Ed. note: The following first appeared in issue #21 of our Strategic Intelligence Report. You can get insight like this every week, along with timely charts, high quality market commentary, and actionable long/short ideas, all for a shockingly reasonable price. To find out more, go here.
What does it mean to see a bad moon rising? In markets specifically, what does it mean to be aware that danger is at hand… that dark clouds are ominous and should be heeded?
Different groups respond to the “bad moon rising” question in different ways. For instance, a large group of market participants – the “passive indexers” – sees the very concept of a bad moon as meaningless. They have no truck with paying attention to market conditions at all. As such, they wouldn’t know the difference between a bad moon, a harvest moon or a blue moon, because they never bother to look. This bah-humbug is the domain of strait-laced financial advisers, personal finance columnists, and efficient market enthusiasts. “You’ll never time the market successfully,” they say, “so don’t even try.” And you might as well not bother with stocks, they’ll add. Just put your money in a low-cost ETF or index fund, then take what the market gives you.
One of the problems with this view (and there are many) is the “embedded bullish macro bet.” Even if you shun all forecasting… if you revere Jack Bogle and Eugene Fama as saints… and if you index-invest retirement funds like clockwork on the thesis that “in the long run, stocks tend to go up,” you are still implicitly making a bullish macro bet on the continuation of the long-standing “stocks-generally-tend-to-go-up” phenomenon.
The reality is that stocks have gone up on balance for most the 20th century… but they have also gone down for very long (and painful) stretches of time. Adjusted for inflation, it is possible to lose a lot of money in passive equities… spend a decade clawing your way back to “break even” in nominal account terms… and then discover you have lost purchasing power to inflation! As you can guess we don’t think much of passive indexing. It is overly complacent and potentially hazardous to one’s wealth.
Another group that ignores the bad moon – that is to say, they don’t even look – are the ones we shall dub “micro bulls.” These market participants are very much oriented toward stock-picking – no passive indexing for them – but they are generally long-only, thus enthusiastic fans of the Jim Cramer mantra: “There’s always a bull market somewhere!”
This group plugs their ears when talk of bad weather comes up. They are happiest when the sun is shining, again on the assumption it is always shining somewhere, and have little patience for meteorology of any form. “Why worry about the weather,” the philosophy of this group goes, “when you can be hunting for the next Apple or Facebook.”
If these first two groups respectively deny or ignore bad moons, the third group obsesses over them. Call them “debt doomers.” The debt doomers are the stopped clocks of the investment world. Their tireless mascot is Zero Hedge, and they congregate under uber-pessimist banners like “The Economic Collapse Blog” (there really is such a place). The doomers always see the pitch-black storm-lining to every fluffy cloud. They cater more to ideology and tribal motive than genuine profit motive. They are typically so early in their crisis calls, and so persistently wrong leading up to an actual crisis event, that when the volatility finally shows up they are dismissed as broken clocks. (If you constantly predict that the S&P is going to have a 10-20% correction, then someday you will be right. But so what?)
The first two groups at least have a real shot at making money over extended periods. With rare exceptions, the debt doomers almost never make a profit. To the extent they are heavy on bearish talk, they are woefully light on actual bear market navigation skills.
The third group, whom we will dub “Wise Value,” is the first that has our respect. This group is typically long-only, again – shorting is an acquired taste – but comprised of seasoned old hands who actually pay attention to things like credit conditions, irrational exuberance, and so on. The wise value group is perhaps epitomized by Howard Marks of Oaktree Capital, who made his clients many billions buying distressed debt in the aftermath of the crisis. The wise value crowd will not make hay from the unfolding of crisis, as a general rule, but they are savvy enough to have a sense of what real value looks like – and what it doesn’t look like – and can thus do well, while preserving their capital, over the long term.
In the presence of a bad moon, the wise value group will often voice their discomfort in various ways – pointing to this metric or that, grumbling about how valuations are stretched and the market’s underpinnings look unsound – but they are slow moving and, as we said, don’t like to short.
The fourth group of market practitioners – and the group with whom we identify – is what one might call “old school macro.” The old school macro guys pride themselves on versatility, flexibility, and timing. They make it their business not just to identify bad moons, but to profit from them. Take Stanley Druckenmiller, for example, one of the greatest money managers of all time. Now retired from outside money management – focused on running his own billions – the amazing Stan D. amassed an incredible track record of 30%+ compound returns, over a 30 year period, with nary a losing year. What’s more, this return was delivered on billions under management, not chicken feed. How did Stan do it? By his own admission, through the identification of bad moons. There were certainly multi-year stretches where Druckenmiller was “long and strong.” But he has gone on record saying the bulk of those returns as a money manager, over his stellar career, came from identifying inflection points when crisis was unfolding, and then nailing ‘em good.
We pay homage to the “old school macro” style – and practice it – because it is so powerful and versatile. It takes a certain meta-ability to access different types of market mindset, and change one’s behavior appropriately, based on the thrust of general conditions: Being a growth investor with the micro-bulls… going on bear raids in harsh crisis periods… then scooping up bargains with the wise value crew once the dust has cleared. As Jesse Livermore opined via Reminiscences, “There is only one side to be on in the stock market; not the bull side or the bear side, but the right side.” Hallelujah and amen.
If you recognize there is merit in spotting a bad moon, then, how do you do it? The formula is deceptively simple (just as the game of poker is deceptively simple). You pay attention to three things: Fundamentals, Sentiment, and Price Action. And you seek out inflection points, and potential clues to future market movement, via observed interplay between those three things.
These three factors – originally laid out by Michael Marcus in Market Wizards – are the macro practitioner’s three-legged stool. If you are missing one of the legs, the stool will not stand up. Fundamentals are important for obvious reasons, but perhaps not in an obvious way. The macro practitioner does not use fundamentals to predict what will happen, necessarily, but to get a better sense of odds and probabilities… what scenarios are more likely than others to unfold as the result of specific information.
Take the following observation, for example, from Ruchir Sharma, head of emerging markets at Morgan Stanley:
“Recent studies have isolated the most reliable signal of a looming financial crisis and it is the “credit gap”, or the increase in private sector credit as a proportion of economic output over the most recent five-year period. In China, that gap has risen since 2008 by a stunning 71 percentage points, taking total debt to about 230 per cent of gross domestic product.
“A credit boom of [China’s] scale is not likely to end well. Looking back over the past 50 years and focusing on the most extreme credit booms – the top 0.5 per cent – turns up 33 cases, with a minimum credit gap of 42 percentage points.
“Of these nations, 22 suffered a credit crisis in the subsequent five years and all suffered an economic slowdown. On average, the annual economic growth rate fell from 5.2 per cent to 1.8 per cent. Not one country got away without facing either a crisis or a major economic slowdown. Thailand, Malaysia, Chile, Zimbabwe and Latvia have had a gap higher than 60 points. All those binges ended in a severe credit crisis.
“Although there have been no exceptions to this rule, most economists still believe China will prove exceptional…”
Economists see China as the exception to the rule, in large part, because the bulk of these economists are employed by government agencies and Wall Street banks hungry to do business with China, and thus have an incentive to be myopic based on the source of their paycheck. Individual traders and investors face no such peer pressure to be delusional.
So does the data presented by Sharma tell us when China is likely to have a credit crisis? No. Does it say with certainty that China will have a credit crisis? No. But based on the lessons of history, the odds of such occurring are pretty damn high.
And that type of fundamental information is useful in the hands of the right market participant: Not to predict, per se, or to go on CNBC and say “the market will do X at such-and-such juncture,” but to build out plausible scenarios… to watch for meaningful short-term developments… and make advance preparations for reacting to “the market script” when something big may be unfolding. This is why macro practitioners pay attention to fundamentals: For the same reason, more or less, that professional poker players pay attention to hand values and flop textures. Not to predict the future with any kind of certainty – that’s not the goal – but to know when to trigger pull, and with what degree of conviction in bet sizing when time to do so.
Sentiment, the second leg of the stool, is equally important to observe. (This is where the “stopped clocks” fail.) To briefly encapsulate, the reaction to a piece of news is more important than the news itself. One sees this on a constant basis with earnings: A company has an ugly earnings report and the stock goes up, because the news is not as bad as investors feared. Or a company has a strong earnings report and the stock tanks, because the good news was not as good as hoped, or some item in the footnotes caused alarm.
We can take this basic principle – “it’s not the news, but the reaction to the news” – and extrapolate it out to total news flow on the whole: Corporate earnings, government data releases, Federal Reserve announcements, everything. What matters is not “objective reality.” In markets such a thing does not exist! No, what matters is how Mr. Market feels about the data at any given time. The data itself is not the key thing. Profit-oriented market practitioners who understand this are not bothered when stocks keep going up and up even though the Fed balance sheet is overloaded, or the unemployment figures are tragic, or etcetera etcetera blah blah blah.
These data points matter on three levels: How the crowd chooses to interpret them; whether the crowd’s interpretation is valid or invalid (false); and when that interpretation might change. If the crowd has an invalid view, that does not mean you argue, any more than one might argue with a herd of cattle; instead you observe this Soros-style “false trend,” possibly ride it as an outsider, and make mental note to step aside (or even go short) upon sign the trend is, in the eyes of the crowd, discredited.
This is what so many traders and investors miss completely. You and I are therapists; the market is the patient; underlying fundamental realities are the external world placing limits on the scope of the patient’s delusion. Our job is to figure out the patient, not to make claims on objective reality – and to get a sense of how the patient’s delusions will ultimately collide with external real world factors (forced wake-up calls and such).
If you really get this concept, you are on your way to understanding how the great Stan D. made 30%+ compounded over 30 years…
The third leg of the stool, price action, is subject to all kinds of bah-humbuggery from market participants of the other schools who don’t understand price at all. Price action also suffers at the hands of its inept would-be defenders – those traders who think a chart pattern represents an actual physical thing, rather than a simple confluence of buying and selling behavior patterns in the rough manner of a poker tell. Price action provides clues as to what the crowd is thinking at any given moment; it acts as a footprint tracker for institutional elephants (who cannot hide their impact, no matter how hard they try); and most importantly of all, price acts as a validator or invalidator of plausible market scenarios.
To wit, if you have a theory that says “the market script is unfolding like this,” and price action confirms your theory, then good news: You may well be on the right track (or at least odds of such are increased). If, on the other hand, price action runs directly counter to your theory, guess what: You need to either take it back to the drawing board, put it on the shelf, or get another hypothesis entirely.
As a final service to the humble trader, price action can tell you when to pull the trigger. This is especially important in regard to developments that have no set time schedule; as we have said repeatedly, one rarely knows when a macro crisis will show up, or when a stock long in consolidation will finally decide to break out. Sometimes the catalyst is extremely late to the party (though it can sometimes be early too). Price action thus helps one avoid the sin of bad timing, which in markets can be mortal. And thus price action is an indispensable tool for noting when to act, quite apart from all the “voodoo mumbo jumbo” accusations thrown at it by those who would beat up straw men.
JS (jack@mercenarytrader.com)
p.s. Here’s an example of what folks are saying about our Strategic Intelligence Report (from which the above is excerpted):
There are very few things I look more forward to reading than your Strategic Intelligence Report. Not only does it provide entertainment, it almost always adjusts my perspective on topics in which I mistakenly thought myself well versed. As you are aware, I’ve worked for more than 25 years in the investment banking industry, and am bombarded with supposed “industry insight.” Very few services provide what yours does. Thank you for helping this rather stubborn, opinionated banker, see a bit more clearly. The laughs are always a welcome bonus.
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