It’s Not All Bad – Covenant’s Weekly Synopsis

October 7, 2019

In this week’s edition:

  • Last Week Today – A summary of news impacting the financial markets and the economy.
  • It’s Not All Bad – Survey data is weak, but hard economic data is holding up better.
  • Twitter Put – It’s difficult to short this market.
  • Behavioral Finance – Representativeness, the stereotyping bias


Last Week Today. Australia’s central bank joined the global monetary policy easing cycle and cut their official borrowing rate to an all-time low 0.75%, attempting to sustain an expansionary business cycle that has lasted nearly 20 years (Australia’s last recession was in 1991). | Brokerage powerhouse Charles Schwab announced they would no longer charge trading commissions. ETrade and Ameritrade followed suit quickly, and in a world of negative interest rates, it’s not unreasonable to question if brokerages might pay investors to trade someday. | After a 15-year administrative process, last month the World Trade Organization ruled the European Union’s subsidies of the French airline manufacturer Airbus were illegal and that the U.S. is therefore authorized to levy retaliatory tariffs on $7.5 billion of European goods. The U.S. announced the tariffs on planes, cheese, and whiskey on Wednesday. The European Union promised to retaliate, even though these tariffs followed traditional trade dispute guidelines. | Saudi Arabia announced they had restored full oil production at the facility attacked by drones in mid-September. | For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

It’s Not All Bad. Recent data on the U.S. economy is signaling a further downshift in the growth rate, which is not surprising as we’ve been expecting slower growth and warning that 2018 was an anomaly. Tax cuts and fiscal stimulus propelled economic activity well above its sustainable rate, and now that the effects of the stimulants are wearing off, growth is slowing. The big question investors and economists are debating is whether this is the end of the 10-year expansion or a mid-cycle slowdown a la 2015/2016.

Much of the soft data (e.g., the ISM surveys released last week) is pretty concerning, but the hard data (i.e., non-survey data) is holding up reasonably well. For example, in September, the unemployment rate hit a 50-year low of 3.5%, and wages continue to rise, even if at a slower pace than earlier this year.


Source: FTN Financial

Moreover, total weekly hours worked were stable, which is often an early warning sign if managers begin cutting hours. Indeed, even in the troubled manufacturing sector, the workweek has held steady for the last three months at 41.5 hours vs. a long-term average of 40.8 (source: Foleynomics). Our thesis on the economy for the last several years has been “Good But Not Great.” That is, at this stage, the economy is only capable of growing at about 2% per year. It’s not the eye-popping 4%+ growth rates experienced in past expansions, but ten years into the economic cycle, it’s not bad. We’re not Pollyannaish about the economy, and, yes, the risks of recession are higher than at the beginning of the year. We’re watching closely, but currently sticking with our theme until the data tells us otherwise.


Twitter Put? Early last week, the ISM Manufacturing survey plummeted to 47.8 (10-year lows), and the export orders component hit 41 (well below 50, which is the dividing line between growth and contraction). On Thursday, the ISM Services survey for September hit 3-year lows at 52.6, and stocks fell hard before reversing mid-day. Typically, when stocks fall quickly, insurance on stocks gets more expensive (i.e., the pricing of put options rises quickly). But that didn’t happen during last week’s sell-off. Why?

With the election only a year away, President Trump and his team’s most significant advantages are a strong economy and a rising equity market. Remember James Carville’s “It’s the economy stupid” campaign slogan Bill Clinton rode to victory in 1992? Investors have seen markets turn on a dime because of Trump’s tweets. Thus, they’re reticent to be short the market when new all-time highs are merely a tweet away and the Chinese trade delegation is visiting the U.S. this week.

Be well,



How the Mind Works Against Successful Investing – Representativeness aka “The Stereotyping Bias”

(Entry #9 in a series on Behavioral Finance)

As we’ve touched on before in this series, the human mind is an incredibly powerful system. Yet, in spite of that potential power, humans are conditioned to use mental shortcuts or “rules of thumb” when making decisions or judgments. There are sound evolutionary reasons for these shortcuts or heuristics, and psychologists like Steven Pinker theorize, “Our brains are shaped for fitness, not for truth.” In other words, despite the enormous power of our brains, our default way of thinking is better suited for survival than for the types of problems we face today. On the prairie, our ancestors benefited from making quick-decisions to avoid danger, but in today’s world, most decisions are not about survival, and these hard-wired short cuts can lead to poor choices.

Representative Bias, for example, occurs when people rely on a rough, best-fit approximation about something (an idea, an object, a thought, etc.) based on only a few observations. Researchers call this phenomenon the “law of small numbers,” which equates to drawing conclusions about an entire population based on a few available data points. In other words, we wrongly judge that something, or group of things, is more representative than it actually is.

In sociology, representative bias presents itself as stereotyping groups of people by race, sex, political beliefs, etc. For example, consider how jurors’ opinions about whether a defendant is guilty or innocent might be biased by how they believe a criminal should look. If the accused has an intimidating presence or angry eyes, the jurors may be more likely to perceive that individual as guilty.

In finance, representative bias leads to critical errors when investors draw conclusions based on insignificant statistical data. For example, investors may think they see patterns in data where none exist or expect future patterns to resemble past ones.  However, unless highly trained in the art of technical analysis, these investors typically only find trends when they’re well established. Hence, the investor tends to be reactive, jumping on board late in the trend and failing to forecast the all-important trend change, leading to the wealth debilitating practice of buying high and selling low.

This bias also emerges when investors are selecting portfolio managers based on a limited set of performance data. A new manager may have a great year or two of performance, leading investors to believe he can continue to generate the same high returns in the future. The mental shortcut of assuming the past is representative of the future, precludes investors from putting in the work to understand the strategy and trying to discern if the excellent performance is the result of luck or skill. As the old Wall Street saying goes, “you can’t eat last year’s returns.” Or, as the Securities and Exchange Commission (SEC) requires managers to disclose with all of their marketing, “Past performance is not indicative of future results.”

Addressing representative bias is difficult but not impossible.  As with most heuristics, overcoming representative bias requires effort. For example, using an investment diary to record your reasoning (or investment thesis) before investing, along with the expected outcome. As time goes by, record the performance of the investment and compare it to your thesis. When divergences occur, try to understand what elements of your forecast were inaccurate and why.  Over time this practice can help you identify your natural biases to become a more effective investor.