Weighing the Tails

Plus, a rebrand

A lot of times, people don’t know what they want until you show it to them.

Steve Jobs

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THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.

Today I want to talk about risk and, further below, an evolution of this Substack. The name, as you can see, is changing to A Letter from Paul and the pricing is shifting to no cost model for most of the content but a price increase for those of you that find the asset allocation relevant.

Risk

I’ve have had a few close calls. Likely you have as well.

There was the time my wife and I flipped in a raft in Chile during a torrential rain, a freak weather event, or when I got T-boned in a car near the Triboro Bridge. If things had shifted just a bit, I would not be writing this now. When in my 20s I worked as a bike courier or was into rock climbing there were other close calls.  One acquaintance miraculously survived a plane crash. Others have been diagnosed with cancer and, also miraculously and thankfully, bounced back.

When I read about the tragic sinking of the yacht off Palermo and the awful loss of life, I think about such incidents. We pay attention to what is in the news in a way that can lead us to miss more statistically significant risks. In 2023, over 1 million people died in car accidents but because we are used to this, it doesn’t hit the news. Still, the boating accident is a reminder of how bad and how fast things can go wrong. How much weight do you put, both in life and investing, in low probably events with terrible consequences? There is not a precise answer to that question.

Investing

Markets resemble that sailboat. In general, they endure intense turbulence well, even gracefully. This is due to what economists describe as equilibriums, or self-corrective features. If the economy weakens, for instance, stocks go down (because earnings fall), but bonds go up and as the price of the bond rises, yields fall, which tends to drive up the price of stocks (because it boosts PEs and lowers debt service). The rising bond price end up stabilizing the stock price. Similarly, when the economy gets out of whack the “invisible hand” leaps into action. Shortages cause price rises, which reduces consumption, increases production and, voila, prices fall. We’ve just seen that with inflation that went from 2% to 9% to back close to 2%.

But it’s also possible for markets and economies to get way out of whack, like that boat. When things fall far out of equilibrium, typically isn’t one thing, it is a combination of things. Fast speed and ice and fatigue. A higher-than-normal mast, a retracted keel, a stronger than expected wind. An unexpected geopolitical event and overdone market positioning, a clumsy policy error. Once the moves become big enough, it then creates other vulnerabilities. The tipping sailboat makes something once innocuous--an open hatch—suddenly lethal.

If you are truly aware of how risky things are, you might never leave home. Most people on the planet today will get up, go about their business and come home tired and hungry. A few thousand people, however, are going to leave home today and die in a car crash. That’s a basic statistical fact.

Similarly, over time, markets are straightforward. Good companies need financing and if you provide it to them and they do well you make a lot of money for doing nothing more than giving them money you don’t at the moment need. You can do that in the form of equity or debt. But at moments in time, markets go haywire, which leads to severe drawdowns, which makes it much harder to recover or, if you are concentrated, you get wiped out.

I recently looked back at the size of the moves in 2008, a time I recall vividly. The typical risk models investors use are based on “standard deviation” or how far from normal things are. In trader parlance, a big move is “a 2 z move,” which statistically is something that is only supposed to happen 5% of the time. But in 2008, there were 10z moves, which theoretically are only supposed to happen 1 in 10 billion times. But it happened and will continue to happen. Markets are people and people get squeezed and panic.

What to do?

My answer—be it relative to an outdoor adventure or in investing—is a moderate, not paralyzing, degree of paranoia. I know we are supposed to be zen and present. But we also need to survive. Said differently, don’t bank on risk being normally distributed. We live in complex systems, be it weather or financial. Take risk, because life is too short to live in fear, but move fast and reduce risk quickly when you need to.

The yacht went down not far from where I had been vacationing. In that part of the world, the heat builds for days, then when the storm comes it is vicious, ribbons of lightning, rain so hard you can’t drive. In the days leading up to that storm, the weather was oppressive.  A storm was brewing. How bad? Impossible to precisely predict.

When it comes to investing, at least for me, the answer is to take less risk when you are doing something unfamiliar and listen to that voice in your head that says “something may not be right.” This is not foolproof but can be invaluable. I sold all my Russian investments January of 2022 (shortly before the invasion) not because data suggested they were a bad investment, but because I felt Putin’s intentions in Ukraine were unknowable. I’ve also mistakenly sold investments that were behaving oddly, which subsequently rallied hard. That happened recently with CLMT.

Most people advise ignoring emotions in investing. There is a difference, however, in emotions and intuition. Emotion is more fight or flight. Intuition is your unconscious putting together a conclusion faster than you can put into words. At times, intuition can be an early warning systems to warn of danger. I have learned not to be a perfectionist. In Croatia, that prolonged infernal heat seemed dangerous to me, I just didn’t know exactly how. Now, sadly, we know.

The Present Situation

In terms of investing and today, the medium-term path is clear enough—monetary easing, fiscal tightening, slowing growth, falling inflation, global conflict, much of which is discounted. I’m worried about the tails, however, which is that growth is weakening much more quickly, on the one hand, or that the seemingly weak data was a head fake, on the other hand, or that either the Ukraine war or the US election goes off the rails.

As stocks have rallied, I’ve bought more puts on the S&P 500, after cashing in on the last set I bought. The short-term risk is that the market begins to discount less easy monetary policy, which would paradoxically drive the dollar up and bonds and stocks down even as the Fed is actually easing. I’ve also increased the 10-year short. That leaves me long stocks, long a tail hedge, long a curve steepener and short 10-year US bonds.

This Substack

A few weeks ago, I asked you all for feedback. I got plenty and learned a lot. Thank you. As a result, I am changing the name because it is more a letter of me to you than a discussion of what I didn’t learn in school. I am making almost all of the posts free except the asset allocation which, for people who like such material, is worth more than $700. I am going to raise the price to $2500 starting September 1. I chose that price based on other quality analysts I track, some of whom charge well above that, though they tend to publish more frequently. As Kate Capital’s research team grows, we will share more of our research behind the paywall.  People who pay that fee will expect access to me and the Kate team, which we will happily provide. I’ve learned from these conversations and value them and hopefully subscribers have enjoyed them as well.

THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.

Asset Allocation