What is Reality?
My mother passed away unexpectedly when I turned 17. I feel for anyone who loses a parent early in life. The years stretch into decades, but the memories don’t go away, however distant they might become. Like ensconcing myself between my parents first thing every morning during the months I was home from boarding school.
A strong and fond memory I have of my mom is bedtime stories of the Mahabharata and Ramayana, two riveting Sanskrit epics full of demons, sages, and imperfect gods dealing with the full range of human tendencies.
I was particularly intrigued by the Mahabharata character Narada, a restless sage who had been cursed to be a perpetual wanderer, and never find liberation. On one occasion, Narada claims to Vishnu – one of the principal Hindu deities – that he has conquered illusion. “Oh yeah?” says Vishnu, who decides to show Narada the true power of illusion. Narada wakes up as a woman, marries a king, and bears many sons who have grandsons, all of whom are suddenly killed one day in battle. As she grieves, Vishnu appears and asks “why are you so sad, this is just an illusion.” To which Narada responds, “how do I know that THIS is real and not an illusion?”
My latest episode of Brave New World features the renowned philosopher David Chalmers, author of a new book called Reality+. Interestingly, Dave opens with the Vishnu and Narada story to frame the reality/illusion conundrum that was expressed in western philosophy by Rene Descartes in 1641.
Dave’s book addresses questions in philosophy – such as what is reality – in light of advances in Artificial Intelligence and virtual reality. As VR gets better, it will become increasingly difficult to distinguish between reality and illusion. In such a world, is virtual real? Dave frames this inquiry using a line from Freddie Mercury’s Bohemian Rhapsody:
“Is this the real life,
or is this just fantasy?”
It’s totally mind-bending stuff, which Dave explains with great clarity, so check out the podcast and his book. I should mention that Dave’s book doesn’t read like a typical philosophy book, where you have to read everything multiple times to understand it. The book is full of clever cartoon-like AI and VR illustrations to express the classic questions in philosophy. It’s an enjoyable read that I highly recommend.
Meanwhile WTF is Happening in Financial Markets and What Should You Do?
Have you realized that the market gurus always caution you to be careful after the market has already hurt you badly? However, this isn’t the time to lick your wounds, but to focus. Times like this offer opportunity.
I tend to prefer systematic algorithms over humans when it comes to trading, but current markets provide opportunities for humans willing to do some homework.
If you do have some cash sitting around, what could you do?
I’ll start with similar advice I provided in March of 2020, the last major market meltdown at the onset of COVID.
If you’ve got some domain expertise, such as in Tech, Biotech, Pharma, etc., go for the dominant quality companies that have been beaten down with the market. Yes, Tech and Biotech have taken a beating, but they will be a big part of our future. If you can pick up companies like Microsoft at, say, 10 to 15 times cash flow, consider them. You could hope for a bounce in the beaten down sector like crypto, but a lot of the crypto enthusiasts are already hurting, so they may not come charging back.
If you are lazy or unable to do the analysis, there’s a simpler approach. A friend of mine belittles me sometimes for being a business school professor, asking, “isn’t business school all about buying low and selling high?”
It is indeed. But how low?!
How Low is Low?
Based on an analysis of the daily prices of the S&P500 over the last 60+ years, here are some interesting takeaways.
The index has dropped by more than 25% from its last peak only eight times. Prior to now, the last time it hit fell 25% from a previous high was on March 12, 2020. The index lost another 9% in the subsequent eight days, after which it took only 103 trading days – until August 20th, to recover to its previous high.
If you had entered on March 12, when the S&P500 was down 25%, your return in just five months would have been a whopping 37%.
The dotcom bubble of 2001 and the oil shock of 1974 had the longest recovery periods, of 1556 and 1575 trading days respectively. The great financial crisis of 2008-09 had the largest drawdown of 57%, meaning that if you had gotten in at the 25% drawdown level, you would have ridden the market down another 32% before the recovery began. Catching a falling knife isn’t always clean.
In contrast, the drawdown of August 1982, caused by Paul Volker raising rates like crazy to fight inflation turned out to be the least painful. The market took only 64 trading days to its new high.
Across all drawdowns, the average recovery period from the 25% down level was 709 trading days, and the average return to the new high was 37%.
How will this latest drawdown play out?
There is considerable variance in recovery periods. I was shocked by how quickly the market shook off COVID. Tech companies became even more dominant, due to the increased reliance on technology in an increasingly virtual world.
Today’s reaction to inflation may be similar in some ways to the inflation concerns of 1982. If things play out similarly, getting in at current levels is a unique opportunity. If things play out more along the lines of the great financial crisis, you’ll need to be more patient and be content with an annualized return of 7 percent until the market recovers. I wouldn’t be too unhappy with that return.
Many years ago, I asked my colleague Aswath Damodaran whether he follows his own advice. His response? What’s the point of doing valuation otherwise. I feel the same way. I’m doing my homework now on specific companies, and also intend to invest in the broader market.
It will be interesting revisiting the current situation a couple of years from now.
Until next time.
V/