“The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism.” – Benjamin Graham
The Superinvestors of Graham and Doddsville  lived between two emotional stations. Peace and equanimity. Both are wonderful places for investors to reside. The rest of us mere mortals oscillate between fear, confidence, chaos, arrogance, panic, and euphoria. Why?
The Superinvestors had a trusted framework to recognize value investments, which served as their North Star. This framework kept them grounded and impervious from Mr. Market’s emotional hijackings. Investors spent most of their time digging for the next great investment, rather than building a framework that does the work. Repeated success builds trust. Without such a framework, we give up when our investments go against us. Let me give you a personal example.
My first day as a professional investor was June 1st, 2006. What followed was the global financial crisis. From 2007 to 09, the S&P fell by 58%. Early on, It was clear as daylight that U.S. consumer balance sheets were over-levered. They had very few options but to cut back on spending. However - as a rookie - the banking crisis was past my comprehension. The lack of understanding of market cycles, the barrage of bad news, and a long bear market made me deeply pessimistic. My wife jokes that I was busy opening multiple bank accounts to protect our savings when we barely had any to begin with. “What if our bank is the next Bear Stearns?” The undeniable truth of recessions - no matter how bad - is that they all end! I stayed in my deeply pessimistic state for much longer. It was a great lesson to never make that mistake again. I realized that great money management requires thinking in frameworks.
I see many investors making similar mistakes today. Without a framework, long periods of volatility bring out the worst in us. Today, high-growth investors are looking to invest in Energy. U.S. investors are making macro assessments on Europe. Would it surprise you that investors have turned into arm-chair military strategists? Investors who pick businesses are predicting the Fed’s next move (LINK) or when the U.S. economy will enter a recession. None of this is in any way surprising. The market has only one job – and that job is to fool the majority.
Here is my recession framework that has proven the test of time. It has identified every recession post World War II. There are four key criteria. Think of this as a dashboard with green, yellow, or red lights. If the dashboard is mostly green - sprinkled with a few yellows - we are safe. As the count of yellow and red lights rises, so does the risk of a recession. Similarly - reds turning to yellows is a sign of optimism -that the worst may be behind us.
1) Is the Leading Economic Indicator (LEI) gauge falling sharply and close to Zero? NO
The LEI is a comprehensive forward-looking metric that accounts for manufacturing new orders, building permits, changes in hours worked, credit issuance, interest rates, stocks prices, etc. As you can see above, when the LEI falls sharply and turns negative, a recession follows. For the LEI to turn negative, multiple end markets are either in a sustained slowdown or in outright decline. Today, the situation is different. The LEI reflects a strong, but slowing economy.
2) Has the yield curve inverted? NO
When long-term rates are below short-term rates, lending is unprofitable. So, banks stop lending. New businesses cannot get off the ground and existing businesses cannot expand. This slows new economic activity. Today, the 10 year vs. 2 year curve is close to zero but hasn’t crossed below. Our yield curve indicator is flashing yellow light. We need to be watchful. As you can see in the chart above, a recession follows within 6 – 12 months of yield curve inversion.
3) Are credit spreads widening significantly? NO
When junk bond yields move significantly compared to (safe) treasury yields, it is a major warning. Investors are selling risky investments and buying safe ones. They are demanding a significant premium to compensate for the rising risk. Indicated by the red arrows above, at least a deep market sell-off, if not a recession follows. Today, credit spreads although rising, are still at benign levels.
4) Are unemployment claims rising sharply? No
When a business lays off an employee, that layoff is reported to the government and is captured as an unemployment claim. To avoid false signals, we need claims to rise sharply. This triggers a warning sign for the labor market. 70% of U.S. GDP depends on consumer spending, and consumers don’t spend when they are fearful of layoffs. As the red arrows indicate, recession follows sharp and sustained spikes in claims. Today, we are seeing quite the opposite. The jobs market is strong and unemployment claims are near lows (see below).
This dashboard has 3 greens and one yellow light. While the probability of a recession is clearly higher today vs. six months ago, our dashboard indicates that a recession in 2022 is still unlikely.
Thinking in frameworks keeps us objective. Most importantly, it keeps our emotions in check so we don’t oscillate between fear, confidence, chaos, arrogance, panic, and euphoria. It has helped me immensely. While it won’t miraculously transform us into the Superinvestors of Graham and Doddsville, the road to Peace and Equanimity starts by thinking in frameworks.
 The Superinvestors of Graham and Doddsville (LINK)
This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund"). Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law. An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.
This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund. These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in future.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework