The Non-Dogmatic Approach to Investing

Expected Returns | August 18, 2010

There’s no better proof that we’re in a tough market environment than when one of the true investing legends, Stanley Drunkenmiller, calls it quits because of drawdowns. I’ve said repeatedly that this is a market environment that is going to crush both bulls and bears while shattering conventional investing wisdom. In order to profit, one must be an investing atheist who is able to nimbly navigate treacherous markets.

Both permabulls and permabears are getting whipshawed by this market environment. The way to make the really big profits is to ride bull markets and cut losses. There is absolutely no reason to hold on to a losing position just because of a flawed outlook, but this is what most people do. The goal of investing is not to stubbornly cling to a faulty outlook and be incredibly right once a decade (like Robert Prechter), but to be one of the few who consistently captures moves in either direction.

As most of you know, I am a gold bull. Apparently this means I think the world is ending. The last thing it means is that I correctly picked the asset that has benefited from this market environment. The world is a funny place isn’t it? Anyway, I like to think of myself as an optimist. I genuinely feel investing opportunities are opening up for those with liquid capital. It is always in Depressions that the real fortunes are made.

If you had to categorize me, I suppose I would be called a bear. But how many bears were bullish on stocks at the intermediate term bottom when 90% of investors were bearish? I’m not saying this to boast, but to show you that interrelationships between markets are a lot more nuanced than people think. You must strive to have a flexible mind that accounts for ANY possibility, because eventually the unthinkable happens- always.

Stocks

There are basically two camps right now: those who believe we will retest and break the March 2009 lows, and those who see clear skies ahead. Those who are bearish on the economy tend to be bearish on stocks and vice versa. I honestly think this is a little simplistic.

The way I think of markets is somewhat cynical: I think in terms of how the most people can get screwed by market movements. With that in mind, I think 1200+ on the S&P is still on the table before a potential plunge to 800-900. It will all hinge on supply and demand.

Permabears who are going short right now will start capitulating as we approach 1200 on the S&P. Retail investors will then start piling into stocks. So shorts will have covered and investors at the margin will have bought; where then is the buying going to come from? Exactly. This is the nature of tops.

On the way down, shorts will cover way too early and permabulls will buy dip after dip and get crushed. This is a scenario I can easily foresee: Bulls and bears getting slaughtered. For most people sitting on cash is probably the right play.

Bonds

Bond are obviously a major bubble, but that doesn’t mean I have to take a position this very instant. I’m patient. I’ll let the retail money flood the bond market before fading them.

Bubbles are difficult to trade because they always last longer than people expect. So again you have a phenomenon where very few people profit from something that is “obvious.” I personally think we’ll have another sell-off in stocks by the end of the year that will support bonds. You will then likely see divergences between stock and bond prices as the smart money heads for the exits. This is about when I want to open up short positions on bonds.

Gold

Gold is a bubble to those who have never looked at a chart of a bubble in their life. If people weren’t calling gold a bubble every single day, I would be very fearful right now. As is, I sleep easy at night knowing so many people are on the opposite side of the trade.

The next financial crisis, which will probably come in the next year or two, will serve as a stern wake-up call. It is at this point that gold will really start moving as the flood into tangible assets begins. Long-dated puts on gold will be incredibly cheap, so I will be buying them. Again, this is called profiting on the upside and downside instead of being dogmatic.

General Outlook

What bothers me as an American is the obliviousness to obvious tail risks. When it really hits the fan, our leaders will be scrambling for answers when they should have been preparing long ago. I mean seriously, is the demographic time bomb that’s approaching that much of a surprise? Will the eventual debt default be that much of a shock? Will the collapse of the public sector and the spike in unemployment be a surprise? Where are the intelligent policy actions that will preempt future crises?

Major economic crises in history always follow the same playbook. What you need is a deficiency in leadership (check) and fiscal irresponsibility (check). The destruction of the public’s confidence will be very severe. It will lead to inflation that is induced by a loss of confidence. This is the kind of inflation you never hear the mainstream talking about since they obviously refuse to open a history book.

The dollar will have to be devalued in order to prevent a disastrous crisis. Gold will rise substantially. Those who disagree are deluded in the order of those who didn’t foresee the housing crisis. Have faith that your implicit bet against politicians will win out in the end. Try to emulate the truly great investors who have the conviction to be patient as their investment thesis plays out. Watch for sovereign debts to implode, capital to concentrate in gold, and history to repeat.

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