What I’ve Learned From Waves (So Far): Inflation Edition By, D.R. Barton, Jr.

“If you want to know everything about the market, go to the beach. Push and pull your hands with the waves. Some are bigger waves, some are smaller. But if you try to push the wave out when it’s coming in, it’ll never happen. The market is always right.”

—Market Wizard, Ed Seykota

After the big U.S. Consumer Price Index report was announced yesterday (April 12, 2022), inflation is front of mind for almost everyone. The CNBC headline screams, “Inflation climbs 8.5% in March, highest level since December 1981”. That’s a bit misleading since the 8.5% number is a year-over-year number, but it is a BIG number. And, many traders and investors today have not navigated higher inflation markets since we technically haven’t had high inflation markets for a decade (or for four decades, depending on how you’re counting):

There are a lot of analysts who will give you best guesses for how high inflation will go and how long it will last. But for now, the bottom line is that this wave of inflation IS here. There are some signs that the momentum of inflation is slowing (the rate of change) – we’ll see a few of those indications below. And even if that’s the case, there are very few signs that inflation will revert all the way back to “low and slow” anytime soon. So, riding this new wave is one of the most important things we can do as market participants. As our quote from Ed Seykota shows, understanding big forces is a key market requirement. (Ed taught in Van’s courses back in the late ‘80s and early ‘90s)

Surfing the Next Big Wave

My guess is that many of you in our Van Tharp Institute demographic can empathize with my situation – I have adult children who are deep in the middle of establishing careers and new family relationships. And that means that we don’t get to spend as much time together as I’d like. But in the last couple of weeks, we got to enjoy a trip together as a family on the island of Maui. We got to watch whales from our balcony, snorkel, hike, and just enjoy each other’s company. We also got to do one of the most cliché Hawaiian things—surf.

But I’m a surfing purist. No silly boards. No sails. No kites. Just me and the waves. That’s right, I’m not really a “hang ten” surfer. I’m a body surfer. My friends who use mechanical contraptions to help them ride the waves look down on body surfing as a simplistic pursuit. That may be the case. But there’s something pure and untainted about this pleasurable activity—just me and the water.

For those of you new to body surfing, it is largely an issue of finding the right wave, and then leaning into the oncoming wall of water at the right instant so the wave rushes you to the shore. The combination of a little bit of speed and a whole lot of rushing water all over your body makes this a very tactile experience that is both fun and easy.

Trading analogies are legion. But as I enjoyed the body surfing, my head was filled with the similarities between body surfing and trading. I’ll talk about a few of these today and save a few for another time; I think there are some truly important lessons here and some key ways that you can improve your trading and investing by thinking like a surfer.

Catch a Wave and You’re Sitting on Top of the World…

There are many investing tools and techniques that mimic the natural phenomenon of waves (e.g., Elliott Wave Theory). Treating the market as a wave to be surfed is a very natural extension.

When body surfing, catching a good wave should be easy. In the type of body surfing that I enjoy, one of the real pleasures is that, once the wave comes, I have to do almost no work.

The technique is this: When the wave conditions are right, the most important thing is to wait for the under-the-surface “pull” away from the beach. This is the returning water from the last wave. If you have enough temporary current pulling back toward the ocean, almost any size of wave will give you a great ride in. All I must do, if the proper “pull” is there, is to lay my body parallel into the wave and it will turn me 90 degrees and push me into shore with a rush. No swimming, no mad paddling, just laying gently down into the wave.

I think the best trades happen the same way—they seem to be effortless. I believe the ease with which I catch a wave has a direct relationship to catching a great, easy trade. The set-up makes the entry very easy. I do all of the “work” just to get ready to catch the wave. I have to fight my way through the surf to get out to the optimum spot. I have to wait patiently for the proper amount of “pull”. And I have to choose a wave that hasn’t already started to break. If I do those three things, then catching the wave is pretty easy. Getting in on a great trade is similar; if I have a workable plan and if I’m patient enough to follow the plan, I can catch great, effortless trades.

Of course, not every wave is a great ride. When I catch a wave, one of three things will happen.

  1. I won’t really go anywhere; the wave pushes me a few feet, but I end up basically where I started. This happens when there is not enough “pull” or if I have poor timing catching the wave.
  2. The most desirable thing is when I hit the wave just right and get a great ride into the beach.
  3. Things can go poorly. I can catch the wave a little too late and it “breaks” on top of my body and crashes me down into the sand. I have plenty of scrapes and bruises from doing this! And Hawaiian waves are much stronger than those I’ve experienced on the east coast of the U.S.! Another ominous variation of this third option can happen, especially if the waves are wind-made. I’m talking about a second wave that intersects the one I’m riding from a different angle. This contorts my body and disorients me while slamming me into the sand. Not very pleasant.

With all three of these outcomes, I see useful trading and investing analogies. When I catch a wave that doesn’t take me anywhere, I can stick with it or I can bail out and go back to wait for another, better wave. With a wave that moves my way immediately, I find myself enjoying the ride. That’s it. I’m not thinking about the last wave that didn’t work out or the next wave that’s coming. I just enjoy the moment.

I think all of our trading activities would be better if we could focus on the trade at hand and not worry about how bad that trade four days ago was, or about whether we would ever get a move like this again. Stay in the moment to get the most enjoyment out your trades.

Lastly, there are the trades that figuratively knock us into the sand. How do you respond to trades like these? Do you get back up and calmly look for the next trade? Or do you sulk and play the “poor me” game? We all catch a bad wave or a bad trade. That’s part of the game. How we respond to those unpleasant episodes will dictate how well we play.

I think that the waves that blindside me are the most interesting. They are unusual but not rare. We have outside influences that hit us in trading as well. How well are you prepared for an unexpectedly early Fed rate hike? How about really bad, or really good, geopolitical news? Even a good trade can get punished for reasons that are outside of our current point of view. Techniques like visualizing best and worst-case scenarios can help a trader be prepared for these events.

One day we saw some really big waves and I thought about the markets and what you do when things get rough. When the waves started to get bigger and stronger last week, most folks headed for the safety of the beach. To some, the whitecaps looked too rough, while for others, those big waves looked like an unexpected treat. The same can be said for the markets.

At extremes, when prices have pushed to new highs or lows, some run for safety and others lick their lips in anticipation. Neither reaction is right or wrong. We just need to know what we want to do at extremes.

There is big money changing hands by “trading at the points of maximum pain or euphoria” as one top trader puts it. For others, these rough areas are best avoided. Which is right for you? Do you like the consistency of routines? Then your strategies should have you on the sidelines or at minimum on “high alert” when the market is approaching extreme price levels. On the other hand, if you handle uncertainty well and manage risk and emotions with ease, then trading these extremes could be a source of opportunistic profit potential. Spend some time reviewing your reactions to and performance during the price extremes that we have seen in the past few years. How would you like to position yourself the next time the market probes an area of price extremes?

What do you see when you look at the ocean?

This is a bit “touchy-feely” … but the concept is important; when you look at the ocean, and the movement of the water, what do you see? Some see cycles, some see the inevitability of going with the flow (or with the trend). But it’s hard to argue with the power and constancy of motion. Both are always there. If you approach the markets and don’t understand the power, you can easily get swept in the wrong direction.

And just when you think that you’ve figured out how things move, you can be sure of one thing—they’ll change again. The markets, like the sand and waves, are in constant motion. We have to adapt to new conditions. We’ve seen huge market changes in recent decades: the 2000 dot.com bubble showed us that the market doesn’t like certainty. Things don’t keep just going up. And 2003 showed us that they don’t just keep going down either! 2007 and 2009 showed us similar lessons in very different ways. And the big bull market of 2010 showed us even more nuances of the market that creep up for long periods of time—when modest pullbacks seem bigger than they really are. 2020 brought a once-in-a-century reality check to markets of all kinds. And now, the highest inflation numbers that the U.S. has seen in four decades have us looking at something else that’s new to most traders and investors today.

I promised a couple of quick insights into that 8.5% Year-over-Year Consumer Price Index number that was reported yesterday.

  1. Roughly half of the March headline increase was due to higher energy prices… They were up 11% month-over-month and an eye-popping 32% year-over-year!
  2. Food was up 1% month-over-month and 8.8% year-over-year. Again, that is the highest level since 1981.
  3. Used vehicle prices came in lower, as expected—down 3.8% month-over-month. That’s the biggest month-over-month decline since 1969 and some welcome relief from this bubble market.
  4. And the specter of rising rates is already cooling the red-hot housing market: Home construction investors are bailing out of that market with the Home Construction ETF off 30% from highs earlier this year:

Bottom line on inflation outlook:

a. Energy can’t keep up this torrid pace

b. Food prices probably can for a while

c. Homes and cars seem to be slowing down

d. WE MAY BE SEEING THE FIRST SIGNS OF INFLATION SLOWING (not dropping, but “rate of increase” slowing)

e. And, the Fed will take big action in tightening, so we’re looking at higher interest rates for a while

As always, please send me your thoughts and comments. I always love to hear them and I answer as many as I can! Email them to drbarton “at” vantharp.com

Great Trading and God bless you,

D. R.

P.S. In last week’s article I said, “In my next article, we’ll take a look at some potential ways to play these rocky pullbacks in the companies that are still bringing in tons of profits.” We’ll get to those soon, but this inflation number was too big to ignore.

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