“Take a simple idea and take it seriously.” ― Charles T. Munger, Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger
We’ve spent a lot of time thinking about the ruminations of Charlie Munger lately. It’s hard not to frankly, given where we are in the current cycle. Despite the buoyancy and effervescence of the current markets and considering the never-ending chaos emanating from DC, Charlie is always a safe harbor. He’s the voice of reason in a blizzard of disinformation and financial news media cheerleaders.
Once upon a time, Charlie coined the term "Lollapalooza effect" for multiple biases, tendencies or mental models acting in concert with each other, simultaneously, in the same direction. More simply put, we humans have many inherent biases and tendencies that can sway our behavior one way or another. When several of them act in concert to drive us toward a particular action, you have a Lollapalooza effect. (For those in the viewing public who don’t know, cognitive biases are those troublesome things that unknowingly impact one’s decision making ability; and Lollapalooza was/is a festival phenomenon, most popular in the 90’s, that was/is a celebration of musical acts and other decadent and hedonistic activities). The Lollapalooza effect can create large-scale drivers of human behavior -- and often error. With the Lollapalooza effect, the result is often extreme, due to the confluence of the mental models, biases or tendencies acting together, greatly enhancing the likelihood of acting irrationally.
In 1995, during a talk at Harvard entitled The Psychology of Human Misjudgment, he cited Tupperware parties and open outcry auctions, where he described "three, four, five of these things work together and it turns human brains into mush," suggesting that normal people will be highly prone to succumb to the multiple irrational tendencies acting in the same direction. In the Tupperware party, you have reciprocation, consistency, commitment tendency, and social proof - or the tendency to do what everybody else is doing. Tupperware parties and open outcry auctions demonstrate the same effect. Both are designed to manipulate people into certain behavior. In the Tupperware party, the host/hostess gave the party, so the tendency is to reciprocate; other person’s decision to buy satisfies the desire to get social proof. In the open outcry you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprived super-reaction syndrome, the thing is going away…hence, the desire to get it even more. These biases often occur at either conscious or subconscious level, and in both microeconomic and macroeconomic scale.
November was a relatively uneventful, yet fruitful month, with the S&P 500 +3.62% and the Nasdaq +4%. Markets rallied further throughout November, clearly lifted by the improvements on the trade fronts, but also helped by some stabilization in economic data and better than feared earnings season. There were particular gains in Europe and in the US while Asia and Japan lagged. In sectors and themes, Cyclicals (+4.7%) and Value (+3.8%) extended gains against Defensives (+1.3%) and Growth/Momentum (+3% and +2.1%) as bond yields rose further, and as commodity prices gained (Brent +3.65%).
Markets were driven by the following: 1) Politics: US-China trade negotiations improved further with the “phase one” of a deal expected to be agreed by end of year or by the beginning of 2020. The rhetoric between the two parties remained positive and reports mentioned the possibility of removing Dec and Sep tariffs but also potentially scrapping the initial 2018 tariffs. Another set of Huawei waivers were granted to US companies while on the EU front, EU auto tariffs expired without being implemented. In Brexit, the situation improved but uncertainty remained going into the UK elections. Boris Johnson campaigned on his negotiated deal with the EU and continued to lead in the polls, remaining the big favorite. 2) Growth: Global Economic data remained subdued and below trend but some improvements were noteworthy and kept investors and economists optimistic. In Europe, PMIs for November came out disappointing again but some indicators hinted a potential upturn and kept investors hopeful for a more meaningful pickup of the economy. In the US, data also improved slightly with ISM for October bouncing from the lows and with PMIs for November also showing some improvements. Chinese data remained very mixed with the most recent PMIs pointing to different directions while October activity data and industrial profits declined further and came out below expectations. 3) Positioning, earnings season & seasonality. Positioning remained a tailwind through the month and net exposure to equities across regions remains light. Seasonality was also very supportive - November, December and Q4 as a whole are historically very positive for equity returns while earnings season was less bad than feared with stronger than expected earnings delivery and much better numbers than what was implied by the weak PMIs.
“More important than a will to win is the will to prepare.” ― Charles T. Munger, Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger
We are reminded that late cycle investing is arguably the most challenging time for investors for a variety of reasons; this is a fact that is squarely front and center in our purview as we look over the short and medium terms. Late cycles are characterized by above average, or in worse cases unmitigated, risk taking, which often passes right before investors’ eyes, unbeknownst in some cases, despite the warning signs. Even worse is the formation of asset bubbles, such as the internet bubble and the US housing bubble most recently; the Tulip Mania of the 1600s or the Railway Mania of the 1840s are further examples going back in financial history. Presently, we see equity valuations elevated and rising, we see credit spreads continuing to tighten, we see bond curves gyrating between flattening, steepening & falling and we are just starting to see the green shoots of potentially higher volatility on the horizon. All of these characteristics are the hallmarks of a late cycle. What makes this present cycle much more challenging is the fact that the current interest rate environment is historically low, as a decade plus of central bank intervention and worries about long term growth and inflation have undoubtedly created an unwavering bid for most assets. Recall, in modern financial history, recessions have been caused either by energy shocks, financial imbalances, inflation/policy errors or imbalances in inventories. We can certainly argue endlessly the likelihood and timeframe of each, as this has been fodder for the general public today, as it’s been for the decades. We could also posit newer, more nuanced red flags (herding) that could occur, such as a potential passive investment bubble. (As Ben Graham said, it’s not the bad ideas that do you in, but the good ideas that go too far that can do the most damage.). The critical element, however, is the recognition that all the ingredients for the end of the cycle are upon us. In the final innings of a roaring bull market, it’s very easy to fall victim to complacency and be resistant to change in one’s investment allocations, or even worse, succumbing to a Lollapalooza Effect.
Be sure to consult your financial advisor with any questions regarding the markets and investments. For more information about LHT Consultants as well as to receive more updates on the markets, please visit us at www.lhtconsultants.com.