Cauliflower Ears

If you’ve ever traveled in the world of wrestling—or MMA, judo, or jiu-jitsu—you know that sometimes people get “cauliflower ears” from years of getting their heads ground into the mat. It’s a disfigurement, but also a good one, because if you’re in a bar getting tuned up and thinking about getting up in some guy’s grill, you do not want to do it to the guy with cauliflower ears. He’ll flip you like a cheese omelet.

I have cauliflower ears from 26 years of trading. For sure. Cauliflower ears are earned from losses, not from gains. I sure have had some losses. The first time it happens to you, it is a bit of a shock. The 100^th time it happens to you, you view it with some equanimity—easy come, easy go. 

What I am seeing today is that there are a many people sitting on a lot of paper gains who have not earned their cauliflower ears. Aside from a mini-crash in 2020, and a couple brief bear markets in 2018 and 2022, nobody has any battle scars. And if you bought the dip in each of those cases, there was really no pain to be felt. Just because we have gone a long time without a big bear market doesn’t mean that we are going to have a big bear market, but if it happens, it will come as a surprise to a lot of people.

Here's an interesting tidbit: Anyone under the age of 39 had no experience with the financial crisis in the markets whatsoever. Someone who graduated from college in 2008 was 22, and 17 years later, they’re 39. 39-year-olds are managing directors at banks. 39-year-olds are running hedge funds. They never saw what I saw, a sustained 80–90 VIX environment over a period of months, with 10% intraday moves. They never saw the S&P 500 go down 19% in a single week.

The 2010s were pretty quiet, relatively speaking. There has been more volatility in Trump’s second term but nothing catastrophic. I’d add to this and say that nobody under the age of 45 has had any significant amount of responsibility since the financial crisis. We’re getting to the point that most bank and hedge fund employees have had no contact with the financial crisis whatsoever. Just the old newsletter writers like me.

“Smart Retail”

DoorDash has a $113 billion market cap, higher than Nike and Starbucks. Palantir has a $441 billion market cap. Duolingo, the crappy language-learning app, has a $17 billion valuation. Things are plenty goofy out there. 

I did some plumbing on Twitter last week and tested the sentiment and found that people are definitely confusing brains with a bull market. Someone referred to “smart retail” with a straight face. Smart retail? I have never heard of such a thing. Next time you are in the barbershop, and people start talking stocks, pay attention to the tickers, and then go home and short the bejabbers out of them. Listen to what people talk about at the neighborhood cocktail parties, the taxi drivers, the brother-in-law with the failing tractor business. I think my problem these days is that I don’t encounter enough dumb people.

So, to be clear, I am bearish, and I am probably early, but I am a lot less early than I would be when I was younger. For most of the readers of this newsletter, I would encourage you to lighten up on some of your stock holdings. You don’t have to get out all at once. You don’t have to top-tick the market. You can average your way out. And if you have a portfolio with 20 stocks in it, you will probably sit there and look at your portfolio and try to figure out which stocks have the potential to go down the most. 

One thing I have learned over the years is that in a bear market, stocks go down—all stocks go down, with the possible exception of Walmart. If it is a stock, it will probably go down. I’ve gotten myself into plenty of trouble over the years “hiding out” in stuff that I thought would outperform.

Confusing Brains with a Bull Market

I want to get back to this concept of confusing brains with a bull market. If you own stocks, and stocks are going up, you are being rewarded for taking risk at the right time. Did you know it was the right time to take risk? Probably not—you felt secure in your job and your financial situation, and you thought you were in a good position to take risk.

Don’t get me wrong, there are a lot of strong fundamental reasons why the stock market is going up. The AI boom. Trumponomics. What could be a declining interest rate environment. Deregulation. Taxes aren’t going up, especially on capital gains. I can think of lots of reasons to be bullish. But if you remember, I am the sentiment guy, and I can tell you that bullish sentiment has just gotten goofy. Of course, it can get goofier, as everyone knows.

Remember, the two sources of financial stress are debt and risk. If you have a lot of risk on right now, you will probably feel better if you make some sales. But people don’t because they are operating under a regret minimization framework. They don’t want to make sales and then watch their stocks go higher. You can’t think about it like that. You make the decision, and you live with the decision. You don’t have to make infinity. You don’t have to top-tick everything. Be a scale-up seller of stocks.

Note that nowhere in here did I say that the market is going to crash. I am not a doomer. This is all about risk management and being able to sleep at night. Take it from the guy with cauliflower ears.

Jared Dillian, MFA