The Bearish Persuasion

Lots of people buy stocks, hoping that they will go up. Some people sell short stocks, hoping that they will go down. The stock market goes up most of the time, so why do this? It would seem to be suicidal.

Well, there is an answer, and the answer is that when stocks go down, they go down a lot faster than when they go up. So you can make more money faster. There is a complicated mathematical explanation for this, but really it’s about the asymmetry between gains and losses—the stock market grinds higher, but crashes lower. And as usual, it comes back to optionality.

Buying stocks is a bit like selling options. You are getting small gains, at a risk of a large loss. That is like selling options. When you short stocks, you are getting large gains, at a risk of a small loss. The stock market doesn’t usually crash up. That is like buying options. So what I’ve found over the years is that the bears are really option buyers and the bulls are option sellers, forgetting all the other factors for a moment. I am an option buyer. I like to buy options, have them go in the money, and pick up my bag of cash at the second window. I like to insure against the large drawdown, because large drawdowns affect behavior and psychology in negative ways. I don’t mind getting nicked seven times in a row trying to short stocks if I catch the big move lower. When the bulls get nicked, it can be catastrophic—like what happened in April.

Now, aside from the options math, bulls and bears do attract very different personalities. The bears are skeptics—they disbelieve in the transformative potential of new technologies, and the look for ways that things can go wrong. A lot of people equate bullishness with optimism, and yes, it is that, but I’ve found that bulls are frequently incurious and naïve about how things could go wrong. The bulls make fun of the bears for their skepticism. The bears make fun of the bulls for their lack of skepticism. Everyone gets to be right, and wrong, at some point in history. Skepticism was the motive force behind The Big Short trade, which made some people very wealthy. Everyone else was incurious. Optimism is important—without it, we would never grow. Skepticism is important, to correct the excesses of the optimism. If you can do both, and do it well, you are a hero. I have been a skeptic of private equity for almost two years now. I think it poses systemic risks, and could be the cause of a deep recession. Nobody was listening two years ago, but they are listening now.

A further justification for bearishness—to prevent a misallocation of capital. Nvidia is nearly a $4.5 trillion market cap. Who knows what the right valuation of Nvidia is, but maybe Nvidia deserves a lower valuation and something else deserves a higher valuation. Maybe by putting more money into Nvidia, you are setting it on fire, and you might be better served putting it in global small cap value. I’ve always been one to say that valuation doesn’t matter—except at the extremes. But there is a general rule of thumb in investing that if you buy stuff that is cheap and you sell it when it is expensive, over long time frames, that is a recipe for success. These days, people are buying stuff when it is expensive and waiting for it to get even more expensive—which works, until it doesn’t. Everyone lionizes Buffett and then basically does the opposite. I suspect the reason that there is a giant money market fund in Nebraska is because Buffett, and his heirs, don’t see a lot of opportunity. So they wait. Funny—out of all strategies in existence, whether it’s momentum or long/short or vol arb or macro, the one that reliably cranks out returns is distressed investing. The distressed guys always, always make money—because they are buying stuff when it is cheap. I’m not kidding about this. Go look at a table of hedge fund strategies, and see which one makes money the most consistently. It is distressed.

There is a cohort of bearish investors that are doomers. I’m sure you know the type. There is a whole website dedicated to doomers, and it is quite large. You do have to be quite insane to be praying for an economic collapse. I was a bear leading up to 2007, and the bear market was much worse than what I predicted, and I wish it never happened. Don’t get me wrong. On a long enough timeline, we are all doomed. In particular, we are doomed by deficits. But it might take 20 years or more to play out. As someone once said, most disagreements in finance are about time frames, which is why you have to reconcile different timeframes in your head. Something bad is going to happen in the long term, but I don’t have to worry about that now, and I will buy stocks in the short term. Everyone predicted that inflation would be the result of quantitative easing. It was—13 years later. Stuff takes a long time to play out. They managed to prop up the Soviet Union for decades, long enough so that people had real doubts as to whether capitalism was the superior economic system. Gradually, then suddenly. I do think that the United States will one day be doomed to a hyperinflationary bust, but I think it will be after I have retired, or perhaps even after I have expired. We don’t want to be around when that happens.

There is a quote: Pessimists sound smart; optimists make money. That is true most of the time. It wasn’t true from 1929-1945, from 1969-1982, and from 2000-2011. We had 50% bear markets in 1929-1932, 1974, 2000-2002, and 2007-2009. The CAGR of the stock market in my first ten years in the business was negative. Quotes like these go in and out of fashion. I can tell you that it was very fashionable to be bearish in October of 2022, and that was a mild bear market, by historical standards. There is a word I am looking for, perhaps a German word, that means being able to remember what it felt like during historical events. Do you remember the feeling of the financial crisis? When Citigroup was trading at 99 cents, when you were freaking out that you might lose money in any bank you put it in? The feeling of the stock market going down day, after day, after day? I think that quote is exceedingly glib. Human progress is all about three steps forward, two steps back. There is a whole discipline of investing that seeks to profit from the two steps back. It has gone out of favor in recent years, but it will come back, I assure you of that. In the meantime, bears try to make money around the margins. There is always a bull market somewhere.

I find the permabulls to be, like I said, incurious, naïve, and ignorant of market history. Or really, maybe they are that cynical—they will make hay while the sun shines and disappear when things go tapioca. I found out today that I have earned 12.8% in my brokerage account in the last five years (annualized, of course). That doesn’t take into account my futures trading, so that probably goes up to 15-17%. The S&P 500 has returned 17-plus percent over that time period. I have earned almost the market return with a lot less risk. Two-thirds of the risk, in fact. Risk-adjusted returns are the goal. The goal isn’t to make infinity, the goal is to maximize your return per unit risk. That means hedging with options. That means shorting things. That means trading overseas. That means trading different asset classes. People pay 0.03% for the S&P 500 index fund. People pay two and twenty for a hedge fund. What they are paying for is professional risk management, as opposed to an index fund, where you have zero risk management—just pure beta. Every stinking Bloomberg article about XYZ hedge fund will always take pains to point out that XYZ hedge fund is underperforming the S&P 500 this year. Nobody cares. It’s like they have never heard of Sharpe Ratio before. Let me put it this way—the rich people who invest in these funds are not stupid. It got so bad that Cliff Asness had to write a paper on why people shouldn’t be in 100% equities.

Hard to keep your wits about you in an environment like this, when buying stocks is so easy. One last thing. I am a big proponent of taking profits, lustily. Something goes up, sell it, move onto the next trade, because there is always a next trade. I don’t want to jump off a bridge if I sell something and it goes up another 50%. It happens to me sometimes, and I have no regrets. I am not in the regret minimization game. I am in the profit maximization game. There are so many people out there who say that they will never sell, sitting on millions of paper profits and refuse to lock in the gains. In an effort to minimize regret, they will end up maximizing regret, which is usually the way it goes.