Random Thoughts, Truth Telling and Autumn Expectations

Today strikes me as a good day to share some random thoughts, research, and readings and anything else that crosses my synapses.

I told you back at the beginning that I write pretty much whatever I want here, and today is one of those days I just think it's a good idea to spill a bunch of random thoughts and ideas out and see if anything emerges.

For the most part I have avoided politics. While the rest of the world seems insistent that you join one tribe or another, I really do not care what your beliefs and preferences are.

I do not like any of them.

I think that the perfect presidential ticket would have been Milton Friedman and Jack Kerouac, but alas, it never came to be.

I do not think we are heading to Armageddon any time soon.

If it does happen, the selection of stocks I bought prior to the event will matter very little.

If America ends in a cloud of debt and fury, there is not some magic collection of assets and stocks that will protect you.

Canned green beans, Spam, and bullets will be the currency of choice.

If you are worried about such things, Swiss accounts would be a good idea. (Yes, you can open Swiss accounts. Just pay the taxes.)

I am not so sure that we are on the edge of the greatest cycle of prosperity in human history either.

If we are, the stocks I own will soar in value and I will share in all that prosperity.

Spending my time worrying about such things is a waste of my time.

I cannot control the apocalypse from happening.

The Great American Boom will happen with or without my input.

All I can do is invest using what empirical evidence suggests gives me the opportunity for high returns.

That evidence suggests that Deep Value and Fundamental momentum combined with price momentum are the two paths to prosperity.

Evidence also suggests that we can capture the excess returns using empirical data and financial statements.

Unless you are going deep on extremely illiquid stocks like Dave Walter at Alluvial Capital (https://substack.com/@alluvial), the deep dive is not necessary.

Most of the deep dive reports I see today are marketing material more than anything else.

That has always been the case with Wall Street research reports. I learned that very early in my career.

The official looking reports were stories well designed to bring in commission dollars.

Thanks to rigorous disclosure laws and software packages that make it much easier to research and test than sitting in a corner of the office late into the evening with cold coffee and a full ashtray while using a highlighter to search through the S&P stock guide and a Texas Instruments Business Analyst.

That's how I started the more quantitative portion of my Deep Value journey.

By the way, this is not originally my idea. Adopting a more quantitative approach was Ben Graham's idea.

Shortly before he passed away in 1976, he gave an interview to the Financial Analysts Journal. I have shared the more critical part of it with you today so you can get some idea of how Quantitative Deep Value investing was born.

"In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.

What general approach to portfolio formation do you advocate?

Essentially, a highly simplified one that applies a single criterion or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole—i.e., on the group results—rather than on the expectations for individual issues.

Can you indicate concretely how an individual investor should create and maintain his common stock portfolio?

I can give two examples of my suggested approach to this problem. One appears severely limited in its application, but we found it almost unfailingly dependable and satisfactory in 30-odd years of managing moderate-sized investment funds. The second represents a great deal of new thinking and research on our part in recent years. It is much wider in its application than the first one, but it combines the three virtues of sound logic, simplicity of application, and an extraordinarily good performance record, assuming—contrary to fact—that it had actually been followed as now formulated over the past 50 years from 1925 to 1975.

Some details, please, on your two recommended approaches.

My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net-current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets. We used this approach extensively in managing investment funds, and over a 30-odd year period we must have earned an average of some 20 percent per year from this source. For a while, however, after the mid-1950s, this brand of buying opportunity became very scarce because of the pervasive bull market. But it has returned in quantity since the 1973-74 decline. In January 1976 we counted over 300 such issues in the Standard & Poor's Stock Guide—about 10 percent of the total. I consider it a foolproof method of systematic investment—once again, not on the basis of individual results but in terms of the expectable group outcome.

Finally, what is your other approach?

This is similar to the first in its underlying philosophy. It consists of buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months. You can use others—such as a current dividend return above seven percent or book value more than 120 percent of price, etc. We are just finishing a performance study of these approaches over the past half-century—1925-1975. They consistently show results of 15 percent or better per annum, or twice the record of the DJIA for this long period. I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public."

There you have it. While some of the formulas have been tweaked and twisted, or in my case modified to fit banks specifically, the core of this approach was laid down by Graham almost 60 years ago.

It still works as well today as it did then.

Of course, everyone wants to own the same 15 stocks and trade in and out all day, so the strategies are ignored today as they ever were.

All little kids want to be the starting quarterback and throw the game winner in the Super Bowl or be the point guard who leads the team down the court in the final minutes of Game 7.

Today it seems as though those dreams have carried over into adulthood, with all retail investors wanting to be the wild steely-eyed trader that is played by Christian Bale in the movie about the monstrous success they achieved thanks to their variant perception and enviable trading acumen.

The odds of success are about the same for both groups.

Two researchers recently did something unprecedented: they analyzed $15 billion worth of actual retail trades, tracking every buy, every sell, every profit, and every loss. Vincent Bogousslavsky and Dmitriy Muravyev's study, published in January 2024, represents the most comprehensive look inside retail trading behavior we've ever had.

What they found would make any rational person delete their trading app immediately.

But first, let's step back to understand how we got here. Just five years ago, commission-free trading was revolutionary. Robinhood's slick interface made buying stocks feel like ordering an Uber. TikTok influencers started showcasing six-figure gains from their bedrooms. The pandemic hit, stimulus checks arrived, and suddenly everyone was a trader.

The numbers tell the story: retail trading volume exploded from 14.9% of all market activity in 2019 to 19.5% in 2020. Options trading—once the domain of sophisticated professionals—grew 35% between 2020 and 2021 alone. The stock trading app market swelled to $9.63 billion and is projected to hit $30.39 billion by 2034.

We democratized trading. Mission accomplished, right?

Not exactly.

The $15 billion study revealed something stunning: options now constitute over one-third of all retail trades. Think about that for a moment. Complex derivatives that require deep understanding of time decay, implied volatility, and risk management now make up more than a third of how regular people invest their money.

It's like discovering that a third of people learning to drive have decided to start with Formula 1 racing.

The results are as predictable as they are devastating. The researchers found that retail options traders consistently lose money—not sometimes, not occasionally, but systematically. When they examined trades around earnings announcements (a favorite time for options speculation), they discovered retail investors losing 5-9% on average per trade.

But here's what makes it worse: these aren't small bets. The study tracked individual traders making thousands of transactions, some losing tens of thousands of dollars. The aggregate losses? $3 billion during the study period alone.

To put this in perspective, that's enough money to fund a small country's annual budget. Instead, it evaporated into the pockets of professional market makers who knew exactly what they were doing.

While options trading grabbed headlines, day trading was busy destroying wealth on an even more systematic scale. The University of California's landmark study revealed something that should be taught in every high school economics class: only 3% of day traders make money.

Three percent.

Imagine if 97% of people who tried skiing broke their legs. Imagine if 97% of restaurants failed within their first year. Actually, that second one isn't hypothetical—about 80% of restaurants do fail, and we consider that industry brutally difficult. Day trading has a failure rate that makes opening a restaurant look like a safe bet.

But the data doesn't lie. The most active traders—the ones doing this full-time—earned 11.4% annual returns while the market returned 17.9%. They weren't just failing to beat the market; they were getting crushed by it.

Even more sobering: 40% of day traders quit within the first month. Only 13% make it past three years. And of those stubborn enough to persist? Only 1% achieve consistent profitability over five or more years.

Dr. Eric So, the MIT professor behind another major retail trading study, discovered something fascinating when he examined why smart people keep making these mistakes. It wasn't lack of information—if anything, retail traders today have access to more market data than professional investors had twenty years ago.

The problem was psychological.

"Overconfidence emerges as the most destructive bias affecting retail traders," So found. Overconfident investors trade 45% more frequently than average, and that extra trading doesn't improve returns—it destroys them.

The gender differences in his data were particularly stark. Men trade 45% more than women due to overconfidence, resulting in returns that are 2.65% lower annually. That might not sound like much, but compounded over decades, it represents hundreds of thousands of dollars in lost wealth for the average investor.

Here's the kicker: even when controlling for financial knowledge and experience, overconfidence persisted. Education helped with understanding markets, but it couldn't cure the fundamental human tendency to believe we're better at predicting the future than we actually are.

The rise of mobile trading apps was supposed to level the playing field. Instead, it created a generation of impulse traders.

Consider what happened when Yahoo! Finance shut down its free API in 2017—an event that forced many retail traders to lose easy access to real-time market data. Researchers studying this natural experiment found something remarkable: retail trading volumes dropped 8.6-10.5% within a month, and the remaining trades became more predictive of future returns.

In other words, when it became slightly harder to trade on impulse, people made better decisions.

But the industry moved in the opposite direction. Apps got slicker, easier, more addictive. Push notifications started arriving with rocket ship emojis. Social features let you share your trades and follow other "successful" traders.

Nothing crystallized the new reality of retail trading like the GameStop saga of early 2021. Reddit's WallStreetBets community grew from obscurity to 16 million members almost overnight. Posts with rocket ship emojis and "diamond hands" memes drove billions in trading volume.

The narrative was intoxicating: finally, retail investors were banding together to take on Wall Street. David was fighting Goliath with call options and social media coordination.

But research on the actual outcomes tells a different story. Studies of positions created during peak social media attention found average returns of negative 8.5%. While a few traders made spectacular gains that dominated headlines, the majority lost money—often substantial amounts.

GameStop itself provides the perfect example. It peaked at $347 in January 2021 amid the frenzy. As of late 2024, it trades around $20. Many of the retail investors who bought during the excitement and held with "diamond hands" watched 90% of their investment evaporate.

The meme stock phenomenon wasn't David beating Goliath—it was Goliath learning to profit from David's emotions.

After analyzing decades of research across multiple markets and millions of trades, the conclusion is inescapable: active trading is a negative-expected-value activity for the vast majority of participants.

This isn't a moral judgment about trading—it's a mathematical reality. The combination of transaction costs, behavioral biases, and professional competition creates an environment where retail traders systematically transfer wealth to more sophisticated market participants.

The traders who succeed—and they do exist, though in tiny numbers—typically possess some combination of exceptional discipline, substantial capital, sophisticated risk management, and emotional control that borders on the superhuman. They're statistical outliers, not evidence that the system is beatable for ordinary people.

The question isn't whether retail trading destroys wealth—the research has settled that definitively. The question is whether we're going to keep pretending otherwise or start having honest conversations about what actually works.

Some more random thoughts: Spreads on mortgage-backed securities are at historically high levels.

Prepayment risk is minimal.

The two biggest buyers are out of the market.

This makes mREITs like the ones we own in the paid letter a high yielding, solid total return opportunity.

With CRE much closer to a bottom than a top, the same can be said of select CRE mREITs.

Banks are healthier than the public and the instant experts of the internet want to acknowledge. Many of them represent high dividend and dividend growth opportunities.

On paper it should be hard for the Baltimore Orioles to be this bad. Whatever magic Elias had appears to be gone.

The interesting research on maximizing returns is not in trading strategies.

It is in risk management and leverage levels.

Yes, I will have more to say about this in fairly short order.

I get asked a lot about closed end funds and when we will be revisiting that topic.

It is going to be a while. Discounts have contracted thanks to strong market sentiment and activism.

We have not suggested selling any of the old positions, and former subscribers who have patiently collected the dividends and seen narrowing discounts have been handsomely rewarded.

It is a tad warm. Apparently, Thunder Dome is not enough. Now we have Heat Domes.

This is why we have lemonade and ice cream.

Every day that passes brings us a little bit closer to the start of college football season. Notre Dame will contend. Navy looks solid. The Archie Manning and Longhorns show should be entertaining.

A Tigers-Cubs World Series would be old school entertainment.

Phillies-Yankees would be a blood feud.

The Blue Jays are a tempting bet at +1300.

If you are in Greensboro or Cary, North Carolina, then dining at Lucky 32 is a must. We ate at the one in Greensboro last night and everything from start to finish was superb.

Jeremy Grantham on a recent podcast with Jesse Felder of the Felder Report:

"Don't be conned into being super-optimistic by the industry that makes money from overconfidence. Look around for signs of crazy bubble behavior which we have seen as splendidly in this last several years as we have ever seen in history."

Felder also pointed out that Mark Hulbert recently pointed out that insiders have never been as bearish as they are today.

Very little has been said about Druckenmiller's first quarter purchase of CCC Intelligent Solutions Holdings (CCCS), a fascinating company that is bringing AI and cloud to the property and casualty insurance industry.

We are closing in on second quarter 13F filings and I will be very interested to see if he added to the stock.

That's all for now. Stay cool, stay hydrated, and stay profitable.