The 2-Minute Thought: Handling Investment Pain

I really enjoyed a recent blog by Cliff Asness of investment firm AQR Capital. It’s called “Liquid Alt Ragnarök?” and it’s on how to deal with the intense pain of investments going badly.

Liquid Alt is the name of AQR’s investment strategy. It’s explained in the paper, but that’s not the important part. The important part is about the extreme discomfort that arises when your investment strategy performs poorly. Ragnarök is kind of like the end of the world in Norse mythology, and yes, things have been going badly enough that Asness wonders if this is it.

Well, not really. But the thing is he feels awful. I mean terrible – even though he still believes in his strategy and hasn’t found any evidence to stop believing in it. He starts out this way:

“This is one of those notes. You know, one from an investment manager who has recently been doing crappy . . . I must admit up front that they all sound kind of alike to me. Performance attribution sounds like an excuse . . . There is often at least a dash of a tone of ‘we’re losing because everyone else is an idiot.’ Optimism for the future often sounds forced and self-serving. . .”

The paper is a good review of what has been happening with value investing, which has had an unusually long period of poor performance. AQR is not a pure value investor -- but it does believe in value among other attributes. You might say that AQR likes individual stocks with good value but also good momentum, low risk, and high quality. But again, that’s not the important part here.

Asness talks about the psychological toll that poor performance has taken on him. He writes that he is embarrassed he has had such a difficult time keeping a “long-term” perspective even though it is his job to encourage other people to stay “long-term.” He even invokes Casey Stengel, the 1962 Mets coach who lost 120 games, saying, “Can’t anybody here play this game?”

But the thing is, there are really only two things you can do when your investment strategy stops working. First you have to re-examine why you believed in your investment process in the first place and look at strength of the evidence behind it.

Second, you have to look for any kind of evidence that ‘this time is different’ and why what has been true wouldn’t be true going forward. Of course, this is very hard to do. You look at the numbers. You look for real-world explanations. But there are no clear answers.

Asness goes through this exercise himself in the paper and can’t find any evidence for things being fundamentally wrong. He concludes with Winston Churchill saying, “If you’re going through hell, keep going.” Actually what Asness says is, “So, while it’s been hell to go through for a value investor, we’re going Winston Churchill on this one.”

This 23-page paper isn’t for everyone. There’s some geeky investment stuff in it, and Asness’s sense of humor might not be for everyone either (though he’s pretty funny). But the paper is a great account of how bad investment can feel -- and how hard it is to separate your head from your heart, or your nerves.

You know, it’s easy to trivialize those small declines from the past you see when you look at a graph of a generally rising uptrend over the long-term. Those small blips don’t look like anything at all. But it is so very different when you’re living it every day. “Time slows down in a drawdown,” Asness says. His paper can be found here (https://www.aqr.com/Insights/Perspectives/Liquid-Alt-Ragnarok).

Please Note: The 2-Minute Thought will be on holiday and will return December 6.

The 2-Minute Thought: Extreme Stock Price Reactions

Recently, there have been some pretty extreme stock price reactions after earnings announcements.

Why would Chinese test prep company New Oriental Education trade down by 17% after announcing a negative 2% earnings surprise -- while the shares of apparel company VF Corp see a drop of 11% on a 9% positive earnings surprise and higher guidance? Why would Vulcan Materials jump more than 22% on a 2.4% positive surprise? And why would Caterpillar fall almost 8% after meeting earnings expectations but seeing a modest decline in backlog?

It’s hard to make sense of it all – and perhaps fruitless to try.

According to FactSet, a positive earnings surprise usually leads to a 1% rise in the company’s stock price. But as of the end of last week, the average earnings “beat” sent stock prices down by 1.5%. We haven’t seen such negative responses to positive reports since 2011 – and if you remember 2011 like I remember 2011, that was a hard year.

Obviously, a single quarter is only a single quarter. But this is weird.

The Financial Times wrote this morning that S&P 500 companies are on track to reporting average earnings growth of more than 26% -- and that more than 75% of the companies that have reported results so far have exceeded expectations. But good results haven’t counted for much this quarter. And companies that haven’t met expectations have gotten severely punished. That means that double digit percentage declines in a single day have been pretty common.

The popular narrative is that stocks – and all asset classes – are getting re-rated in light of tariffs, China, inflation, and the possibility that economic growth and earnings are peaking in the U.S. Those all seem like good reasons to reassess stock valuations. But in truth, there is very little clarity yet on what is going on – nor is there ever much clarity when it comes to short-term stock price movements.

In his blog this week, NYU finance professor Aswath Damodaran looked at the most common explanations that have been put forth for October’s market chaos. They include the Fed raising interest rates, a technology meltdown, a correction in overvalued stocks, an end to U.S. economic outperformance versus the world, and just plain old panic. But there wasn’t enough evidence behind any of these explanations to say anything definite.

In addition, Damodaran found that stock declines in October happened regardless of valuation. The idea that “overvalued” stocks would decline more than “undervalued” ones just didn’t play out.

That is a reminder that short-term stock price movements have a lot of noise in them and probably are best ignored. In the short term, prices are a puzzle. And while things will get sorted out longer-term, we know far too little to do anything yet except pause and take a breath.

If we are seeing individual stock prices decline 10% or 20% or sometimes even more in a single day, and those declines don’t make sense in light of the new information being released – well, that suggests that either the price was quite wrong before the announcement or that the extreme reaction after the announcement is. But since we don’t yet know which of those is true, take that breath . . . and hold on.