Q1 2020: A True Black Swan
by Zach Marsh on Apr 3, 2020
“Domestic animals expect food when they see the person who usually feeds them…The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken.” Bertrand Russell, The Problem of Philosophy
In his book “The Black Swan: The Impact of the Highly Improbable,” author Nassim Taleb borrows Russell’s philosophy to create one of my favorite charts ever presented. Here it is:
The story, as Taleb tells it, is that a farmer feeds his turkey for 1000 consecutive days. Each day that the farmer goes out to feed the turkey, the turkey’s belief that the farmer is benevolent continues to grow. Until the 1001st day, Wednesday before Thanksgiving, when the farmer goes out and chops off the turkey’s neck. Taleb goes on to write that the turkey’s “feeling of safety reached its maximum when the risk was at the highest…it strikes at the nature of empirical knowledge itself. Something has worked in the past until—well, it unexpectedly no longer does, and what we have learned from the past (is)…irrelevant or false.”
Q1 In the Rear-View Mirror
I open with this rather lengthy introduction because it seems to have never been more relevant than present day. The first quarter began where the last quarter of 2019 ended, in continuous euphoric rally-mode. The first two weeks saw the S&P 500 rise nearly 3% capping an impressive three-month increase in the large-cap index of 15%. After a brief hiccup at the end of January, which saw the market drop 3% in two weeks, the S&P 500 pushed higher, taking out the old high levels and peaking on February 19th, 17.5% higher than October 1, 2019. The high point also marked an impressive increase of roughly 45% since the lows of Christmas Eve 2018. Within 24 short trading days all those gains were gone, and our world has been turned upside down.
In our current reality, the most obvious statement seems to be that we have no idea how or when this will end. Who among us can predict what, up until now, has been unpredictable? Sure, our government may have been able to react quicker to the outbreak in China, but can we even be sure how much that would’ve changed the outcome—or more aptly put, was the virus simply the catalyst for an event that was just searching for…a catalyst.
Market valuations, as they stood on February 19th, represented levels, which by many accounts, appeared over-valued. In our 2/21/2020 Market Commentary we highlighted the extent to which this market was hyper-valued. If you want to re-read it here it is What Goes up Must Come Down. By the way, in no means am I claiming to have foreseen the actual collapse which ensued, I did not. I merely mention this to illustrate the hypothesis that perhaps this has all been a case of a bubble in search of a pin.
In the 2/21 letter we discussed the path of the Nasdaq after the popping of the Tech Bubble. Over a three-week period from March 28-April 14, the Nasdaq Index fell over 30%, does that sound familiar? What happened next? After a brief retest of the lows in May, the market rallied back, recouping nearly 60% of the losses incurred. The market then began another descent at the beginning of September 2001. When it was all over in September 2002, the Nasdaq stood at levels 80% below its March 2000 highs.
Q2 Through the Front Windshield
Is there any information we can gleam from the history of the Nasdaq? What about the history of the Great Depression? If I answered in the affirmative, I would be prone to the same problem as that of the Thanksgiving Turkey. The truth, as I see it, is that the virus, or the world’s response to the virus, simply pulls back the veneer of our understanding. It exposes us to the harsh reality of the world: that certainty, for the most part, is an illusion. That narratives are attempts by our sub-conscious to delude ourselves into overvaluing our power in the determining the outcome. And maybe this illusion is in fact our defense mechanism which diverts our attention from our Sisyphean reality.
Like Sisyphus and his boulder, investing feels like an endless, perpetual struggle against the much stronger natures of gravity and time, each one pushing against us as we attempt to get to our destination. Yet, say what you want about Sisyphus, while it may have been a hellish punishment, at least he knew what he was supposed to do. Are we able say the same about ourselves in these times of discomfort, confusion and panic? In our volatile and perpetually uncertain times, having a model to follow increasingly proves its value. No model is perfect, all models are flawed to various degrees, but at least it prevents us from guessing or falling prey to the delusion we can predict the future. Models protect us from ourselves, from the behavioral tendencies which cloud our judgement and cause bad decision making.
Our model for investing is systematic in its approach to market environments. The model adapts to market conditions and looks to these same market conditions to determine which assets may be the most attractive. Like all models ours is imperfect, but it is vital for decision making in the face of uncertainty. While “these times” make us feel uncomfortably insecure, I try to remember that my existence before the virus only represented an illusion of security, and that right now I’m not living in an absence, only just a reminder.
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