Things Everybody Knows…

It ain’t so much the things we don’t know that get us into trouble. It’s the things we know that just ain’t so. 
– Mark Twain

Mark Twain probably wasn’t thinking of investors when he wrote those words, but truer ones have rarely been written. Investors routinely become overconfident in their assessment of economic and market conditions. They assume that recent trends will extend far into the future. They take positions based on assumptions that either aren’t true and sometimes can’t possibly be true or are true now but won’t be for long. Those who believed that the economy and markets had entered a “new paradigm” back in the late 90’s were assuming a growth rate for technology companies that was, in some cases, literally impossible. As Herb Stein once said, things that can’t go on forever, won’t and the new paradigm turned out to look a lot like the old one.

The tech stock mania at the end of the last century was an extreme example but we are social animals with a need for the comfort of the crowd so markets often price in a future that won’t or can’t happen. One would think that burned once, investors would learn but the real estate boom quickly followed on the heels of the tech bust proving that while children may learn from their mistakes, adult investors seem uniquely prone to repeating them again and again. In truth, we see these cases of market/investor overconfidence all the time, just not usually to the extreme seen in the recent tech or real estate booms. Alpha is found in those areas where a trend has been taken beyond the level supported by fundamentals, to a price that incorporates and extrapolates too much of the past and present into the future.

For the alpha seeking investor then, finding trends that have been taken too far, that are near a reversal is key. Momentum investors, those who surf the established, existing trends, must find a way to exit those trends before the crowd. Momentum assets can take on a life of their own, running far beyond what you think they should, and providing great rewards right up to the point of reversal when the risks suddenly become obvious, large and realized quickly. Value investors, those who search for new market trends, must find a way to enter assets at cheap prices that don’t become cheaper or exit assets at prices that are dear but not so dear they take on momentum style risk. Neither practice is easy which is why alpha – true alpha – is so hard to come by.

But, unless one is satisfied with taking the passive investing route – one that I believe will be a lot harder to stay on in a world of low returns – then search one must for these anomalies, these trends that are vulnerable to reversal just when the crowd becomes too comfortable. There are plenty of individual stories that are vulnerable to reality – Amazon can ramp up profits whenever they want so the stock isn’t really expensive, Tesla is more than just an unprofitable car company, Netflix is worth more than twice what CBS is – but several big picture beliefs also appear to be past their sell by dates: