Things are not predictable

Recently on the Internets I ran across this photo:

This seems true, I'm not inclined to go to a fact-check website on it. Assuming the laws of physics don't change between the time you pass under the sign and when you reach the bridge, and assuming you are continuing forward, you know what will happen.

A lot of these types of "signs" pop up in the financial news, and in people's minds. Signals flash. Many times these signals, in the past, preceded something. (Note "preceded," not "predicted.") All kinds of things then dominate an investor's thinking, like recency bias, or confirmation bias, or narrow experience bias.

Let's look at one example. On bond trading floors people like to rattle off the catchphrase "Don't fight the Fed," meaning that when the Federal Reserve is raising rates, stocks aren't going to do well, and you shouldn't buy them. They won't do well, in theory, because bonds will pay more going forward, attracting money away from stocks, and because capital will be more expensive for corporations to employ.

I like the phrase! It kind of rolls off the tongue, and when you don't feel like doing that complicated valuation spreadsheet for your boss because the Yankees are playing at 7 PM and you want to get out of the office, you just simplify down to "Come on, don't fight the Fed."

So how did that work out the last two periods the Fed raised rates, the first being from the start of 2004 to the summer of 2008? The S&P 500 compounded return was about 33%. Maybe that's just an anomaly you say? What about the period from the start of 2016 to the fall of 2019? Oh, hmm, then the S&P 500 gained about 66%. Maybe it's the alliteration of the phrase "Don't fight the Fed" that's attractive, but not the reality.

Perhaps the Fed starts raising rates when the economy is doing well, and in the past two periods that has dwarfed the negative effects on corporations? Or perhaps they raise rates to fight inflation, which is the dominant meme now. But controlling inflation helps businesses as well, as Warren Buffett points out in his 1981 report (1).

The lesson here is to be careful when you hear a financial statement, and someone says X is happening, therefore Y is going to happen. The problem is there are a lot of X's, and no one really knows how they interact, or what weighting to put on each X.

In other words, you may hit the sign, and be fine at the bridge.

Dan Cunningham

1. Click here to read the 1981 Berkshire report which discusses inflation. It's about 2/3 of the way down.

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