Don't Run With the Crowd; Embrace Contrary Thinking

Don't Run With the Crowd; Embrace Contrary Thinking
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We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children."

--Warren Buffett

Every one to two weeks this fundamentally based observer leads off on Monday with a technically oriented market assessment that ends by focusing on the contrary.

Wednesday's election underscored the need for considering the contrary, and the market's surprising reaction to the election emphasizes the importance of what Howard Marks has described as "second-level thinking."

Unfortunately, the business media stream, investment research and other threads are dominated by consensus thinking. Their utility for both short-term traders and long- term investors is diminishing over time as they not only refuse to make waves with dissenting views but by their representations of foogazi-like and mistake-free recommendations. (Divine Ms M calls these pundits "carpet sweepers.")

As an example of such objectionable commentary and absence of humility, I watched money manager Bill Miller on Squawk Box emphasize the positives and de-emphasize the negatives this morning as he trumpeted stocks that he made 50x to 100x on over time -- though he failed to mention that from 2007 to 2009 his main fund was down by about 80%. He also didn't talk about his mention of the upside to Valeant Pharmaceuticals(VRX) shares (now trading at $17 a share) that he thought could double or even triple in the next few years, though he initially purchased the shares in the high $30s.

More than ever, some messengers are asked to explain daily action in individual stocks and sectors and in the broader markets. The reality is, more often than not, there is no clear answer, though they too often respond to the question with self-confidence and authority. Business shows that emphasize how "fast money" can be made are asked to do the impossible -- to predict literally the market action of the next day or two with a logic of argument and a degree of self-confidence.

My pet peeve is that too many make up an explanatory narrative instead of just saying, "I don't know."

Again, to quote The Oracle:

"Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future."

My advice is to remember, as a trader or investor, you don't get paid for activity -- you get paid to be right.

Importantly, every trader and investor should consider the role of second-level thinking as well as the contrary when confronting investment decisions.

Second-Level Thinking

"What's clear to the broad consensus of investors is almost always wrong. First, most people don't understand the process through which something comes to have outstanding money-making potential. And second, the very coalescing of popular opinion behind an investment tends to eliminate its profit potential."

--Howard Marks

If you're looking for someone who's reactive, solely influenced by the current price trend and ignores the emerging and changing risk-vs.-reward ratio, stop reading this missive. But if you're looking for someone who's anticipatory and fully influenced by the difference between current share prices and an analytical assessment of intrinsic value (i.e., risk vs. reward), then read on.

Oaktree's Marks, whom I consider a pal of mine, addresses the difference between what he called "first-level thinking" and "second-level thinking":

"First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in: 'The outlook for the company is favorable, meaning the stock will go up.'

Second-level thinking is deep, complex and convoluted. The second-level thinker takes many things into account:

* What is the range of likely future outcomes?

* Which outcome do I think will occur?

* What's the probability I'm right?

* What does the consensus think?

* How does my expectation differ from the consensus?

* How does the current price for the asset comport with the consensus view of the future and with mine?

* Is the consensus psychology that's incorporated in the price too bullish or bearish?

* What will happen to the asset's price if the consensus turns out to be right, and what if I'm right?"

--Howard Marks, It's Not Easy (September 2015)

Great investors and traders (such as Druckenmiller and Soros) dismiss the obvious view, or "first-level thinking," in favor of "second-level thinking."

There's no dogma in their playbooks, or, as Marks further writes:

"The bottom line is that first-level thinkers see what's on the surface, react to it simplistically and buy or sell on the basis of their reactions. They don't understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how pries change. And they fail to understand the implications of all this for the route to success."

--Howard Marks

To understand second-level thinking pick up a copy of Marks' book, "The Most Important Thing: Uncommon Sense for the Thoughtful Investor."

Considering the Contrary

Group-think permeates consensus thought in the business media, in sell-side research and in the broader investment narrative from other sources.

The general inability to deviate from consensus is something that I refer to as "group stink."

The contrary must always be considered as, more than ever -- given the market's structure (quants) as well as volatile and unknown political and geopolitical developments -- we are in a business of wider probabilities and expanding certainties. That helps to explain why I don't do price targets but do do reward vs. risk (upside/downside) based on a broad list of outcomes that includes outlier events.

Investing your own or others' money is not nor has it ever been an easy business. We need more than history, for if history was all that was needed to play the game of money, the richest people would be librarians.

Successful money management requires a lot of reading and research and a willingness to consider the contrary. Yet investment ideas delivered in the business media platform are too often conveyed around the consensus mean and unduly underscore how simple or routine the trading/investment game is.

Caveats and qualifiers around that consensus are few. Words such as "may," "likely,""could" or "possibly" are rarely employed. Rather the word "will" exists in nearly every idea or recommendation.

Bottom Line

As you consider the probabilities associated with every investment or trade, always consider the contrary and employ "second-level thinking."

In order to achieve superior investment and trading returns, do your own homework and generally ignore Group Stink.


Doug Kass is president of Seabreeze Partners Management Inc. This essay originally appeared at  

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