Moneyball - 20 years later

Moneyball was a great book when it was first published, and it still is a good book 20 years later. I want to reflect on the book and what investor should still takeaway from Michael Lewis's ultimate story. 

I first wrote about Moneyball and learning from Michael Lewis in my first blog post in 2007 and another a few weeks later. See "Moneyball and Market Efficiency" and "Learning financial research from Michael Lewis".

I have not significantly changed my views from these two posts; however, I have further developed my thinking by adding structural and behavior aspects to the disruptive thinking of Lewis. Quantitative methods can be disruptive because it can find relationships that others take for granted or assume away. Market relationships are taken for granted because we have behavioral biases. These biases do not easily go away even when they are identified and highlighted. 

Nevertheless, disruptive thinking can learned, so the baseball analysis of 20 years ago may not work today. Opportunities can last for some time because they may be structural in nature, but this is usually the exception not the rule. Opportunities from specific analysis can fall in and out of favor.  Looking for value is not often easy when the objective may be to win today at any costs. If the market is overvaluing certain players, you may have to pay the higher price. 

Success is always about a disciplined approach to following the numbers and not getting caught up with emotions. Excess return is always about seeking disruptive ways of finding value not used by others.

The words of the year - polycrisis and shrinkflation

The word of the year is POLYCRISIS. 

"A global polycrisis occurs when crises in multiple global systems become causally entangled in ways that significantly degrade humanity’s prospects. These interacting crises produce harms greater than the sum of those the crises would produce in isolation, were their host systems not so deeply interconnected."

See Polycrises - multiple crises are a reality. 

In 2023 we will see multiple crises come together to create a bigger market dilemma for the global economy. The Ukraine-Russia War will spill over to the energy and commodity markets again. The slowdown in Europe will continue as it searches for a more effective energy future. The COVID pandemic in China will be a headwind against growth in many EM countries. All this means that global macro will be a dominant strategy for 2023.

The second word of the year is SHRINKFLATION - the process of adjusting to inflation through maintaining prices but offering less quantity for what may seem to be the same package. See Higher labor costs and "shrinkflation" - Inflation beyond the headlines.

Firms are negatively affected by inflation because costs cannot always be passed through to buyers. Earnings will shrink for many firms, and this will have a further impact on valuations. Shrinkflation is a first response but cannot last forever. 2023 will be the year that firms must adjust to the price shocks of 2022. Inflation may fall but the impact on firms is just beginning.  

2022 - A year of extremes

 

2022 was not a good year for holding passive exposures, but a close look at the details shows that the dispersion across asset classes, factors, and sectors was large and could be exploited. The 60/40 allocation decision was problematic, but adding greater exposure to some factors and sectors that are viewed as defensive would have cushioned the overall decline.

Holding stocks with dividends was a winner. Low volatility strategies lost less than 5% and a value focus was down only 5%. A simple strategy of holding an equal weighted portfolio would have outperformed the SPX index by close to 800 bps. Th switch from growth to value and a focus away from overvalued pandemic high-flyers was a good defensive choice. This switch was a derisking strategy based on rates rising.

Holding energy stocks would have outperformed SPX by over 75%. Utilities, a classic defensive sector, gained 150 bps for the year. Commodities were another winner albeit with large swings and volatility. 

The answer for 2023 is to look for factor and sector exposures that will offset the downside potential from holding the market-weighted benchmark. Following a simple trend model can identify some of the sector and factor exposures that can serve as defensive allocations and still offer return opportunities.

We know that history will repeat and 2023 will be very different from 2022; however, the dispersion across sectors and factors will continue. This offers investors the chance to exploit return differences. Even if all of the dispersion is not collected, the large differences offers ways to extract return.

The challenges for 2023 - Can you see better than the consensus

 

The challenge for 2023 is not different than for any year. It is not about predicting the future market direction but preparing for the changes that may occur in the new year. There will be changes in 2023.  Our forecasts today will be wrong. The challenge is adapting quicker than the market to stop downside risk and take advantage of upside opportunities when the forecast errors are realized.

Some of the changes for 2023 are already embedded in the market consensus. Our job is to be prepared for both downside and upside events away from this consensus. The left and right-tail opportunities will be determined by the deviations from consensus. The challenge is to first know the current environment or regime and then handicap the potential for change in the regime. 

For example, the consensus is that Fed will likely top out rates at around 5% before the summer with a decline in rates during the second half of the year. This is based on an inflation forecast which shows continued declines and the potential for a recession in the second half of the year. Much of this consensus is already embedded in prices. The challenge is to look for signals that suggest the consensus will not be realized before the market identifies a change. 

Forget predictions and focus on the how to prepare and react when the current consensus changes.