On Human Fallibility

Though time moves relentlessly forwards, the progress of this secular bear market moves in waves. Whatever the presumptions I had, or expectations of outcomes related to the current recession, it is clear that an excessively strong bias can have negative repercussions. This relates closely to Soros' statement that the secret of his success is knowing that he is fallible. 

The market is, in many ways, a mechanism that transfers wealth from those with a short-term bias to those with a long-term bias (Buffett). Based on the truth therein, it would appear wise to adopt a long-term bias. So what prevents rational people from doing so? One thing, human fallibility. Hence the successful speculator's answer, of knowing he is fallible. Soros' ability to turn from long to short on such information as a back ache is the stuff of legend. My ability to turn from bearish to bullish is disastrously lacking.

There is really only one way to react to the knowledge that adopting a long-term bias is the way to have an enduring competitive advantage in the investment game, and that is to adopt such a bias. And to do so wholeheartedly and without regret or remorse. And yet, I have found myself continuing to pursue trading opportunities that can only be described as short-term speculative activities. I have managed to create a rationale that supports this activity, but the rationale probably belongs somewhere between spurious and hopeful. However, for the sake of argument it is included below.

Back in the recent years of 2006 and 2007, when the economy was ticking along nicely with 10 years of positive growth behind the UK, it seemed unlikely to me that the housing market would hold on to it's 100% gains of the prior decade, and that the consumer, having reached indebtedness to the tune of £1trn, would continue to spend more than he was earning each year. Thus spending was to decline eventually, and the very full prices for equities were likely to decline also.

Armed with this knowledge and a speculative bent, I set out to capitalise on my beliefs in the form of profits from shorting the equity indicies - a rather blunt effort in what could have been an incredibly profitable targeting of  the housing and financial sectors, given the benefit of hindsight. As the markets fell, I would open new short positions, and generally lose a little as the declines were met with bids to keep levels held up well... until the crash that is.

Beginning largely in May 2008, a year ago almost to the day as I write, equity markets (and many others in sync) began an incipient slide that wiped 50% off their values over the space of the following summer months. A fine speculator should have absolutely cleaned up, with the insight as to the depth of problems to come, the slow response to these problems, and the massive reactions once the realisation hit market participants that the great debt party was over. Many fine speculators did, and yet I did not.

Excessive short-term trading during the period, including a week of madness around the Lehman's bankruptcy in September (precipitated in part by the relative shock as to the level of profits achieved by that date), took at least 1/3rd of the profits I should have made, given my leverage and positioning, out of my hands. Still, the year's overall profits were fantastic and enough to fund 18 months here in The Alps, so you can't complain too much about that sort of outcome, can you, unless it's not the final outcome of course...

As we reach a point a year from where the depths of problems inherent in many western democracies was finally appreciated by the masses, many of the factors that were closely scrutinised, acted upon, and reacted to, appear to have been conveniently forgotten once again. Consumer indebtedness is still excessively high, corporate leverage remains problematic for many firms and the banking sector remains in a state of de-leveraging, thus reducing the availability of credit to those institutions and individuals who simply cannot maintain old levels of spending without such leverage.

An investigation of the Crisis of 1929-32 shows many bear market rallies, of up to 52%, lasting for periods of an average of 50 days (http://www.zealllc.com/2002/rallies2.htm), so the thesis that the current crisis is not yet over is far from written off by the current 40% rally over the past 60 days.

Anyway, my rationale for remaining short-termist is one of a practical nature. If markets are to continue to decline, the pain associated with my being right and losing money from adopting a long-term bias will be high. In this scenario, however, my prospects for employment will be significantly better than I currently envisage them to be, as the 'old order' of affairs will be restored and people will be looking to expand once again. I cannot for the life of me, however, escape the notion that the probability of this being the low point in our current economic cycle as hopeful at best, and plain nonsensical at worst.

So, as I find myself at a junction with the potential for further losses if I remain stalwartly short and markets continue to forge ahead, I have decided to continue in the vein that I started with back in 2006. It is my strongly held belief that markets have a strong tendency to overshoot, and that this is a behavioural phenomenon in mankind, so will repeat ad nauseam so long as people remain determinants of market prices.

Furthermore, the currently held beliefs that we are in the midst of an economic recovery create an opportunity for fine speculators to profit from the likely coming realisation that the old order of affairs simply cannot be repeated.

Finally, that the deleveraging process that began in 2007, has barely started, let alone run it's course, and it is the lack of understanding prevalent in the majority of commentary that leads me to conclude that markets have yet to fully appreciate the incipient problems that have to be worked through the economy in order for it to be righted once again on a surer footing.

And so, back to the fallibility issue. If I am to realise my fallibility, it makes sense only to focus on the knowable, those long-term micro-economic issues that have created wealth in all those who follow the facts to their relevant conclusions and are not swayed by the emotions of the markets. But to avoid the realisation of my own fallibility, to cling to the notion of my undefined and unlikely superior ability to make sense of short-term swings in markets, would appear to be the position that I am currently adopting by having short positions out there in the market.

So, to end, the ultimate realisation that one is fallible, is the major step REQUIRED to become a significantly good speculator, or indeed investor. My own, overriding, fallibilty (on a general level) is to not react accordingly to other areas of my own fallibility (on a short-term predictive level). Or will it be my saving grace that I have finally reached such a state of self-awareness as to be able to truly adopt the mental position of the rational, long-term biased investor that I so dearly want to enter into.

Old father time, as ever, is watching and marching ever forwards. My aspiration is that my knowledge and self-awareness will lead to appropriate actions tomorrow and forever more.