Good Morning,

Stocks closed mostly flat on Friday amid a strong dollar and as earnings season continued.

The S&P 500 ended around breakeven after holding lower for most of the session, with consumer discretionary leading advancers. Consumer discretionary stocks were led by Time Warner, which rose more than 7 percent amid reports the firm has engaged in talks for a deal to be bought out by AT&T, which dragged the telecommunications sector lower.

So far Q3 earnings have been pretty good according to data compiled by The Earnings Scout, 80 percent of the 116 S&P components that had reported as of Friday morning had beaten Wall Street's earnings estimates, while 65 percent had beaten revenue estimates. This week also saw encouraging beats from Microsoft, Netflix and MacDonald’s in addition to a juicy bid announced by British American Tobacco to acquire one of Logos LP’s holdings Reynolds American (RAI). Look for strength next week as Apple, Amazon and Google report.

Our Take: The investment mood is still downright miserable. Hedge funds are bleeding money, closing up shop and complaining that: “There’s gloom everywhere,” or that the financial crisis “was a sudden death for a lot of people, like a heart attack, but this feels like cancer to many people, a slow death.” Or that “There was a playbook based on logic that worked most of the time before 2008...But the game has changed and logical investors haven’t got the new playbook figured out yet.”

The International Monetary Fund chief economist Maurice Obstfeld said in October, while presenting the fund’s 2017 outlook, that “taken as a whole, the world economy is moving sideways” with other pundits stating that: “The crisis has left a cocktail of interacting legacies—high debt overhangs, nonperforming loans on banks’ books, deflationary pressures, low investment, and eroded human capital—that continue to depress potential investment levels.”

Furthermore next year ends in a 7. If you’re superstitious or a little loose with statistics, that makes us due for another financial crisis. The biggest one-day stock drop in Wall Street history happened in 1987. The Asian crisis was in 1997. And the worst global meltdown since the Great Depression got rolling in 2007 with the failure of mortgage lenders Northern Rock in the U.K. and New Century Financial in the U.S.

And if that wasn’t bad enough, calls for a correction in Silicon Valley are multiplying. Bloomberg reports that “things were different in Silicon Valley in the distant year of 2012, when iPhone sales were skyrocketing and you could still buy a house in Palo Alto for less than $2 million. Back then, most restaurants had menus, not tasting menus. Chief executive officers could say something grandiose at a tech conference without worrying about getting mocked on HBO six months later by the Beavis and Butt-head guy. And a talented entrepreneur could walk into a venture capitalist’s office, say his startup was a mobile-first solution for pretty much any problem (payments! photos! blogging!), and walk out with a good-size seed investment. “That pitch was enough to get going,” says Roelof Botha, a partner with VC firm Sequoia Capital. “It’s not enough anymore.””

Well from where I’m sitting things aren’t that bad. There are still plenty of ways to outperform the market if one is patient and thoughtful in their approach. (We would be happy to show you how we do it.)

Furthermore, as I’ve stated before being bearish costs nothing and quite frankly is a healthy sign of a market that hasn’t yet peaked. The most likely scenario is a sideways market in which returns will be more difficult to come by but this is how systems work. Reset expectations and take a close look at what the market is now offering you.

There are still many individual businesses that are generating immense shareholder value growing their top and bottom lines. Instead of “whining” about a “rigged system” or “unconventional central banks” or a “climate you don’t understand” or “no longer recognize,” enjoy the challenge. Relish in it. It is through adversity that growth occurs. Life like investing is in many ways simple. But never easy….

Thought of the Week

"Times of transition are strenuous, but I love them. They are an opportunity to purge, rethink priorities, and be intentional about new habits. We can make our new normal any way we want.” –Kristin Armstrong

Stories and Ideas of Interest

A visual history of US elections and global markets suggests business as usual. A few weeks ago I addressed the question of whether a Trump victory would send the markets into a tailspin. My answer was that a win by either candidate would most likely have very little impact. Chris Groskopf and David Yanofsky, after charting changes of power in the White House going back to 1992, show that market reactions to new presidents are generally a great big “meh.” Ignore the noise.

The real danger of Donald Trump’s conspiracy theories. The Republican nominee is whipping up his supporters into a state of paranoia, convincing them that the election will be rigged and everyone is against them. To prevent violence, Sarah Kendzior argues, Trump’s critics—especially Republican ones—should stop pressuring him to drop out; it just gives him ammunition. Furthermore, the claims are unfounded. “It is more likely that an individual will be struck by lightning than that he will impersonate another voter at the polls,” said a 2007 report from the New York University School of Law’s Brennan Center for Justice that the center has been referencing in light of Trump’s claims.

An alternative way to cope with failure. At present there is a craze for celebrating failure in entrepreneurial culture. The problem is that it is confined to those who’ve eventually made it big. What about those who haven’t? Bene Cipolla argues for a new way of confronting failure: accept it. Bask in it as it can be life giving.

The smart money suggests that Italy will leave the EU. The country’s outflows are accelerating - up €118 billion ($130 billion) from just a year ago. No I suppose we haven’t seen the last of troubles originating in the EU….

We need to plan for a future without jobs. Very interesting article in Vox from Andy Stern former president of the Service Employees International Union (SEIU), which today represents close to 2 million workers in the United States and Canada. A Universal Basic Income is coming…..Consider the types of businesses on Forbes’ list of 25 Next Billion Dollar Start-Ups….Lots of “productive” software offerings…. What are you worth anyway? Career website Glassdoor Inc. is releasing a new tool aiming to help employees find out if what they are earning is fair based on their location, employer, job title, years of experience, and education. Is it a cruel world that our efforts have been reduced to each worker having a simple fair “market value”? Or is this a helpful tool?

Toronto real estate looks set to slow down. Evan Siddal CEO of the CMHC raised a red flag this week and stated in relation to the new real estate measures: “If people can just save a bit more money and have a bit more equity in their homes, that would be safer,” Mr. Siddall said. “A 5-per-cent down payment means you don’t have a lot of cushion on the downside.” Yet he states that there may be unintended consequences. Luckily Toronto Life Magazine looks into their crystal ball and finds that the average home in Toronto in 50 years will be 4.4 MILLION….(average price now is $620 000 which represents 7% CAGR over next 50 years. A lot can happen in 3 years let alone 50…)

All the best for a productive week,

Logos LP

"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent." -Charlie Munger

On a recent trip abroad I took some time to think about the decision of 51.9% of UK voters to leave the European Union. As I sifted through the commentary regarding the historic vote, what struck me was how wrong the "experts" got it. The consensus of public opinion experts - at least if one uses prediction markets as a proxy - was that voters would in the end decide to stay in the EU. At certain points on Thursday before the results of the vote were released, the probability of a "remain" vote implied by betting odds stood at 90 percent. Furthermore, the majority of hedge fund managers worldwide looked at the stats and also concluded that the law of averages supported their decision to position for a "remain" vote to pass. Even the billionaire hedge fund manager Leon Cooperman told an audience of Wall Street insiders on Wednesday that there was a 70 percent probability that Britain would stay inside the European Union. "I don't worry about Brexit," he added. I myself as Head of Strategy at my investment firm Logos LP also made this mistake.

How could we all have been wrong? How could we "experts" have been caught flat footed in the face of an outcome the statistical averages so clearly suggested? The chapter on mathematics from one of my favorite books on investing by Robert Hagstrom suggests an answer: the concept of variances. Most people look at averages as basic reality, giving little consideration to the possible variances. Most of us have a tendency to see the world along the bell shape curve with two equal sides, where mean, median and mode are all the same value. The reality is that things are not so neat. Things do not always fit in a symmetrical distribution and instead skew asymmetrically to one side or another. What causes a distribution to skew to left or right is variation. As variation on one side or the other side of the median increases, the sides of the bell curve are stretched either right or left.

What does this mean in the context of Brexit? Without diving too deeply into the specific reasons 51.9% of UK voters choose to leave, many voters demonstrated high variance. Research has shown that in our "modern" digital age people make up their minds too late. According to a recent report by the market research firm Opinium, 20 percent to 30 percent of voters make a final decision within a week of casting their ballots, half of them on the day of the vote. This suggests that although a majority of UK voters polled to stay within the UK many politicians and experts ignored or simply downplayed the widespread attitude of disillusionment and misunderstanding amongst the electorate. This high variance pulled the curve to form a right skew.

In a right skewed distribution, the measures of central tendency do not coincide; the median lies to the right of the mode and the mean lies to the right of the median. If the experts had been more attuned to the concept of variance they would have been able to think deeply about the characteristics of those voters who populated the right skew of the distribution. Those individual voters who were so disillusioned with the status quo (remain in the EU) that they were unable to make up their minds until the last minute. Perhaps this knowledge would have changed their predictions.

Either way the above explanation leads me to believe that our culture favors a powerful bias to neglect or ignore variation. As the result of the Brexit vote demonstrates, focusing exclusively on measures of a central tendency can lead us to make significant mistakes.

Is there a lesson for investors? The answer is yes. As suggested by Hagstrom, perhaps the most important lesson for the prudent long-term investor is to grasp the differences between the trend of the system and the trends in the system.

There is an important distinction to be made between the average return of the stock market and the performance variation of individual stocks. To illustrate the significance of this lesson one has only to consider periods in which the S&P 500 (NYSEARCA:SPY) has been stuck in a sideways pattern. Consider the following charts:

The above chart shows the S&P 500 from 1995 to present. Albeit a recent breakout which began July 1, 2016, note that from roughly December 5, 2014 the S&P 500 has gone sideways. Consider the following chart which provides a more recent snapshot:

For the vast majority of an investor's lifetime he or she will be exposed to either bull or bear markets which either go up or down. Yet at present, the investor appears to face a sideways market in which the major indexes remain range bound without a significant and sustained move higher or lower. Should investors thus conclude that stocks are a poor long-term investment?

Can history offer any insights? Consider one of the most pronounced sideways markets in history which occurred between 1975 and 1982. On October 1, 1975, the Dow Jones Industrial Average (NYSEARCA:DIA) stood at 784. Roughly 7 years later, on August 6, 1982, the Dow closed at the exact same 784. Fast forward to the present and with the market currently appearing to be stuck in a similar holding pattern, many forecasters and "experts" are concerned. They fear that in light of corporate earnings declines, weak global growth, unprecedented global monetary policy and investor complacency p/e multiples will fall leading to at worst a major correction or at best a prolonged period of low returns i.e. a sideways market.

It is no wonder that investor bearishness is at a record high. Based on research conducted by Bank of America investors ended June with the highest cash allocation on record at 5.7% on average and the lowest equity allocations in 4 years. Moreover, it looks as if investors are capitulating into bonds with an annualized year-to-date return from global government bonds at 25% in 2016, the highest return in 30 years. These three bearish indicators combined with the fact that inflows into precious metal funds hit a record during the first week of July, all point to the fact that investors are very bearish on global equities. Furthermore, Bank of America, Merrill Lynch's Bull & Bear Indicator, fell to an "extreme bear" reading of 1.6 on June 28. Is the "herd" right about the system? Should investors stay away from stocks?

In Hagstrom's book he points out that during the sideways market explained above which lasted from 1975 through 1982 Warren Buffett and Billy Ruane were both able to generate impressive returns. During this period in which the DOW gained exactly 0 percent, Buffett was able to generate a cumulative return of 676 percent and Ruane was able to generate 415 percent…

It would appear that the herd might be correct in their read about the trend of the system but dead wrong about the trends within the system. Diving deeper, Hagstrom found that over the 8-year period, only 3 percent of the 500 largest stocks on the market at that time went up in price by at least 100 percent in any one year. Yet over rolling 3 year periods, 18.6 percent of the stocks, on average, doubled. That equals 93 out of 500. But when the holding period was extended to 5 years, an average of 38 percent of the stocks went up 100 percent or more; that's 190 out of 500.

What a mistake it would have been to focus on the market average and avoid stocks altogether during this period. To have done so was to ignore the variation within the market and thus to miss out on the myriad of opportunities to generate excess returns by investing in high quality businesses.

Whether using averages to forecast the probable result of votes such as Brexit or perhaps the US presidential election or the future returns of the stock market we would do well to pay attention to the role variance plays as we distinguish between the trend of the system and the trends in the system. We may find that there is much more at stake than simply our ability to generate excess returns over the long term…

For original article published on SeekingAlpha click here.