Reflections on equilibrium
Figuring out where you are is important if you want to get to where you are headed.
I'm changing my substack to suit where I think the conditions are going. I am not going to make my framework rules based. Instead it will be a framework based on looking for rules that have changed recently or are in the process of changing.
My approach will involve working with a hypothesis. I'm going to form a thesis about an anticipated sequence of events which I will then compare to the actual events. From that I will get criteria by which I will evaluate the thesis.
I'm going to set up a model portfolio with 16 components. If it works then I will double it to 32 components and if that works I will double it to 64 units.
I'm going to write memos detailing my rationale and then provide monthly reports reviewing the portfolio with updates on any changes.
Decisions will be made with a combination of theory and instinct. I will discuss developments within the portfolio.
The initial portfolio will be called the McLellan fund. My opinion at the moment is that stocks should be avoided. 80 to 90 % of all stocks have been sold and the only sectors I favor are oil and gas, some uranium, and some other commodities. Because of where we are in the cycle I believe that gold is a good place to be right now.
Gold is currently a good hedge against many possible scenarios.
The basic framework for understanding markets will be 1. Dynamic disequilibrium 2. Static disequilibrium 3. Near equilibrium.
Similar to the different states of water. 1. Liquid 2. Ice. 3. Steam
Boom / busy sequences will be interpreted using distance from equilibrium reflexivity. No reflexivity is the normal state. Far from equilibrium reflexivity becomes important when we have boom / busy sequences.
Forces that take us away from equilibrium are always at work. They are resisted by countervailing forces. However, when these countervailing forces fail then we have a regime change. There is no developed theory for explaining or predicting regime changes or boom busy sequences.
Right now three things are important. Political risk, geographic risk, and historical precedent. I can sum up my attitude as follows, there are some places where money goes to die. We should avoid them. Other places money goes to be destroyed. Sometimes it just disappears. Never to be seen again.
The framework involves market prices being influenced by participants and by their biases. Boom busy sequences occur when market prices influence the fundamentals.
Let us take some examples. 1. The conglomerate boom. Conglomerates used their overpriced shares as currency to buy earnings. I.e. to keep prices of shares up.
The international lending boom. Banks used debt ratios to measure borrowing capacity of debtor countries i.e. the ratio of debt to GDP and or the ratio of debt to exports. These ratios were considered objective but they turned out to be influenced by activities. I.e. when banks stopped lending the GDP deteriorated.
Fundamentals and valuations have a short circuit between them. 99% of the time it's not a factor but when it is used it sets in motion a process that initially is self reinforcing but in time it becomes self defeating. An error in valuations is normally involved in a boom busy sequence. A recent example is the use of a facility to avoid having assets on balance sheets marked to value.
A common error. This is the failure to recognise that fundamental value is not independent of the act of valuation.
I.e. the conglomerate boom. Per share growth could be manufactured by acquisitions. In the lending boom in international finance lending activities of banks helped improve debt ratios that banks used to guide them through their lending activities. This will end this particular post. The second part will follow soon.