piece, which comes with a certificate of authenticity from the artist, along with installation instructions. It is up to the owners to secure their own materials from hardware and grocery stores, and to replace the banana, if they wish, whenever it rots. After Mr. Datuna consumed the banana, the gallery taped another one to the wall.”

That makes perfect sense. Glad the Times could clear that up for us.

Well, anyway, I believe I have proven my point. The market is a banana… or rather a banana duck taped to a wall.

What’s that? You’re not fully convinced?

Okay, let me explain this a bit more.What I’m trying to say is that the same forces which drive the valuation of “banana stuck to wall” are the exact same ones that drive the valuation of the stock market.

“Banana on wall as a concept” sold for $150,000. I’m not certain but I think that’s in the higher valuations given to a ripe banana. It received this high valuation because there’s a low supply of concept banana art yet tons of demand for stupid… I’m sorry… unique works of art. Low supply, high demand, high price.

The stock market is trading at a record price to sales (chart via NDR).

It’s trading at record valuations because like banana-as-a-concept, there’s lots of money that needs to be invested and the supply of stocks keeps falling.

This chart of gross share issuance (new issues minus buybacks) shows how large the supply deficit is — and this isn’t even counting M&A which is running hot as well (Chart via Yardeni).

This is why market valuations are such a useless variable (over the intermediate-term at least) in gauging the sustainability of a market trend. Valuations can always go much higher or lower than you think. Because, as we discussed, multiples have nothing to do with the durability of the cycle.

Like the pricey banana, it has everything to do with your basic supply and demand. The model for which I have laid out in these pages here along with my earlier write-up. ‘

Where does this model of supply and demand leave us today? Well, with rates pinned low due to the shortage in safe assets globally. And buybacks set to continue unabated as financial conditions remain easy. We get, well, banana on wall selling for $150k… that is… stupidly high prices for stocks.

I think Five Minute Macro nailed the current zeitgeist in a recent tweet, writing:

There’s still plenty of risk premia spread to tighten should things get “fruit art as a concept” silly… which I very much believe they will.

I’m seeing lots of opportunities in this market; both on the long and short side. I’ll be putting out a report to Collective members next week where I’ll be sharing a handful of incredibly asymmetric plays that I’ve found in the small-cap space — I expect small-caps to outperform their larger siblings by a good amount this year.

There are two stocks in particular that I honestly believe have 10 bagger + potential. I can’t wait to share them and am really looking forward to getting the report out to the group.

If you’d be interested in receiving this report or any of our work along with the many other benefits that come from being a member of our Collective, then go ahead and sign up for our risk-free trial by clicking the link below. Enrollment ends this Sunday and won’t be opening up again until next quarter when prices will be 47% higher.

I hope to see you in there.

“Unpleasant Truths” or “Comforting Lies” and The Path To Trading Mastery

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In trading and investing, the taste for “unpleasant truths” is slim.

This is human nature… it’s always been this way. And we at MO know something quite important. We know it with the certainty of gravity:

    • The millions who take the “comforting lies” approach to trading will fail.
    • A large portion of this group will quit in disgust, never to trade again.
    • Another portion will become “permanent dabblers,” screwing around forever.
    • But a small portion, a remnant, will tire of the lies and finally seek truth.

Simon and Garfunkel: “A man hears what he wants to hear, and disregards the rest.”

Truer words were never spoken. What most people “want to hear” is that a trading method or system can make them successful, with a small amount of capital and minimal effort, in three to six months.

So when we come along and say nope, it’s more likely to take three to six YEARS minimum… with a LOT of effort and focus and sweat equity on your part… and by the way, your focus should be on training and growing your first few years, with the life-changing profits coming later (via scale)… how do you think that goes over?

Like a lead brick, that’s how. For those still hooked on comfort at least.

And yet, for those who have “taken their share of beatings” from markets… who have wrestled with the real pitfalls and challenges of trading… who have gained enough knowledge and seasoning as such that the “comforting lies” simply aren’t comforting anymore… the “unpleasant truths” become something different.

The unpleasant becomes pleasant after all.

How so? Because after passing through the “comforting lies” phase, for many (who are honest with themselves) there is a moment of confidence-shattering doubt. There is the question thrown out in despair: “Is it even possible to become a successful trader at all?”

We’ve seen it on Twitter and message boards. Maybe you have too: Call it “failure fatigue.” The trader who has burned up all his patience for the “comforting lies” stage, banged his head on the wall 500 times — or maybe 5,000 times — and has finally exploded, raging to anyone and everyone who comes across his posts that no, no, no, it can’t be done, you’re all full of shit, trading is all a bunch of lies…

Or they go and start a newsletter and spout eternal bearishness and rage against the machine. Maybe they call this trading service SouthmanTrader or something along those lines… but I digress….

Here’s the thing… It can be done. And there is ample empirical proof of this. And theoretical proof, and overwhelming data. (For those not emotionally bound to blindness that is.)

On progressing to a certain stage of maturity and readiness, the unpleasant truths become pleasant because they are revealed as the true path forward. The only path forward. Insanity has been defined as “doing the same thing over and over and expecting different results.” At a certain point in the struggle, for an honest few, the wake-up call comes. Then, with enough searching and questing, the path reveals itself.

And then comes the hard part. Morpheus to Neo: “There is a difference between knowing the path… and walking the path.”

    • First there is the false path (comforting lies).
    • Then there is discovery of the true path (unpleasant truths).
    • And then there is getting on it…

Becoming “the one”

There is a scene in The Matrix where, after questioning Neo on being “the one,” The Oracle tells him:

“Being the one is just like being in love. No one can tell you you’re in love, you just know it. Through and through. Balls to bones.”

You can have that feeling as a trader. Not at first, and not automatically (just as neo had to take some time, take some beatings, and learn to believe in himself).

But having progressed far enough down the path of knowledge and experience and training, you can know you are “the one”… in the sense of having made it as a trader.

You can wake up in the morning and know — not half-believe, or try to talk yourself into believing, but know — you are a master of your craft. That you have earned the right to call yourself a trader… and that the profit goals which you seek to achieve, will be achieved, short of a meteor striking you down.

But you don’t get to this place through wishing or hoping or ginning up lots of enthusiasm. You get there by walking the path. The path of training and knowledge and experience. The path is not months or weeks but years long… and in exchange provides freedom and benefits, financial and otherwise, that will last your entire life.

This is an important point so we will indulge all caps. Walking the path is a PHYSICAL FORWARD PROGRESSION. This is why enthusiasm is great as an ignition boost — a way to get started — but it won’t take you where you want to be. Progress along the path is NOT a self-esteem trick. It is NOT a “positive affirmation” thing. It is an actual physical progression.

Memories have a literal physical presence in your brain. Connections between memories have a physical presence in your brain, via the highways and byways of neurons and synapses. This means, as you progress along the path of knowledge and experience as a trader, you are ACTUALLY BUILDING SOMETHING. You are literally BUILDING NECESSARY CONNECTIONS within your PHYSICAL BRAIN.

I shout (the all caps) because this is another reason the “comforting lies” are so obnoxiously stupid. Someone who suggests you can have the seasoning and training of an experienced trader quickly and easily might as well tell you it’s possible to build a skyscraper in two weeks with your bare hands. It takes time to build a structure… including a knowledge and experience and emotional reference structure, with a physical three-dimensional presence within your own brain.

The Martial Arts Paradigm

In some ways, trading is comparable to a martial art. If someone said “my system will take you from zero to black belt in three weeks,” you would laugh out loud. (Or at least I hope you would).

The notion of becoming a trained martial artist (on par with becoming a trained trader) without requisite time and effort applied — with zero time and effort, really — is beyond ludicrous. In fact, it’s insulting. The prospect of becoming highly proficient and combat-trained over a period of years, however — via putting in the effort, with the high-quality feedback and instruction — has genuine merit. What you put in is what you get out.

The martial arts / trading comparison is also apt in respect to the above and beyond benefits acquired by training.

I’ve never heard of a serious martial arts practitioner who did it “just for the belt,” or solely to handle themselves in a fight, or to stay in good shape or some such thing. There are always reasons, and discovered benefits, that go much deeper, touching on things like personal philosophy… self-awareness and self-confidence… way of life.

And so it is with trading…

Attuning the subconscious

In the 1920s, a German philosopher named Eugen Herrigel went to Japan to study archery. Except he wasn’t really studying archery, he was studying Zen. Herrigel wanted to truly understand Zen from the inside out. He achieved his goal through a combination of theory and practice, over a six-year span of becoming proficient with the bow.

Years later Herrigel wrote the amazing little book “Zen in the Art of Archery,” which contains the following observation (in the 1953 introduction) from D.T. Suzuki:

“One of the most significant features we notice in the practice of archery, and in fact of all the arts as they are studied in Japan and probably also in other Far Eastern countries, is that they are not intended for utilitarian purposes only or for purely aesthetic enjoyments, but are meant to train the mind; indeed, to bring it into contact with the ultimate reality. Archery is, therefore, not practiced solely for hitting the target; the swordsman does not wield the sword simply for the sake of outdoing his opponent; the dancer does not dance just to perform certain rhythmical movements of the body. The mind has first to be attuned to the Unconscious.”

“In the case of archery, the hitter and the hit are no longer two opposing objects, but are one reality. The archer ceases to be conscious of himself as the one who is engaged in hitting the bulls-eye which confronts him. This state of unconsciousness is realized only when, completely empty and rid of the self, he becomes one with the perfecting of his technical skill though there is something in it quite of a different order which cannot be attained by any progressive study of the art.”

What Suzuki calls the Unconscious, we know as the subconscious. When Suzuki speaks of an element “which cannot be attained by any progressive study of the art,” he speaks of training…. The actual practicing and doing of the thing.

This reveals another puzzle piece — more illumination as to why the 90 percent fail. Herrigel, based on his writings, was a devoted and attentive archery student. If it yet took Herrigel six years to fully master something as surface-level simple as “letting the arrow shoot itself” — i.e. gaining mastery-level proficiency at archery — can we expect less of trading?

Can we really expect to take a mastery path measured in years, and compress it down to weeks or months (or no time at all), or otherwise count “time served” via flipping through books on weekends? No.

This is another “unpleasant truth” to most ears, yet pleasant to those with ears to hear… because it highlights that the path, though extended and challenging, truly does exist.

When you think there is an easy road, you don’t want your delusion taken away. When you realize the easy road was a lie, if you still burn with desire to achieve your goal, then the confirmed existence of a hard road is good news, not bad. (The hard road reality further explains why most do not walk it. Too long! Too much effort!)

The ideal training scenario

But returning to the trading vs martial arts comparison… let us say, for theory’s sake, you wanted to attain a black belt in a certain martial art. And not just any black belt, but a ninth-degree black belt from a world-class teacher. How would you go about doing it? What would the ideal scenario be?

The optimal setup, if you were dedicated enough, might be moving to a dojo in the rural wilderness of Japan — cut off from disturbances of the outside world — where you could train with a handful of fellow students.

This would provide access to the instructor, whose insights are vital… access to proper knowledge, without which you might stumble for years in the dark… structured routine and motivation to train… and access to your fellow students, who would provide friendship, encouragement, and comparative notes along the way.

In training to become a trader, something similar might be ideal.

Going off to some remote setting, surrounded by fellow traders, wholly devoted on both an individual and group level to mastering the craft. If it’s going to be a long journey, you want guidance and friendship and shared milestones along the way.

The “dojo in the wilderness” isn’t’ realistic, of course.

But something comparable is…

The Macro Ops vision

At MO, community is central to our vision. But we want to do more than just attract excellent traders to our community. We want to create them.

To succeed in your ultimate growth path as a trader, you need training. And feedback. And camaraderie wouldn’t hurt either. Hardships go down easier when they are shared. Celebrations are better enjoyed in company too — the company of those who know the meaning of your victories and defeats, large or small, because they are fighting the same battles.

Man is a social animal. Standing together as a group is better than standing alone.

Ask yourself: Is it time to join Hernan Cortes, burn the f*cking ships, and commit to a path of mastery?

Die-hards only, need apply. We want those who are committed to the journey; regardless of current skill level. We want those who embrace the “Unpleasant Truths” and will stop at nothing to get what they want.

If that sounds like you, come join our Collective.


Click here to enroll in the Macro Ops Collective

Winter enrollment for the Macro Ops Collective is now open. This enrollment period will end on January 19th at 11:59PM. If you’re interested in joining our community make sure to sign up by this Sunday! This is the last enrollment till Spring when we’ll be raising our prices by 47%.

Click here to enroll in the Macro Ops Collective