The Matrix

My theme for the next six plus months is ‘The end of inflation’. And that has some pretty big investment calls riding on it. Short oil, copper & gold, long US stock indices and long specific US and Asian consumer stocks. Long the dollar, long Australian rate futures, short Eastern European banks and currencies.

What’s notable here is that this is completely at odds with the broad investment themes of the past few years. I’m calling for a reversal of the six year commodity bull, the five year dollar bear, and the one year drop in stocks.

Now, what is plain is that these kinds of tectonic shifts are not going to happen without some serious market tremors.

So it struck me during the last week or two that I needed to do a lot of work to prepare myself for trading the next six months.

Brett Steenburger, of ‘psychology of trading’ fame has some classy advice. He has identified frustration as the primary enemy of the trader. Trade when you’re frustrated, and you pretty much guarantee you lose your edge and blow your performance. And to avoid it, you’ve got to visualise ahead of time your successes and failures, and how you will deal with them. It’s all about emotion – the visualisation gives you a control over the situation you didn’t have before – it stops you getting frustrated and it kicks out a lot of bad trading.

So what I visualised was three outcomes;
1) I’m right in size from day one.
2) Several of the markets I think will reverse will see double or treble bottoms/tops
3) It isn’t the end of inflation, oil and gold start to recover from recent corrections and punch to new highs. Or instead, we get a full on deflationary bust.

How do I deal with 1)? I don’t increase the bet size. Why? Because I need to be sitting on a decent profit so I can wear the inevitable correction that follows.

How do I deal with 2)? I make sure I’m not running too levered a book, and I run wider than usual, but clearly defined, stop limits. Even worse than losing money because you’re an idiot, is losing money when you’ve got the call right. Why? Because it means you’ve come in low against Puggy Wilson’s three rules of gambling;

1) Know the right end of a 60/40 proposition.
2) Know yourself.
3) Know how to manage your money.

If you lose money when you’ve got the call right it means you’re short on 2) and 3). And that’s too short by far. So how do I deal with this? By not running too leveraged a book I mean 300% gross, rather than my 500% limit. And by wider limits, I mean 3x normal, which is ok given my performance to date. In other words, I do it by being ready for the loss. A loss unexpected is fantastically frustrating. A loss planned for is a cost of doing business. So my attitude to it is completely different. I’m sinking 5% to make 20%. It’s an investment.

The next one is much more difficult.

What do I do if I’m wrong? And how will I know I’m wrong, rather than, say, buffeted by volatility. There’s the nub. The first point is don’t make the decision when you’re frustrated, which means don’t make the decision after you’ve lost money. Make the decision before you’ve lost money, in the cold light of day. And to make the decision, you’ve got to enter the Matrix.

Now the Matrix is an idea, or a way of doing things, that comes from Richard Heuer, the ex-CIA research man who wrote ‘The psychology of intelligence analysis’. When I talked about this book last, I said that when I get to run a fund, I’d buy a copy for every analyst and fund manager there. That’s what I did when I started my own private fund – I bought the book for myself.

So here’s how he does it. He gets a bunch of analysts in a room to chew on a problem – the more diverse the better. And he creates ‘the matrix’.

Along the top; four or five views, or hypotheses. Along the side, loads of ‘evidence’. For markets, this would be everything from sentiment, through positioning, market moves, all the way to actual, er, fundamentals.

This is very different from the usual way of doing things. Mostly, we create a view – our best guess of what’s about to go on. And then we subjectively decide whether each new piece of evidence supports or undermines our call. The question – how likely is that to be the best way to get at the truth? Er, not very likely.

So, before you ‘go deep’ on a call, you’ve got to look at evidence. You can’t say ‘Hey, I’m a genius, I’m right’. What you’ve got to say is ‘that knocks out theory three and four, it fits with my number one theory. But theories two and five, well, they could still be right. They could still be better, more moneymaking, theories than mine.

All my time in markets, I never heard anyone talk like that.

So the best competing hypotheses with mine are;

1) A total deflationary bust wipe-out. The banks become unable to lend. Cash rich corporates and debt laden consumers become unwilling to spend.
2) Inflation a-go-go. Central banks might have acted a bit, but cash rates are still low against inflation. Inflation is always and everywhere a monetary phenomenon – so inflation here we come.
3) Peak oil. Oil supply has peaked. So, from here, weak global growth gets little oil ‘price relief’. Improving global growth gets outsized oil price gains and crowding out.

For brevity, I’ll stick to the big four. Here it is, and I hope you can read the chart.

So, three things to say.

1) It’s pretty easy, physically and mentally, to enter the data into the matrix.
2) It’s actually quite hard to do, emotionally. I almost persuaded myself that I just had to write about it – without actually doing the work.
3) It’s surprisingly hard to eliminate competing hypotheses.

The hardest to eliminate of all is peak oil. That suggests that I need to keep ‘peak oil’ on the backburner, as a potential major trade down the track. Deflationary bust isn’t that easy to dismiss either. If oil, copper and gold keep going down, and the dollar up, but stocks fail, I’ve got to keep my discipline and cut the stocks.

So I’m hoping that my awareness of the matrix does for me what it did for Keanu; lets me fly around in a full length leather coat and kung foo the bad guys.