Possibilities Versus Probabilities

It’s Make Or Break Time For The MarketPossibilities and probabilities are currently difficult to evaluate. The drubbing the market took this week was undoubtedly disappointing. However, the market is approaching deep oversold conditions with some minor support heading into next week. Since March, whenever the market reached such oversold levels, a reflexive rally has ensued. But many concerns are weighing on sentiment currently. The Stocktrader Almanac summed up our current thinking well.
“What’s the history when turmoil grips the planet in October, heading into the Best Six Months of the year? Since WWII, there has been an ongoing war or international conflagration going on practically all the time. Things have come to a head in October many times, with several happening in the Mideast. Current events in the Middle East are especially tense. We’ve tried to pinpoint the Recent High related to the crisis and then the nearest Subsequent Low around October. We included the nearest Crisis Low, the Q4, Year, Best Six Months, and Next Year % Changes. We find ourselves today at a similar crossroads with the Hamas attack, Israel’s reaction and unrest in Mideast and on the world stage. If this situation can be contained the market will likely rally sharply. If it drags on or escalates that will likely negatively impact the market.” 
  We are still in the window of October weakness, but many seasonal factors suggest the possibility of a year-end rally. Given the very negative levels of investor sentiment and oversold technical conditions, as shown, the possibility of a counter-trend rally is decent. Our weekly technical composite indicator has not been this oversold since October 2022 and is near levels that have historically always marked correction and bear market bottoms. Investor sentiment is also negative, which, when it reverses, provides the fuel for a rally. However, use rallies into year-end to rebalance equity risk as needed.Notably, we must continue to assess the “possibilities” and “probabilities” of expected outcomes to manage our investment risks accordingly. Possibilities Versus Probabilities (If It Bleeds, It Leads)Here are some recent headlines: You get the idea. There are many things to worry about between geopolitical conflicts, inflation, rising interest rates, increasing debts, and surging deficits. In such an environment, it certainly seems as if the “worst outcomes” are just around the corner. Critically, when it comes to the media, there is an old axiom that “if it bleeds, it leads.” In other words, to get ratings, or in today’s world, clicks and views, the more dire the headline is, the more attention it attracts.However, as investors, we must carefully navigate the “clickbait” to ensure we are not distracted from our investment goals. As such, we must extract the emotions from our analysis and focus on the underlying data. With that basis, we can begin calculating the “possibilities” and “probabilities” of various outcomes and the potential impact on our investments.On Wednesday’s Real Investment Show, I spent a lot of time discussing the normal distribution of events in the economy. The chart below is a normally distributed “bell curve” of potential events and outcomes. In simple terms, 68.26% of the time, typical outcomes occur. Economically speaking, such would be a normal recession or the avoidance of a recession. 95.44% of the time, we are most likely dealing with a range of outcomes between a reasonably deep recession and standard economic growth rates. However, there is a 2.14% chance that we could see another economic crisis like the 2008 Financial Crisis.But what about “economic armageddon?”That event where nothing matters but “gold, beanie weenies, and bunker.” That is a 0.14% possibility. While “fear sells,” we must assess the “probabilities” versus “possibilities” of various outcomes. Playing PokerPoker is always an easy way to understand this concept.If you were playing a hand of poker and were dealt a “pair of deuces,” would you go “all-in?”Of course not.The reason is you intuitively understand the other factors “at play.” Even a cursory understanding of the game of poker suggests other players at the table are probably holding better hands, which will rapidly reduce your wealth.Investing in the financial markets is one of the purest forms of speculation. Every day, investors make bets on the future and must weigh the possibilities and probabilities of winning or losing. The size of the “bet” should ultimately be determined by the “potential loss” of being wrong.Ultimately, investing is about managing those risks that substantially reduce your ability to “stay in the game long enough” to “win.”It is critical not to let potential outcomes with a minimal probability of occurring dominate your investment thesis.Psychological ImpactAs is always the case, individuals are always looking for why “this time is different.” Not surprisingly, as discussed previously, the consequences of such thinking consistently lead to underperformance. To wit:“Throughout history, whenever most investors believed the worst about a particular asset class, such has often been the right time to start buying. As we have often discussed, psychological behaviors account for as much as 50% of the reasons investors consistently underperform the markets over the long term.”  Behavioral biases lead to poor investment decision-making. Dalbar defined nine of the irrational investment behavior biases specifically:

The biggest problems for individuals are the “herding effect” and “loss aversion.” Notably, “loss aversion” is one of the leading factors influencing investment decisions, according to a survey from the CFA Institute.
“Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.” – Corporate Finance Institute
Therefore, to navigate markets over longer-term time frames, we must: 

While it is easy to get tied up in the daily news headlines, investing requires assessing the probabilities of future outcomes.Nonetheless, we are currently in very uncertain markets, making investing increasingly tricky. Navigating Uncertain MarketsInvesting during periods of uncertainty can be dangerous, particularly when valuations across all asset classes are elevated. Add to that a sharp rise in interest rates, the Federal Reserve tightening monetary policy, and still high prices from the prior inflationary surge. The combination of those events has a long history of unhappy outcomes. However, there are some steps to take when investing in uncertain markets to weather the increased market volatility.

Once you are prepared, what investments do well during periods of uncertainty?
“A recession is a good time to avoid speculating, especially on stocks that have taken the worst beating. Weaker companies often go bankrupt during recessions, and while stocks that have fallen by 80%, 90%, or even more might seem like bargains, they are usually cheap for a reason. Just remember — a broken business at an excellent price is still a broken business.” – Motley Fool
As I noted on Wednesday, there is a large contingent of small and mid-capitalization combines which are not profitable. If the economy slips into a recession, many of these companies will face potential bankruptcies. During periods of uncertainty, focus on probabilities rather than possibilities and look for companies that:

Investing is never easy.Such is why a well-thought-out strategy, a longer-term timeline, and an ability to stick to your discipline can help you reach your goals. How We Are Trading ItAs we wrote last week:“Despite weak rally attempts, the summer weakness that started in July remains. The market is oversold, and the recent selling pressure across all assets is nearing exhaustion. If you are worried about what is happening overseas or with the Fed and the economy, use rallies to reduce risk at better price levels.”

From a portfolio management perspective, we have to trade the market we have rather than the one we think should be. This can make the challenge of battling emotions difficult from week to week. However, as noted, we expect a rally next month, providing a better risk/reward opportunity to rebalance equity exposure.As we noted last week, periods like this are never fun, but the market never goes straight up or down. However, the psychological strain during periods of market weakness leads to a host of behavioral mistakes that lead to longer-term underperformance. This period will pass, and the next bullish cycle will begin. Sometimes, turning off the television can help reduce the emotional toll of headline news.  More By This Author:Economists No Longer Expect A Recession. Are They Right?
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