Imagine you're a weather forecaster. For the last four years, you've predicted a massive blizzard and frigid temperatures. But it never came. It's actually been downright hot for the four years straight. Ninety degrees and sunny every day.
Now imagine you resign from the meteorology business because you are sick and tired -- sick and tired -- of atmospheric pressure. "All of my forecasting models tell me it should be snowing," you say. "But like some spoiled brat, atmospheric pressure waltzes in here like he owns the place, keeping it hot day after day. This pressure has no business being in the sky. It's appalling how much gall the atmosphere has."
This would, of course, be ridiculous. Your viewers would tell you that the weather is always right, and you, as a forecaster, are the one who is wrong. It doesn't matter if it's abnormally hot. Your job as a forecaster was to predict that it would be abnormally hot. That's why they pay you to be a forecaster.
Finance is different. Unlike all other fields, finance people get to blame their poor forecasting skills on reality.
Hedge fund Rinehart Capital Partners LLC announced it was closing last week. It's easy to see why. According to The Wall Street Journal, the fund lost 7% in 2012, another 15% in 2013, and is down 4% this year. The S&P 500 gained 68.2% during this period.
Reinhart founder Andrew Cunagin wrote a letter to investors announcing the closure. He explained his poor performance by blaming high-frequency traders, the Fed, and a market that went higher when he doesn't think it should have:
Just as in previous boom-bust cycles, the seeds of destruction are sewn in the illusion of trend masquerading as truth, with momentum seeming to validate a widening gap between perception and economic reality. And just as in past cycles, the manager who doesn't subscribe to the new rules, who goes against the grain of convention is viewed as out of touch or left behind ...
Since the beginning of our fund's drawdown in early 2012, a Bloomberg index of the "Worst Balance Sheet" companies of the S&P500 has returned to-date over +30% on an annualized basis. An MSCI index of the "Most-Shorted" companies of the Russell 3000—a proxy for the visibility of bad valuations, bad managements, and bad fundamentals—has also returned over +30% annualized. These perversions are even more pronounced within EMs, exacerbated by record fund outflows in the first half of 2014, exceeding even those of the 2008 crisis. This dash for trash puts to shame even the speculative excesses of the dot.com era. This is a circus market rigged by HFT and other algorithmic traders who prey on the rational behavior of warm-blooded investors. They only serve to further undermine the integrity of public markets, which will ultimately bring about their rationalization. Nonetheless, it's an internal dynamic to which we are uniquely levered, by design, as an alpha strategy. One thing is certain, managers whose strategies are working may be bright and well-informed with advanced metrics on which they make investment decisions, but a reasonable assessment of value is not among them. Do previous cycles not bear asking, what other measure is there?
Look, stocks have gone up a lot. Some sketchy companies are expensive by any definition.
But the entire history of the stock market is a pendulum swinging from absurdity to absurdity. There is no such thing as a normal, healthy market. It's perpetually in some state of irrationality that no one can explain.
You should never blame an irrational market for your terrible performance. The market is always right, even if you disagree with it. It's your strategy that got it wrong. And "wrong" is the right word to use here because your actions dragged performance down so far that you're being forced to close, forfeiting any chance of vindication. "The market can stay irrational longer than you can stay solvent," John Maynard Keynes famously said.
What bugs me about this is incentives. When hedge fund managers get it right, they earn multi-million, even billion-dollar paydays, and are paraded around as living gods. When they get it wrong, it's someone else's fault. The Fed is irresponsible, the president is ruining the economy, high-frequency traders are destroying confidence, Congress is creating uncertainty, yadda yadda yadda.
Rarely is anyone in finance forced to admit what the weatherman would have to: I was wrong.
Contact Morgan Housel at firstname.lastname@example.org. The Motley Fool has a disclosure policy.