By John Lunt, Lunt Capital Management, Inc.
I learned an important investment truth early in my career—there are no certain outcomes in financial markets. Rather than prepare solely for what you think will happen or what you want to happen, think in terms of probabilities, and prepare for a variety of outcomes.
Let me rewind to the late 1990’s when my business partner Ryan and I started working together building dynamic models that used some of the earliest ETFs (Country WEBS, Select Sectors, etc.). Although we focused on ETFs, our early days included trading in a wide variety of financial instruments and strategies including individual stocks, currencies, futures, and options. We built momentum models, relative strength models, short-selling models, and even traditional value models.
Our research identified a company that fit all the traditional metrics of being significantly undervalued. This was a textbook case of deep value investing that would have made my business school professors proud! We proceeded to leave no stone unturned as we learned everything possible about the company. We pestered company management for updates. We poured over the company’s financials and studied all types of industry data. We spoke frequently with analysts who followed the company. In fact, our careful research found an error in one of the analyst’s research reports about the company. This analyst issued a new report after we alerted him about his error.
We believed we knew everything about the company and its industry, and we were certain others would soon discover this undervalued gem. We started buying aggressively. As the stock declined, we thought we were channeling our inner Warren Buffet as we bought more. Our conviction did not waiver and our commitment to research did not falter. The stock kept moving lower. This did not make sense! Company management agreed with our views. Analysts concurred with our valuation and thesis. The only one who did not agree with our findings was Mr. Market, as the stock kept going down. More than a year later, we closed this position for a steep loss. More than 20 years later, this experience seems like yesterday. Thankfully, it was just one position, but it left an indelible mark on our investment psyche. It was a painful lesson, but incredibly valuable!
Formal study of investing and markets may create an impression of certainty associated with investment outcomes. Instead, investment reality exposes this pretended specificity and points to the tremendous ambiguity associated with markets and investing.
I have long referenced a 1999 commencement speech at the University of Pennsylvania by former Treasury Secretary Robert Rubin. Prior to his government service, he was senior partner and chairman of Goldman Sachs. He said the following:
“All decisions become matters of judging the probability of different outcomes, and the costs and benefits of each…The business I was in for 26 years was all about making decisions in exactly this way. I remember once, many years ago, when a securities trader at another firm told me he had purchased a large block of stock. He did this because he was sure — absolutely certain — a particular set of events would occur. I looked, and I agreed that there were no evident roadblocks. He, with his absolute belief, took a very, very large position. I, highly optimistic but recognizing uncertainty, took a large position. Something totally unexpected happened. The projected events did not occur. I caused my firm to lose a lot of money, but not more than it could absorb. He lost an amount way beyond reason — and his job.”
A purely academic or historical view often clearly and cleanly explains “why” a stock or market moves. However, we invest in real-time—the “why” is often not known until long after the market or the stock moves. There are often many factors and variables that become difficult to entangle. What is the driving force behind a particular stock, sector, or asset class? Is it fundamental or technical? Are macro factors or policies overwhelming the sector or company-specific factors or vice versa? If we take a myopic view of markets and focus on just one variable, we may miss the more important market drivers.
Adding to the confusion is the reality that positive or negative fiscal, monetary, or company specific policy consequences are not always instantly realized in financial markets. The actual impact of company-specific decisions, central bank monetary policy, or government fiscal policy may lag, creating a seeming disconnect between the announced policy, its real-world effects, and financial markets. Analysis often focuses on one variable that changes while holding all other assumptions and variables constant. It is important to recognize movement in one variable typically changes incentives or assumptions that impact other variables.
This does not mean we throw up our hands and conclude there is no value in expertise, research, or preparation. To the contrary! We believe learning from history and a dedication to research provides context that positions an investor to adapt and innovate as conditions and facts change. History and research should help an investor imagine a range of possibilities rather than create blinders for a specific outcome. Some speak glowingly about those with investment conviction around certain events or outcomes. In our view, investment conviction should focus on principles, process, and strategies.
A probabilities-based investment mindset lends itself to the ambiguity inherent in financial markets. This approach imagines and prepares for a wide spectrum of scenarios. It avoids focusing on the impossible objective of always being “specifically right” and instead aims for a more realistic yet profitable approach of being “generally right.” It is worth repeating this painfully learned but valuable investment lesson—there are no certain outcomes in financial markets. Rather than prepare solely for what you think will happen or what you want to happen, think in terms of probabilities, and prepare for a variety of outcomes.