Nothin’ Much to Say I Guess, Just the Same as All the Rest

As I prepared to write today’s letter the U2 lyric, which I used as the title for this paper, kept running through my head. Sometimes writing a weekly market note can be challenging, especially when not much is going on in the markets. Sure, yesterday we got the monthly Consumer Price Index report which showed a scorching 5% year over year increase in inflation, a number we haven’t seen since 2007. But the market seemed to take that pretty much in stride, with the S&P 500 hitting all-time highs. Heck, even the 10 year US Treasury yield fell after the number was released. If a 5% inflation number isn’t going to jolt the market, what will?

Let me go back a bit. When I was getting ready to write the letter, the lyrics mentioned were running through my head, but I couldn’t place the song. So, I did what we all do, I turned to Google. When I found the result, I found it came from ‘Tryin’ to Throw Your Arms Around the World’. The song begins with the lyrics, “Six o’clock in the morning You’re the last to hear the warning You’ve been trying to throw your arms around the world.” I thought, yeah, that’s a great line that can be applied to markets as well. And it took me back to 2007.

I have very vivid recollections of that time. For those who don’t recall, summer ’07 was when the foundational cracks began to show in the housing market. Housing peaked in 2006, but the avalanche that was about to occur stayed hidden for quite awhile longer. Early in 2007, New Century Financial, a subprime mortgage lender, announced that it had been essentially misrepresenting results for two years. This led to a quick decent into bankruptcy for one of the nation’s leading subprimes. While this caused some tremors in the market, by early summer those were quickly erased from memory. On July 13, the S&P 500 hit a record high. About that time I was preparing to go on vacation. At the time I was an options trader on the floor of the CBOE. Long story short, I thought it would be a good time to reduce my long volatility position as I would be out of the market for a while. For those unfamiliar with options, I sold some options because I didn’t think the market looked like it was going to move very much over the next few weeks. What I didn’t know, and what the world was about to painfully find out, was that the mortgage crisis was about to start.

Six o’clock in the morning, you’re the last to hear the warning, that’s what my vacation felt like. “How did I not see it coming,” I thought. Why did I try to squeeze a little more money from a market that, in hindsight, was running on fumes? I was much younger then. With youth comes pride. Few saw it coming, so why should I have been any different. The barometer, the S&P 500, felt no storm brewing on July 13. From July 19 to August 15 the market fell hard, shedding about 10% by the lows on the 15^th. I didn’t know then, but what we can all see now is that there was no clear warning for the first shock—it wasn’t quite “six o’clock in the morning.” Markets are rarely so cruel as to not give the astute listener a chance to respond, but many—and I don’t exclude myself from this group—are exceptionally hard of hearing. We just cannot decipher the signal from the noise. In this case, the market would give the listener a chance to adjust. From August 15 to October 10 the S&P 500 recovered and actually made an all-time new closing high. For most of us it appeared the party was still going, but in reality, it truly was six a.m.—the signal was just emitted.

In financial markets emotions are our enemy. They cloud our judgement. They distort our reality. They prevent us from separating the wheat from the chaff. Models and rules help override our flawed decision making. They help cut away the cancer that eats us all—our ego. Ego can marry us to bad decisions. Ego tells us it won’t burn me this time. But a pre-determined rules-based model intercepts our ego and helps us to fight through or inclinations of fear and greed.

Thanks for reading,

Zach and Dave

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