How To Think Outside the Box

Much of my 30-plus years in the investment business has been spent developing tools that help me think outside the box. Above all else, I strive for a flexibility of mind which is fostered through continual learning. The ability to filter out noise and short-termism is fundamental to maintaining the presence of mind which allows one to keep sight of the larger picture.

The Power of Contrary Thinking

Of course, nearly everyone in the financial community pays lip service to contrary thinking, but few really practice it. It requires such independence of mind and disdain for popular opinion that by its very nature it can only be embraced by few persons.

Two stories on the subject are worth relating. Many years ago, I became an expert on using best-selling investment books as a contrary indicator, and in fact, they have a flawless record since the 1920s.

In the late 1970s, there were nearly half a dozen best-selling books predicting hyperinflation, the collapse of the U.S. dollar and depression. The books were selling so well that their publishers ran full-page ads in all the major newspapers, featuring bold-faced quotes from these doomsday forecasters, who were literally predicting the end of the world.

This was the impetus for me to take a contrary view, and in 1982, Gary Shilling and I wrote and published a book called, Is Inflation Ending? Are You Ready?

On December 14, 1983, I wrote an article for my clients entitled “The Power Of Contrary Thinking: Economic Boom And Major Disinflation Coming; Buy Basic Industry Stocks”. This article, which referred to the contrary relationship of best-selling investment books, drew a tirade of abuse from the books’ authors. The last paragraph in the article was particularly irksome to them, and we quote:

“The wide scale acceptance of a coming depression in 1979-1981 suggested we would eventually have a major economic boom. The popular belief in the late 1970s that inflation would last forever implied inflation was ending. Finally, the current widespread belief that the industrial age is over indicates that some of the best investment opportunities lie in the out-of-favor heavy industrial companies. If these contrary ‘forecasts’ work out, you won’t need to make another prediction until a stock market book reaches the best-selling list, at which time it will be time to sell.”

The second story involves the weekly breakfast I used to have with another contrarian, Bill Joseph. At these sessions, we tried to think of all the things that everyone knew was going to happen or knew for sure could never happen.

It was the summer of 1982, and interest rates were the highest in the history of capitalism. We were walking across Central Park and suddenly I turned to Bill and said: “Everyone thinks there is going to be a depression, so the best course of action is to leverage yourself to the hilt in stocks and bonds.” We both burst out laughing, because it did seem so absurd and because it was so absurd, it was almost certainly the right thing to do.

My Theory of Contagion

Many years ago, I developed a unique way of looking at the world and markets. It all began with the wave of hijacking that spread across the world in the 1970s. Almost like a spontaneous outbreak of forest fires, hijacking became an international problem overnight.

Ever since then, whenever I see a bull or bear market occurring in a country, or some unusual development, I watch closely for a contagion. Two or three confirmations is usually all I need.

My theory is this: The contagion will spread until proven otherwise.

One of the most interesting contagions was the Asian boom/bust. We had opened an office in Hong Kong not long after the Tiananmen Square disaster, which had caused Hong Kong stocks to crash. The Hong Kong stock market was then selling at about 6 to 7 times earnings, had a 4.5% dividend yield, and the best 30-year earnings record in the world.

Yet, the Hong Kong stock market was also selling at a China “discount”. We thought it should sell at a China “premium”. And, as a result, after organizing many trips to Hong Kong, our clients put many billions of dollars into the Hang Seng Index under 2,500.

However, what was a contrarian opinion in 1991-1992 became consensus by early 1994 and we closed our office and sold all our Hong Kong stocks. There were a large number of magazine cover stories on the coming Asian century and the enormous investment opportunities in the region. Meanwhile, real estate speculation was rampant and emerging Asia was the recipient of much more foreign investment than it could handle.

We watched the region’s stock markets go sideways for nearly 3 years. Then, we learned that Malaysia had built the world’s highest building and planned to construct the world’s longest building, certainly a kiss of death if there ever was one.

At the same time, several stock markets, such as Thailand and Korea, were breaking down from major tops.

On November 8, 1996, we published “IS THE PACIFIC RIM SLIDING FROM BOOM TO BUST?” This series eventually grew to over 100 memos.

Our thesis was that the contagion would spread from Thailand and Korea to the entire region, and the stock market gains of the 1990s would erode and provide investors with a full roundtrip to the downside. We also argued that the contagion would spread to all developing countries and finally to the developed world.

Realizing that over-investment was the culprit in Asia, we concluded the same was likely to occur elsewhere. On November 13, 1997, we wrote a memo entitled, “OVERINVESTMENT BOOM IMPERILS THE GLOBAL ECONOMY”. We said as follows:

“Now, the great question of the age is whether we can stop this investment-led expansion from turning into a boom-bust. Has global downsizing, privatization, financial deregulation and liberalization, and the opening up of emerging markets released a tidal wave of excess capacity that will take years to work off?

“Have we lost the ability to control overexpansion? Do we still know how to stimulate demand? Can the world's policy makers shift from fighting inflation to deflation? Can previously profligate governments, now so proud of their fiscal rectitude, reverse course and open up the spending floodgates? What tools are available to governments to stimulate demand after the boom-bust of an investment-led expansion?”

My Theory on Anomolies

An anomaly is an inconsistency. It might be something that should be happening and isn’t or it might be something that is happening and shouldn’t. The best known and most common examples are stocks (or a stock market) that go down on good news or refuse to fall further on bad news.

When an anomaly first appears, it is only a subject for further study. Perhaps the anomaly will disappear. But if it persists, as strength in house prices has, then you must ask the question why? It is the answer that leads you to the truth.

In the spring of 2003, we had an amazing anomaly: bond yields collapsed, the stock market rose, the dollar dropped significantly and commodity prices strengthened. Obviously, one of the markets was wrong. It was unlikely that two or three of the markets were wrong. If one market were to be wrong, it clearly was the bond market—because rising commodity prices and a weak dollar were not consistent with a healthy bond market.

As is well known, from the June 2003 low in bond yields, we had the sharpest and fastest increase in yields since 1987.

My Theory of Investor Psychology

A long time ago, I came to the conclusion that investors base their attitudes on their last traumatic experience. That says a lot about the past, but virtually nothing about the future. The more traumatic the losses, inevitably, the bigger the bull market in the aftermath.

After the 1929 crash, investors shunned the stock market for a generation. Yet, the values at the bottom in 1932 were the greatest in the history of the U.S. stock market. Obviously, the returns from such lows were hard to ever equal again.

After WWII, investors and businessmen widely expected another depression as the military was discharged. They were looking backward to the aftermath of WWI and the bust of 1920-1921 after the inflationary boom of the war. But what they failed to understand was the huge pent-up demand stemming from the depression years of the 1930s, as well as the optimism that fueled the enormous postwar boom.

Understanding investor psychology is the most critical determinant of investment success. It is the irrational under-pricing of assets that creates the best investment opportunities. Investors who consistently can judge that psychology—by buying assets that are under-priced and avoiding or shorting those that are overpriced—will be successful in the long-term.

How I Process Information

My uncle, the late James Hunt, graduated from Harvard Business School in 1931, joined a prominent investment banking firm, then became a major player in the OSS during WWII and finally became one of the top people in the CIA after the war.

He told me that the investment business was very similar to the intelligence business—there is a lot of disinformation and bad information. Who do you trust? And what information can you believe?

I’ve watched the rise and fall of so many stock market gurus that I could write a book about it. The common theme among all of them was that their biases ended up destroying them. Often, I see very gifted money managers and/or market practitioners basing an investment strategy on certain assumptions. But, as often as not, those assumptions prove false, and then, the whole basis of their strategy crashes to earth.

The French philosopher Descartes said: “The only thing that I know for certain is that I know that I know nothing”. It’s a good place to start processing information. But many people do the opposite—they start with an assumption and then look for the data and the statistics to support their view.

My Theory on Change

I can honestly say that I love change. Dozens of times in my life, I detected the first inkling of change and then quickly embraced it. But, when I argue the case to entrenched and linear thinkers, they generally have a hard time letting go of the old shibboleths.

I am agnostic about change. Neither good nor bad—it’s simply inevitable, and if you fight it, you will be crushed.

How do I recognize change?

• An unsustainable rate of change always brings a major change in direction. Markets must obey the laws of physics. What usually happens is that an advance takes place slowly with many corrections along the way, and almost invariably, there is a blow-off at the end which attracts everyone looking for a quick buck.
  
  
• Unanimity of opinion signals a change in direction. Nature abhors sameness. I detected a shift in the mood of the country away from socialism towards free-market capitalism in the mid-1970s. What initially caught my attention was when President Nixon, in 1972, said that he was a “Keynesian”, in other words, the Republicans had finally come to believe in deficit spending and everyone now agreed in “The New Deal”. So, the times were ripe for change.
  
  
• Longevity of a trend signals the growing potential for a change in direction. The longer a trend lasts, the more likely it is to end. A 20-year bear market in commodities between 1980 and 2000 seemed enough of a bear market to me. A 13-year bear market in Japan seems long enough. Russia had a bear market from 1914 to 1999—maybe it’s Russia’s turn for a long-term bull market.
  
  
• Excesses and extremism almost always usher in change. The excesses of the Russian and French aristocracy brought about brutal and long-lasting revolutions. I’ve always said if you want to effect change, let events go to such an extreme that they cause a major and long-lasting backlash. I’ve argued this is now occurring with trial lawyers, malpractice suits and, particularly, asbestos litigation, which is almost out of control.
  
  
• Imagination helps you understand change. It’s hard to have vision without imagination.
  
  

The answers may be unknown, but it’s only through imagination that you can escape the manacles of conventional thinking.

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