The great investing myth (3): Macro investing & predicting the future 🔮

Every day, news and events move the financial markets (inflation, employment, interest rates, forex, unemployment rates, GDP growth and global issues like trade wars, Russia-Ukraine invasion, Middle-East conflicts, sanctions, etc.), interest rates, inflation and their impact. Experts, gurus and friends give their views in mainstream, social media and conversations on every twist and turn of events affecting the financial markets and predicting the macro directions.

It gives an impression that this is THE way to invest; having an acute awareness of global situations and events and a good understanding of macroeconomics to ride the waves — macro-investing/top-down investing. Certain sectors and asset classes (bonds, commodities, cryptos) can rally or crash depending on the news flow. Profits seem quick and easy being the prognosticator.

Being the prognosticator 🔮

To make money in investing/trading = Knowing the future? Or hoping?

There are several considerations for investing and trading based on macro events and situations:

1. Events cause stocks to rise and fall.
   Many believe that events drive the stock market. This generalisation is true to some extent—in the short term and for some stocks.
2. Events versus processes
   Many focus on the news (the events) and react to them. They do not follow the history leading to the events (such as interest rates, inflation, oil or regional conflicts). This offers important perspectives to understand the situations better and their impact on our investing theses.
3. Reactive
   We usually try to understand the events and situations as they unfold. Each macro situation can represent a lot of information and knowledge to digest. Some anticipate their effects and trade the relevant stocks/financial instruments early to benefit from the situation. Others try to look further to the horizon at lurking issues and the nth order of possible impacts.
4. A + B + C – X – Y – Z = ???
   More than one issue/event is at play (for example: high interest rates + inflation + rising unemployment + middle conflicts). These issues interact with each other to affect and benefit countries, industries and companies in different times and ways. It is almost impossible to predict the likely outcome in the short term and over time and how these will affect companies and countries. New unrelated events may emerge. Governments may intervene to stem the situation before it gets worse.
   
   It always looks smart for people to “summarise” and “simplify” the complex events and offer a view of their future. How right and consistent have they been? Have they been able to make money?
5. Timing the market
   The financial market is sentiment-driven in the short term. It anticipates, front-runs the situation and sells on the news. At other times, it reacts based on the news feed. This creates volatility as the market reacts to every twist and turn. This volatility in financial markets is not reflective of the actual operating environment of some sectors and companies. In the longer term, some sectors may be adversely affected while others may benefit.
6. When will it happen? What will happen next?
   The situation keeps evolving and does not happen as expected (examples: the burgeoning US debts, de-dollarisation and direction of interest rates). Hence, some are bearish or bullish bias.

It is a lot to know and monitor for retail investors. They must know what to buy/sell, and the directional bets (long/short) to profit from each evolving situation by timing entries and exits well.

The economy does not unfold mechanically in a pre-determined direction. World affairs are constantly affected by governments and companies anticipating, reacting and overcoming the situations in their own ways. Hence, while we may know the possible trends and issues, it is complex and almost impossible to predict what will happen to time the market with the right assets with high accuracy.

The problem is waiting until the water clears, the water never clears.

And so the default assumption that I urge all investors to do is consistently put money into the market. It’s really, really simple.

Jim O’Shaughnessy

Our desire for certainty

A common trait of human behaviour is the burning desire for certainty despite living in an uncertain and probabilistic world. The core here is that people think they want an accurate view of the future, but what they really crave is certainty. A related and equally important problem here is how easy it is to underestimate rare events in a world as large as ours.

The inability to forecast the past has no impact on our desire to forecast the future.

Morgan Housel, Same as Ever

What we want to know about the future is certainty. People are concerned and anxious when the situations are uncertain. Despite being proven that no one can know what will happen with certainty, we continue to like to know the future — we watch people who can explain the situation and offer a peak about the future (often with a confirmation bias).

Are there people who can consistently know the future? Are there companies who consistently know the future and work towards it? No!

Knowing the news ≠ Knowing macros

Being updated with breaking news does not mean we know macros.

Conversely, we are subjected to the News Paradox: The more news you consume, the less well-informed you are. Nassim Nicholas Taleb calls it the noise bottleneck: As you consume more news, the noise-to-signal ratio increases, so you end up knowing less about what is going on. The news represents the events as explained earlier. Many do not follow or study what are the processes leading to these events and it is difficult and time-consuming.

There is much foundational knowledge of each topic (economics. political study, history etc.). The litmus test: Do you have an edge?

Always a biased view of the world

Our views of the world are often biased — confirmation bias, negativity bias, identity bias, etc. Our experiences, beliefs, values, background, investment portfolio and other factors shape the way we perceive and interpret information, events, and the world around us. Our investment holdings added further biases. These biases can influence our judgments, decisions, and interactions with others.

Some people can be optimists or pessimists about the future. The extent of our outlooks can be an inherent bias and influence how we view the future and consume and process information and data. Macro prognosticators tend to be pessimists and doomsayers (negativity bias); there is always something they worry about.

Optimism often sounds like a sales pitch, pessimism sounds like someone trying to help you.

Morgan Housel

All past declines look like an opportunity, all future declines look like a risk.

Morgan Housel

A great article: The Seduction of Pessimism by Morgan Housel

It is important to recognize that bias is not always negative or intentional. It can be a result of our limited information, cognitive shortcuts, and the complexities of processing vast amounts of information. However, being aware of our biases and striving to mitigate their impact through critical thinking, empathy, and openness to diverse perspectives can help us develop a more nuanced and balanced understanding of the world.

Fact: There are and will always be problems (somewhere).

There will always be dark clouds. This is an unfortunate characteristic of the world. It is often a question of more or fewer severe problems and how these hinder progress and growth. There will always be something that people are not happy, concerned and pessimistic about.

The world is not heaven. The water is never clear.

I’ve had a lot of worries in my life, most of which never happened.

Mark Twain

Everyone is different; our character and ideology can influence our outlook bias.

Forecasts usually tell us more of the forecaster than of the future.

Warren Buffett

Different types of macros versus what we are buying

We can broadly categorise macro into global events/issues (geopolitics, wars), industry/sector-related (trade protections, shortages, oversupply), regional and country-related. In the short term, they affect the sentiment of the stocks. In the longer term, depending on the severity of the issues, businesses are affected in varying degrees; some are badly affected and some do well.

Macros may determine the markets’ directions and affect many companies but not the exceptional ones in the longer term.

When we use macros to generalise the economy, we will miss the high-quality companies that will thrive and whose growth rates will far exceed the averages.

In the short term, fear, uncertainty or FOMO will determine the market’s direction. Over the longer term, it depends on how companies adapt to the changing environment.

This lies the major difference between macro investing and value investing; see below for elaboration.

Do validate the experts

Ask: Given their views and predictions, what have they bought and sold? How well has their portfolio performed? Show us the money!
It is not just about views and predictions but how their confidence and convictions in their views translate into profitable trades and investments consistently; only time will tell. We have to validate whether their predictions are right months and years later.

Macro investing

Macro investing is an outside-in approach that relies mainly on our understanding of the situations and the newsflow to predict the future, find the right investments, take the right directional bets, and time the market (entries and exits) well.

The professionals are supported by analysts, economists, and experts around the clock who trade based on macroinvesting. It can be difficult for individual retail investors to emulate.

Yes, it looks smart being a prognosticator who can read the tea leaves, know the future and make a quick and good profit. It may not suit many of us as retail investors in terms of the approach, our knowledge and experience, our ability to deal with ambiguity, volatility, and our lifestyle.

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There is more than one type of market edge. We have to find our market edge where we are comfortable with and suitable to our lifestyle and yet can make a consistent profit over the long term. Start with a position of strength and personal preference and improve thereon.

Oaktree Capital Management with an AUM of USD 164b in 2022 has one of its six investment philosophies to be: Macro-forecasting not critical to investing. It elaborates on its website:

We believe consistently excellent performance can only be achieved through superior knowledge of companies and their securities, not through attempts at predicting what is in store for the economy, interest rates or the securities markets. Therefore, our investment process is entirely bottom-up, based on proprietary, company-specific research. We use overall portfolio structuring as a defensive tool to help us avoid dangerous concentration, rather than as an aggressive weapon expected to enable us to hold more of the things that do best.

A good post by Howard Marks: The Illusion of Knowledge

The future is about probabilities and the current situation is about facts and interpretations. No one has privileged access to the future and market forecasts tend to be about as accurate as calling a coin toss. There are, of course, analogies that can be drawn about how the current environment maps onto previous historical data, but success in that depends crucially on how the future will, in fact, resemble the past, and whether the cited analogies turn out to be the governing ones. The record seems to show that sometimes they will and sometimes they won’t and we are back at the coin toss.

Bill Miller 2Q 2021 Market Letter

What is our edge?

Are we having the Dunning-Kruger effect (cognitive bias in which people with limited competence in a particular domain overestimate their abilities)? Do we have the time and resources to understand and monitor the various market situation (economics, geopolitics)? While the prognosticators appeared smart, do check their long-term track investing/trading records to validate their ability to prognosticate with profits.

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

Ben Graham

Yes, it can be short-term trading dealing with a sentiment-driven market. The market may overreact. It sells on the news and it may pump and dump. The ability to stay calm, adaptable, and follow the game plan amidst the volatile market is very important.

Macro investors invest and trade with futures, forex and ETFs (indices, countries or sectors). They rely on technical analysis to study price trends and patterns (price charts) to spot market opportunities more accurately. Some may invest and trade with the market leaders. They do not go for specific companies to ride the trend. However, retail investors may go for smaller companies for better return potential. The question to ask is whether the specific companies can capture higher than the market returns with the macro situation and whether any specific company’s risk (that we are not aware of as we are macro investors) will cause any implosion.

Being aware of longer-term macro sea changes

While there is no new information from the company, changes in the macro environment can affect expectations and share prices. The same macro situation affects regions, countries, sectors and companies to varying extents.

A sea change is a complete transformation, a radical change of direction in attitude and goals. They can be mega trend cycles, strong secular tailwinds or headwinds. It is good to be aware and focus on the more plausible and durable macro trends that can have significant long-term effects on certain sectors and companies on their value drivers such as revenue growth, operating margins, failure risks and reinvestment.

Here are some macro events and trends that we pay attention to their magnitude, pace and impact:

• Interest rates
• Inflation
• Weakening of currencies
• Debt levels of countries
• Wars
• Shifts in world order
• Technological innovations (internet, mobile, artificial intelligence)
• Cryptos and blockchains
• Energy (nuclear, storage, renewables)

If we believe that there is a strong secular trend that will affect or benefit our lives and companies, it is worthwhile to delve into the details of the trend and identify investment opportunities to ride on.

A great memo on interest rates by Howard Marks that is worth reading (and re-read): Sea Change

Here are some other approaches to investing/trading and we can adopt a mix of different approaches for ourselves:

Business analysis versus market analysis

Whenever Charlie and I buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed [in the next essay]) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.

When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.

The Essays of Warren Buffett, The Fourth Edition

Economy versus Companies

It is easier to study companies whose businesses we are familiar with rather than the economy which is complicated to analyse. Analysing companies are easier. It can be easier to invest in high-quality companies, strong moats and people like and require their products and services.

Hammer versus Magnifier

“Don’t fight the Fed” is a popular investment maxim that suggests that investors should follow the direction of the Federal Reserve’s monetary policy. The idea is that the Fed has a lot of influence over the economy and that its actions will have a significant impact on the stock market. It is important to consider other factors, such as economic growth, corporate earnings, and investor sentiment that affect stocks, especially high-quality companies.

While macro investing may generalize a general market trend, value investors go deep to find gems out of the stack.

If the only tool you have is a hammer, it is tempting to treat everything as if it were a nail.

Abraham Maslow

Macro investors generalise. It is analogous to using a hammer where the larger the hammer, the more things underneath appear like nails. Bottom-up investing is analogous to a magnifier where they search and find gems among the heap of nails. These investors look for countries, sectors and/or companies that continue to do well with their revenue growth and profitability.

Don’t generalise. Look harder.

Finding the gems with the magnifier; the high-quality companies are outliers

While the share prices may fall as a whole with poor macro, not all sectors and companies suffer gloom and doom to the same extent.

We underestimate the tenacity, resilience, and creativity of some great companies and their leaders to adapt, survive and thrive in challenging times; they evolve and adapt well. There are some companies, sectors or subsectors that thrive as they become in demand due to changing conditions.

They are the outliers. Great companies with extraordinary businesses and talented management survive and thrive through many crises. Market crises are the best times to buy great companies with good valuations.

“Bad companies are destroyed by crisis, Good companies survive them, Great companies are improved by them”

Andy Grove

How should we (Nalanda Capital) separate the proximate causes from the ultimate ones when there is euphoria or bearishness in a theme?
Unfortunately, I am not aware of a foolproof method for doing so. But here is what we do.
We define their unit of analysis clearly as the company. Not the economy, not the market, not a theme. We care about the fundamentals of the company—nothing else. We have never invested in a theme and never will.

…. In my experience, developing a method and an instinct to separate proximate and ultimate causes of failure or success when they relate to a company event is invaluable for a long-term investor.

Pulak Prasad,  What I learned about investing from Darwin

Over the long run, well-run businesses (Amazon, JPMorgan, Nestle, Visa, Walmart, Microsoft) create a lot of value irrespective of the macroeconomic environment.

In short, you cannot generalise to find exceptional companies and to hold them long term to achieve multi-bagger returns.

We just need a few high-quality companies to invest in. It is much easier than to analyse complicated macros.

Looking back at every exceptional company, their success is not guaranteed. Rather, many often believe they will not succeed.

You will be easily shaken by the news and macros constantly happening every day.

Let the great companies figure out and navigate the future for us instead

Great companies have the right products and services and can improve and introduce new services and products that we keep wanting more. Their leaders have the resiliency, vision and resources to thrive during the good and tough times. They have proven to be able to navigate the various operating environments well and their share prices outperform the market by a wide margin. So, let’s outsource the future to them rather than we, the investors, trying to figure out the future to invest. Just ride on them!

Here is a good reminder of Amazon’s Annual Letter to Shareholders for the Year 2000 when its share price dropped 80% that investors should focus on what the companies are working on and achieving rather than focusing on the plunging stock market. This too shall pass.

Here is one case study:  A case study of a mega-compounder: Amazon
A related post: Here’s why the best investing opportunities are not obvious

Focus on high-quality companies whose demand for products and services can be predicted with high certainty.

As the value investors keep studying individual companies, they get to know many sectors and companies in good detail. The awareness of the long-term macros and secular trends allows them to know which countries, sectors and companies will benefit. This will give them the added knowledge of what and when to invest than many. This gives them a good edge.

It is a case of how knowledge compounds and returns follow. These investors can be generalists focusing on finding stocks that meet their investing criteria with a focus on sectors and countries.

The more general macro investors are less familiar and may be late to the party.

Focus on cash flows and balance sheet

Revenue must be translated into good free cash flow and a strong balance sheet.

Being contrarian and focusing on longer-term

When the market drops, the higher the uncertainty, the lower the risk, the wider the margin of safety and the higher the rewards. It favours those who put in efforts to delve deep to study and find high-quality companies and patiently wait to buy at low prices.
A good read: The Dhandho Investor by Mohnish Pabrai

The purpose of the margin of safety is to render the forecast unnecessary.

Benjamin Graham

Also, almost universally, we tend to overestimate what can happen in the short term and underestimate what can happen in the long term. In many instances, many quality companies (as opposed to cyclical companies and industries) may thrive in various market situations.

The real fortunes in this country have been made by people who have been right about the business they invested in, and not right about the timing of the stock market.

Warren Buffett

Many successful value investors (Warren Buffett, Charlie Munger, Guy Spier, Mohnish Pabrai) are more focused on the long term than the daily market situations. Warren Buffett is one of them. To quote Buffett again, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”

Long-term investors are very boring people compared to prognosticators who always have something new to say about the situation. Investors do not have much to say or they keep repeating what they have been saying. They keep studying the companies using their investing criteria (their version of looking for undervalued companies) and holding on to the same companies throughout. Occasionally, they may get excited about a new company they found. They keep looking at investing with the same (boring) investing criteria and processes.

Take the financial statements and price charts of high-quality companies such as Amazon, Nike, McDonald’s, and Costco and zoom out. Their share prices show ‘mountains and valleys’, and their financial performance is just one direction: keep inching up. They have been able to ride out every challenge to deliver huge multi-baggers.

Don’t follow the herd.

Technical analysis: Summarizing newsflow and market sentiment with price action and charts

Price charts are a visual representation of the ideas, emotions, and positioning of millions of
traders and investors across multiple time horizons. In a short period, they tell us a lot
about the dominating view of market participants in a given time frame. Many use technical analysis as their source of truth where all macro and companies’ news, greed and fear sentiments are all reflected in the price and volume of the charts and it can be a valuable indicator of future price movements.

Technical analysts use a mix of indicators such as price trends, trading volume, oscillators (Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), moving averages, and support and resistance levels.

Technical analysis is usually used for trading. For investing, it helps to identify inflexion points (entries and exits) used together with fundamental and macro analysis. Technical analysis can be switched to different time frames to suit our time horizons for trading and investing.

Fearful and overwhelmed by the macros

If you are overly concerned and fearful by the macros and feel that this time is different, do trim or sell and wait out. As explained earlier, no one can predict what will happen and we are likely to very biased. Wait, chill, observe and learn from the side.

Conclusion

Are there people who can consistently know the future? No
Are there companies who consistently know the future and work towards it? No!

At any period, many different macros are happening and often interacting together in varying degrees. It can be difficult to understand and invest based on macros. Do you have an edge?

Should you find the macro situation worrying,

• Evaluate how the businesses will be affected and whether the companies are capable of handling (in terms of their financial position and capability)
• Vary the portfolio allocation accordingly and have more cash if needed
  (litmus test: able to sleep and get on with lives with our portfolio)

A few perspectives:

• Tighten the investing criteria and validate the investing thesis if needed. Not all companies in our portfolio may be good enough to overcome the macro challenges. We may have been lenient or greedy to buy some speculative or not-so-good quality companies. Do sell them if need to.
• If you are confident of the extent of the macro sea changes, you may want to find a suitable investment to ride on them
• Hold the high-quality companies in an allocation that you are comfortable with
• Add high-quality companies at attractive prices guided by your investing approach
• Don’t waste the macro events, especially sea changes. Keep learning and improving!