A few weeks ago I was rereading Joe Coulombe’s autobiography, Becoming Trader Joe: How I Did Business My Way and Still Beat the Big Guys, when I came across this quote:
“Risk management,” you say? Risk management is asking, “What am I risking if I say yes; and what am I risking if I say no.”
-Bernard McDonell, Vice President of Provigo, Inc., Montreal and one of the most astute people I ever worked with, quoting his former boss and mentor, Saul Steinberg.
If you ask 10 people to tell you what risk is, you should not be surprised to get 10 different answers. If you ask 10 people what risk management is, the same thing. I’ve done both of these exercises 100s of times, and there is no shortage of how people describe risk and risk management. Joe Coulombe’s quote jumped the page at me because it was simple, accurate, timely, and refined through three generations of very astute people.
I’ve found that most people fall along a spectrum between three categories when it comes to their perception of risk.
● Those who perceive risk as a potential
● Those who perceive risk as a likelihood
● Those who perceive risk as imminent
When you take those same three categories of risk and replace it with reward, the story gets a bit more interesting.
● Those who perceive reward as a potential
● Those who perceive reward as a likelihood
● Those who perceive reward as imminent
People slide up and down these spectrums all the time with no rules about risk/reward being treated with a similar thought, care, emotion, etc.
Investing is one discipline where risk is on constant display, so much so that we have thousands of different types of quantifiable risk metrics, ratios, spreads, etc., available to us at any time on an entire universe of securities and more. You can even pack all of these risk thingies together and make a composite risk index if you would like to pay an index provider for it. The idea of risk management is bought, not sold. So much so that many of us forget about rewards altogether! Loss aversion, they call it.
One thing is certain with risk when investing, the longer your time horizon, the fewer types of risk impact you. You could care less about something as obscure as liquidity risk or the various risks associated with derivative instruments when you have 40 years of compounding ahead.
On the other side of that point, the shorter your time horizon, the more types of risk impact you (still talking about investing, not trading). Liquidity risk might be one of your primary concerns and utilizing derivatives to hedge the foreign exchange risk associated with the income you were making from that rental property in Costa Rica you inherited.
Bull, Bear, and Base Cases
There are a lot of theories going around on what the bull case for the stock market could be, what the bear case could be, and what the base case (historical average) outcome could be.
Here are some bull cases for stocks going up:
Technicals – for the S&P500, the list of companies that made their 52-week low point peaked in June, and the percentage of new lows made in the last three months has shrunk from nearly 50% to zero. We don’t need new all-time highs for a bull market to occur, just look at 2009 through 2013 or 2002 through 2007 as examples of a market that ripped while still being below its all-time high. Chartered Market Technician, JC Parets, covered this here.
Macro – inflation can, in theory, go lower without the economy getting weaker. At that time, the Fed pivots from raising rates and starts easing, causing a tailwind for the economy. At this time, multiples (such as PE ratios) have contracted to levels not seen since the 1990s in many areas of the market, and if earnings continue to grow, that could be a great scenario for upside. The Ukrainian situation calms, and multiple returns to their 2020 high of 23, which is about 6% above where we are today.
Meta – everyone who is anyone anticipates a recession ahead. Therefore, it’s already priced in the market. Stanley Druckenmiller recently said, “do not invest in the present, the present is not what moves stock prices.”
Here is my favorite base case of the day that I took from my friend Michael Batnick, CFA:
Base – the stock market tends to bottom before the economy does. Taking a look at the chart below, you will see that the blue dotted line (S&P500) bottoms before the other lines (GDP, Earning, Payrolls). If you are waiting for the economy to tank before buying stocks, it may be too late.
Are there any shortages of bear cases for stocks right now?
Technicals – the average member drawdown of the S&P 500, NASDAQ, and Russell 2000 from it’s 1-year high is -34%, -48%, and -47%, respectively. Only 36% of S&P 500 stocks are above their 50-day moving average. Volatility begets volatility, and stocks being down and out is a choppy environment to invest in, full of nasty feedback loops.
Macro – Inflation, rising interest rates impacting the global financial system, a Fed determined to put us in a recession in the same year it flooded trillions of dollars into the financial system. War with Russia and its greater alliances, supply chains are still being fractured as developed nations move from China and its COVID policy to India as its manufacturing hub while the US dollar surges. An inverted yield curve. No real leadership in the US government can unify our country and set us on a strong path forward. Housing markets are looking very shaky and may cause contagion. Continuous impacts of the liquidity bubble breaking, reconnecting, then breaking again.
Meta – everyone who is anyone anticipates a recession ahead, but it’s going to be much worse than everyone anticipates, causing panic selling across the board. By June, PE multiples drop back to the dot com lows of 12, which is ~45% below where we are today.
What Does This Mean to Me?
Famed physicist Richard Feynman was once asked, “what is it, the feeling, between those two magnets?” He then went on to respond that in order to do a good job of explaining a magnetic force, he would first need to figure out what terms to use with the interviewer that relates to something that they are more familiar with.
Along those same lines, I do not know what this means to you. I know that your perspective of risk and reward is on a spectrum that dynamically slides with your unique life experiences. I know that how you manage your risk and reward perspective may be completely different than most people. I know that the simple framework of asking yourself, “what am I risking if I say yes; and what am I risking if I say no” is a great place to start the conversation, and in order to answer that question, you have to be equipped with a net-worth statement as well as short, mid, and long-term plans to underwrite a life of meaning. Only then can a prudent individual investment process begin. One that brings confidence and pragmatism to today and optimism for tomorrow.
If you would like to have that conversation, please let us know. That’s our passion!