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How To Position After This Market Surge? Follow Logic

Why is it that oftentimes markets move first and the economic justification (and punditry rationalizing the outcomes) follows?

It is well known in the psychological literature that humans tend to favor consistent narratives. I am not a psychologist so will not dig deeper here. But if you scan the writings of so-called market experts, you will find a few things: (1) they all declare victory regardless of whether they are right or wrong, (2) when they admit they were wrong they will qualify it, i.e. “yes we got it wrong, but…”, (3) they tend to make even stronger predictions going forward. Again, there are beautiful models in the psychological literature on why this happens, but I have neither the expertise nor the space to delve into it. We do know that experts will come out of the woodwork to justify every bull market and every bear market, and usually right around the inflection point. Buyer beware.

So at the risk of making the same mistake of selecting our “good calls” vs forgetting the “bad calls” (I actually had none, but yeah the one I did was actually not so bad because…but here is a better one…), we called the latest “bull market in equities”. Now there are two ways to go about analyzing this “greatest and absolutely fantastic” call. First, we could have a crystal ball, and second, we could simply look back and say that the current outcome was so remote in the minds of other pundits that we simply could not lose by taking a contrarian view.

The first approach is the “causal” approach, which basically says that A results in B, and B results in C etc. Hence if you can identify the probability of A, then you can with some degree of certainty identify the probability of B and with a slightly lower degree of confidence identify the probability of C. The other approach is more akin to “diagnostics”. The way this proceeds is by putting yourself in the situation where C occurs, and turning the computation on its head and saying what conditions could have been the proximate cause of C occurring. This leads to a spectrum of possibilities that one is forced to imagine about B, and hence A.

The mathematics of diagnostics follows the simple but confounding Bayes rule that we discussed last month in this forum, i.e. the probability of something happening conditional on something else is proportional to the probability of something else happening conditional on something else times the unconditional probability of something happening. So knowing what happened allows you to go backwards and identify whether or not the conditions were right for said something to happen. I am still waiting for some strategist or analyst to come back and admit that “oops, we got this wrong, but in retrospect it should have been obvious”. The usual explanation is “oops we got this wrong, but it was not obvious at all because…”.

The Bayesian technology is familiar to most probabilists. If we think of probability not as the statistic of things happening, but as information, then even outsized, rare events can be evaluated with the toolkit of mathematics and two simple rules: the sum rule and the product rule of probability. In financial markets, probability is not accumulating simply historical statistics, it is logic! To repeat another way – the rules of logic are the same rules of probability, and as investors, we know markets don’t repeat or maybe even rhyme, but they still have to follow the rules of logic. And that differentiates the great investors from the got-lucky folks.

To bring it to the case today. Equity and risk markets have defied all statistical odds as they make new, record, nosebleed high levels. The bears have turned into reluctant bulls (I know quite a few). “Upside tails” are now in vogue, and rising markets and rising vols are the buzzword of the day. But have they defied logic? I don’t think so. Whatever your political leanings, we have an administration that has the means to receive the baton from monetary stimulus of the last decade, and certainly the desire to do so.

And there are technicals in the market such as the negative convexity positions from being short upside optionality in equities (eg. Covered call writing and the famous 1×5 call spread trade that set the derivatives nerds abuzz last month) that can propel the market higher before any “fundamentals” take hold. Then there is the peer effect – of seeing your neighbor kill it with a 12% return since the election as you sit by the wayside. The market was simply too bearish to justify the low price of upside, and that should have signaled something.

What next? Many of us witnessed the Nasdaq bubble and crash. Many of us saw IPOs of money-losing companies rise to stratospheric levels before the bubble imploded. For life, and for safety of principal, one has to be careful not to be too contrarian too soon. But do get ready for the aftermath of the reversal as the consensus switches to unabated optimism. The economics of this nation are based on bigger and bigger bubbles and bigger and bigger busts. The trick is really not to fight the freight train, but wait until the time is nigh to board it again. In the meantime, start looking for safe places that you might need when the herd changes it mind, which will in hindsight be all too obvious. Again.

Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.

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