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We all know everything
The “smart trade” has become crowded. And so, the alpha for being smart has diminished.
We all have heard about the butterfly effect, the idea that a butterfly flapping its wings can set of a chain of events that leads to a rainstorm half the way around the world. We experienced the investor version of this phenomenon as the market moved down on Friday.
The monthly jobs report came in far better than expectations, which implies that the economy is running hotter than some have feared, which implies that the Federal Reserve should not be in a rush to lower rates, which implies that borrowing rates will remain higher. And so, despite the economy doing well being almost undeniably good news, the indexes were down more than 1% on Friday and sectors that rely heavy on borrowing, including private equity, had stocks down 4% to 5%.
As an aside, the rate scare should not come as a surprise. The era of free money is over. It is fine to debate the margins and exactly what normalized rates will look like from here, but these market temper tantrums because we are not going back to near-zero rates need to stop. Thousands of companies can adapt and thrive in an environment where money actually has value. The ones who can’t were destined for the dust bin eventually.
But as the market reaction shows, clearly this was not all baked in. I think part of the reason for the volatility is the democratization of knowledge: Too many people are hyperaware of the butterfly effect.
Worth noting that the logic driving the selloff is 100% understandable. I’ve been talking down rate cut expectations for a year now, so I definitely don’t see a rush for the Fed to overcommit. The jobs data indeed was strong and indeed should send a signal that we are not in panic mode. Given how few tools the Fed has at its disposal there is no reason for it to move to aggressively to deploy the tools it has.
But nowadays we all think we are smart. The knowledge once limited to ivory towers and New York skyscrapers has spread to us all. We all can see how a strong jobs number might impact lending rates six months from now. We can all make the “smart trade” that back in the day only the masters of the universe knew to make.
The net result is the “smart trade” has become crowded. And for that reason, the alpha for being smart has diminished. Which is a fancy way of saying that even if the moves are directionally correct, they still tend to be overdone.
So, if the “smart trade” is crowded, is the contrarian move to take the “dumb trade” instead? I doubt it. The takeaway is to not rush into the trade at all.
What has really changed is the speed at which knowledge is spread. More people not only know about the jobs number sooner but also know what it means, causing the crowding. The contrarian move, and I believe the move that can generate alpha, is to fade the rush. Trade stocks with the next five to ten years in mind, not the immediate reaction.
To go back to the example of Friday, yes, the jobs number absolutely looks like it will raise borrowing costs for private equity in 2025. Or at least keep borrowing costs from falling the way one might have hoped they would a few months ago. But they should do little to keep a well-run firm from succeeding over time. Selling on Friday might be a good move if your time horizon is short. But makes no sense at all of you are invested in good companies and your time horizon is more than just the current cycle.
Not to sound like a broken record, but the biggest advantage we have is a long time horizon. Squander that advantage at your own peril.
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