A sustainable approach to investment management should be based on four key principles:
I think nobody would object to the last three of these principles, but “truth” always gets the conversation going. This is all particularly relevant in today’s environment of deepening uncertainty.
What I mean by truth is multifaceted, but mainly it’s about discerning what’s true about the world from what is not, since our information universe is chock-full of biased reporting, flawed data, erroneous analyses and outright lies. As we can’t change the external environment, we must take care that our own understanding of things is as close as possible to truth. This is not a small challenge.
We tend to have strong convictions about things and this can distort the way we perceive our world. When we process information, we often disregard or disbelieve whatever clashes with our beliefs and overrate anything that support them. But if our beliefs are flawed, we might misinterpret events and reach erroneous conclusions. From there, we risk making poor decisions. The war in Ukraine offers a stark case in point.
Looking at things as we wish them to be
In mid-March, Sir Tony Blair, Great Britain’s Knight Companion of the Most Noble Order of the Garter, published an article on Russia on the pages of his important Tony Blair Institute for Global Change. The Knight Companion’s article was titled, “The Immediate Challenge in Ukraine: Maximum Pressure Combined With Structured Negotiation” (as opposed to just ordinary kind of negotiation for simpletons). Sir Tony opens with, “Putin has badly miscalculated.”
He goes on that, “The Ukrainians are now fighting for their homeland with a bravery, determination and skill which has rightly fired the imagination of a large part of the world. The West, after a hesitant start, has impressively united to assemble a vast arsenal of sanctions which will over time collapse the Russian economy. … in the end, this aggression may well herald the downfall of Putin.”
Turning to Vladimir Putin, Blair portrays him as an anxious man, “detached from reality and with no one around him prepared to tell him the truth.” In other words, Russia’s president is the archetype of a megalomaniacal cartoon villain. But in expounding on Putin’s isolation, bad miscalculations, Ukrainian military prowess, weakness of Russian economy and ineffectiveness of her military, Blair and others like him have fallen into the trap of their own wishful thinking.
The west’s disdain for Russia, fanned by two decades of wall-to-wall Russophobic narrative, made Blair’s assessment easy to believe. As Niccolo Machiavelli noted in his 1532 treatise, The Prince: “Men will not look at things as they really are, but as they wish them to be – and are ruined.” Western leaders’ collective clash with reality drove them to underestimate their adversary and overestimate their own capability. Six weeks after Sir Tony Blair published his sophisticated prose, Russia is on the verge of a decisive military victory in Ukraine and her economy recovered nicely from the west’s “vast arsenal of sanctions.” Russia did not fade, supermarkets and pharmacies are well provisioned, there were no bank runs, stock markets didn’t collapse and the people didn’t rise up to oust Vladimir Putin.
As even The Guardian, one of the west’s leading exponents of Russophobic paranoia had to acknowledge, Russia’s revenues from the sale of fossil fuels to Europe doubled since the invasion of Ukraine began. Rather than turning into rubble as many in the West predicted, the ruble recovered to new highs. Here’s what that chart looked like on Friday, 29 April 2022 vs. Sir Tony’s premature victory lap:
Western leaders unforced miscalculations carry an economic cost, so much so that we are now paying in full for Russia’s war in Ukraine. To make the humiliation complete, Russia is winning. Even Boris Johnson had to concede that in spite of their poor morale, incompetent command and general disarray, and in spite of the “bravery and skill” of Ukraine’s defenders, it was a “realistic possibility” that Russian military would prevail in Ukraine. Sadly, the high price of the staggering incompetence of our hapless leaders will be paid by the ordinary people, primarily in Ukraine, but also in the rest of Europe.
How to know the truth?
Today we are blessed with a vast abundance of information that previous generations could not have dreamt of. But we’re also cursed with distortions and lies, often disseminated from authoritative. Indeed, we’ve no choice but to research and learn to distill the truth for ourselves. With time, as our understanding of the world grows, we should be able to construct an accurate mental map of the world, society and the way things work. To do that we must also check our biases and our own beliefs and convictions. As Stepford Brooke said it, “If a thousand old beliefs were ruined in our march to truth we must still march on.”
As we distill truth and our knowledge grows, we should be able discern more and more patterns and insights so that our understanding of certain things – even complex things – may at some point cross the threshold of doubt. In that, we should acquire a degree of immunity against lies and deception that are pervasive in our information universe.
It’s a dog. I’m sure of it.
Navigating in the real time
When it comes to investment speculation, things get a bit complicated. While it’s true that the more you know, the better you are equipped to interpret economic conditions and how they’re likely to change. But even if you get the macro picture right, you could still get trampled in the medium and shorter term. For example, in 2010 I read a compelling report by SocGen’s Albert Edwards and Dylan Grice. Their hypothesis was that Japanese equities were an excellent bargain for stock investors. As it turned out, Edwards and Grice were spot on, but it took more than two years for their prediction to come true.
When they published their report (October 2010), the Nikkei was trading at about 9,600. For investors who might have bought Nikkei futures at that time and at that level, they would see the Nikkei drop another 1,470 points over the next 12 months. This corresponded to a $7,350 loss per contract, more than 4x the initial margin per CME Nikkei contract. For traders with insufficient cash cushion (and insufficient patience to sit tight through more than 2 years of losses), the trade could have been a wipeout.
Edwards and Grice got the macro picture right (the dashed expectations line), but could not have predicted the trajectory of market prices or when their advice might begin to pay off. Indeed, even if we have clarity about longer-term developments, their timing and scale are simply impossible to predict. So then, how should investors navigate the unpredictable market fluctuations? This question is increasingly important as we enter a period of deep uncertainty and growing volatility in global markets.
Sail with market trends…
I believe that trend following is the only sustainable solution to the problem of uncertainty. Trend following also offers investors a number of important advantages, starting with truth. Namely, trend following is based on the only source of market information that is true, unambiguous and timely: the price of securities itself. Trend followers can ignore all other information which insulates their decision making from biased reporting, flawed data, erroneous analyses and lies.
Second, trend following entirely absolves us of the need to be right about the future of markets. The strategy will keep you long through up trends, short during down-trends and it will “change its mind,” at the right time, free from beliefs and convictions that could prove mistaken.
Third, trend following can greatly enhance investors’ versatility and diversification. Because the strategy is only concerned with analyzing security price fluctuations, it can be applied in any market. You can just as easily trade stocks, bonds, currencies or commodities with the same conviction, even if you know little about those markets.
If you think that I exaggerate, I’ll confess that during my career I’ve traded in more than 50 different financial and commodity futures markets and I know next to nothing about most of them. In spite of that I was able to consistently outperform my strategy benchmarks for 13 years straight.
The versatility of systematic trend following could be particularly important in today’s market conditions. The ability to diversify from the overinflated traditional asset classes and diversify into commodities like crude oil, copper or silver, or even agricultural commodities like wheat, corn, cotton and coffee could prove decisive. Interest rates are on the rise and the stock and bond bubbles may have begun to pop. At the same time, the commodity super-cycle has already started.
The above chart (courtesy of Incrementum AG, Feb. 2022) shows that the recent rise in commodity prices has thus far only slightly impacted the historical imbalance between commodity and equity prices. A return to the median value in this series, which is about 4.1, should see either a significant increase in commodity prices, a collapse of the equity market bubble, or both. Again, such events tend to unfold as trends and span months and years, allowing trend following strategies to capture windfalls across many uncorrelated markets – a savior for investor.
Last month I sat down with Emerson Fersch of “Upthinking Finance” podcast for an eclectic, unorthodox discussion about trend following, I-System and truth. You can check it out below:
Incidentally, the bar-chart below shows the directional exposure of our Major Markets portfolio as of Friday, 29 April 2022:
If you do not already use such strategies, please do not fly blind through the coming market turbulence. Consider signing up for our daily TrendCompass newsletter by simply e-mailing us your request at TrendCompass@ISystem-TF.com. You’ll begin receiving your reports the very next trading day.
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