On the brink: A game-dominant strategy in the face of recession
Recession predictions are a bit like sensing a bust coming in Black Jack or a “crap out.” You know you’ve been doing well, but when do you pull your money off the table (and tip the dealer)?
The game-dominant strategy?
Keep playing.
But before I dare jump into probability theory, the sinful art of gambling, or recessions, allow me to highlight some recent headlines.
The LA Times (August 26, 2019):
Warning flags are flying: The World economy is heading into a slowdown… Germany, normally the engine of Europe, has seen its growth fall below zero. Britain is steeling for a potentially chaotic exit from the European Union this fall. Trade wars are buffeting China, Japan, and South Korea. U.S. growth has slowed, too — partly because of the same damaging trade battles.
And more artistically... The Economist (August 23rd issue) cover page illustrates row boats rising and falling among rolling waves under the header “Markets in the Age of Anxiety.”
Looking for meaning in financial markets is like looking for patterns in a violent sea. The information that emerges is the product of buying and selling by people, with all their contradictions. Prices reflect a mix of emotion, biases and cold-eyed calculation. Yet taken together markets express something about the mood of investors and and temper of the times… [T]he dominant mood in markets today, as it has been for much of the past decade, is … anxiety. And it is deepening by the day.
Anxiety
While it is hard to find consensus by the way of financial market predictions, the presence of anxiety in the market is undisputed. If we know anything about business cycles, and we do, it is clear that a slowdown is coming. However, a very valid question remains: When?
The recent weeks of volatility along with the long-term bond yield activity do imply that the market is — sticking with the metaphor — headed for troubled waters.
Yield Curve Inversion
For those not interested in how bond yields and prices are correlated with recessions — let me try to spike your interest (someone please catch the pun). Because that sh#$ matters and it’s relatively simple.
Consider the fact that as more money moves into bonds, prices go up (a consequence of high demand), and in turn yields (how much you get from a long-term bond) go down. So when governments bonds, which are relatively safe assets, are in high demand (and cause yields to fall), the market is saying that they expect falling prices elsewhere and prefer government bonds. Case in point: if I’m expecting stock prices to fall next week, I’m going to pull my money and park it under the safest international mattress of the world: the US Treasuries, where I’ll at least get a little return on my money and wait out the volatility.
The point here: if more and more investors are trending to low-yield Treasuries, general sentiment on equities isn’t — generally — positive.
The second critical axiom of bonds is that generally, if you’re going to part with your money, the longer you have to part with it, the more you want back.
If I believe that a dollar put into my business can get me back 50% next year if I work hard enough, why would I ever lock up my cash for five or even ten years? That would drop demand for 10-year Treasury bonds significantly and 10-year yield would be relatively high, taking investors who are more risk averse and not willing to put their money to work in a business (or equities).
Generally, if I’m parking my money for 10 years, I’ll need more than if I loaned it out for 2 years, for example. However, when would that not be true? If I thought that there was no way for me to make a return on my business next year, I may lock my money up for two years for any guaranteed return. That characterizes a short-term pessimistic view, driving risk aversion.
Now that the general trend and anomaly are understood, we can now explain that when shorter term government bonds become priced below longer-term Treasury bonds, the yield curve is said to be inverted.
As described above, this is not normal. A yield curve inversion is the exception to the rule and usually understood within the context of a recession environment. The last time the 5-year and 30-year bonds were inverted was in 2006. We know what took place afterwards.
However, it is important to note that many economists view the yield curve as a correlating symptom of recession conditions. Not predictive.
But if conditions are ripe, and we have been on the longest expansion ride since … well, ever (see table below), then aren’t we due for a contraction soon or yesterday?
And that brings us to the question I began with:
What’s the best strategy given that we are not in a recession today (fact) and that there will probably be a recession in the next 12-months (probabilistic, non fact)?
Game Theory 101: The Dominant Strategy
Before I lose 2 out of the last 4 readers here by introducing Game Theory, let me introduce the key element of what GT is: being smart about your options, given your knowledge of other players’ options, who presumably want something rational (like more money, rewards, attention). Having a game-dominant strategy means that based on your knowledge of your and others’ options and incentives, that there are a series of moves, a strategy, that will (based on expected value), produce generally better results than any other way to play.
Hence, dominant.
I know my GT economics professor would cringe reading that explanation (free from assumptions and citations), but I want to simplify it to make my larger point available: whether or not you know your opponent’s next move or the outcomes of the next decision point (tomorrow), there is still a way to play that will yield better results on average. And generally, if you’re rational (forget that psychology says we’re not), you should play that way. Why? Because that’s the dominant strategy.
So what is the game-dominant strategy in pre-recession economics?
I would suggest it’s to keep playing.
But if I did and made a parallel to gambling, where it really does make sense to keep rolling the dice (or to hit when probabilities suggest you should), we all know that sooner or later things go bust anyway. So shouldn’t we stop before we’re ahead? There’s no way to tell. Yes, you will eventually lose. But… maybe, just maybe, that’s a hand after a big win. A win that’s been compounded, say, after a great run. The key of course, is not to lose it all while managing to keep playing rationally.
However, we should note that not all games have a dominant strategy. But history with markets suggests otherwise:
- Over the last 20 years and including the deepest recession since the 1930's, the S&P 500 has grown 5% (using the most pessimistic figures after adjusting for inflation).
- Across the national real estate markets from 1968 to 2009 (again using low-end figures and including the Great Recession) the average annual home price grew at least 4%. Still positive.
While these numbers may not be juicy or exciting, they do imply that long-term strategies yield positive growth, helping identify (perhaps) a dominant strategy.
So if there is a game-dominant strategy, why do people pull their money at the worst times? The answer lies within this pesky thing we have called the human brain, which has an appetite for wallowing in agonizing indecision before shutting off its more critical components in an effort to avoid perceived pain.
In Summary
Am I saying to shut off Bloomberg and continue to invest heavily in Tesla?
No. And nothing against Elon Musk, I hear he’s a nice guy (okay, not really).
I’m merely suggesting: if you know the game you’re playing, and you know that there is still money to be made, there’s no reason to fold. If you know markets recover over time, there’s no reason to crystalize your losses.
Caveats: make sure you’re not betting the farm, take some winnings off the table, and have a long term view. As we shared, patience has a way of being rewarded, you just have to keep playing.
Just ask the Oracle of Omaha.
Closing Thoughts
So were my thoughts until … my good friend Chris at Catalina Capital Group, flipped my entire view on pending doom…
Sure, it’s coming. We’re playing with house money at this point. You think 20% year over year is sustainable? But also… consider your institution investor, you know these guys that drive the market anytime they buy or sell, we’re talking nation-state sized investors. They have an infinite horizon. And for them, do you think 1.5% treasury yields are going to cut it? No. So what do they do? They’re going to look to get back into to equities — but not until there’s a dip.
So there you have it. One poor man’s crash is another nation-state sized institution’s buying opportunity.
But back to my main point, if we are playing with house money and we’re on a streak, the right call is always to keep playing.
