For those who have never played Blackjack or 21 as it is also known, we will first provide a brief primer.
A dealer, typically from a shoe of six or more standard 52-card decks, deals out cards to a group of players. Each player gets two cards and both are face-up, so everyone knows what each player is holding. The dealer also deals two cards to himself/herself; however, only one of the dealer’s cards is face-up, while the other is face down (the hole card) and thus unknown to the other players and the dealer. The only goal for each player is to beat or outlast the dealer.
Each player must then decide whether or not to ask for additional cards (take a hit(s)) based on what he/she is holding and what the dealer’s “face-up card” is showing. A player can continue to take hits as long as his/her total does not exceed 21 total points, with each numbered card counting for that amount (so a four is worth four points), aces counting for one point or eleven points (it is the player’s choice), and face cards counting for ten points. The closer you get to 21 without going over, the more likely it is you will beat the dealer. If you go over 21, you have busted and thus lost the hand regardless of what happens to the dealer. If you are dealt 21 (a ten or a picture plus an ace), you automatically win your hand (and get paid a little extra) as long as the dealer was also not dealt 21 in his/her first two cards in which case it’s a tie (push) and no money is won or lost.
The dealer, on the other hand, after all players have drawn their cards, will first reveal the hole card and then begin taking hits. The dealer must take hits if his/her total is below 17, but once his/her total is at least 17, but not over 21, the dealer must stop drawing cards. Any players that did not bust who have higher totals than the dealer win the hand (ties are a draw and no money is won or lost for that player), while any players below the dealer’s total lose the hand. If the dealer exceeds 21, he/she has busted and any players who did not bust – win the hand.
Now, the basic strategy of Blackjack is to always take an additional card if your total is below 12, as there is no possibility of busting. Once your total is 12 or more, the dealer’s face-up card becomes important. For example, if the dealer is showing a five or a six, a good strategy would be not to take a hit even if your total is say 12 or 13 as the odds say that the dealer’s hole card is worth 10 points (in a standard deck, more than 30% of cards are worth 10) and thus the dealer is going to have a total of 15 or 16, which will force him/her to take a hit with a high likelihood the dealer will bust (for example, with a 16, ~62% of drawn cards would bust the hand). Conversely, if the dealer is showing a seven or higher, players may want to continue hitting until they get to 17 or more, as there is a high likelihood that the dealer will have 17 or more and thus in a winning position against any players that “stay” with hands below 17. For more on this, rent Rain Man.
While opinions among blackjack players may differ on the above, one near universal truth is that if you are holding 17 or more, you should not take a hit, regardless of what the dealer is showing. Why? Because nearly 70% of cards would bust a hand of 17 with even higher odds of busting when one has 18, 19, or 20. Thus, even if the dealer is showing 10 and the player has only 17, the odds greatly favor not taking a hit for that player as there is a ~70% chance the player will bust, while there is only a ~54% chance the dealer has 18 or more.
Hitting on 17
It is this particular thing – hitting on 17 – that we are concerned about. Why? Because as anyone who has ever played blackjack in Vegas knows, occasionally, someone at the table will hit on 17. Now, when this happens, there is generally a collective sigh at the table, some mumbling of colorful metaphors, and the dealer, who rarely says anything, will even chime in making sure that the player is aware of what he/she is about to do. The fascinating thing about hits on 17 is that when the player wins, there is often a “see, I told you I should hit on 17” look from the player. But as Michael Mauboussin notes (anyone who wants to read great books about investing, pick anything from Mauboussin), this is confusing process with outcome. The outcome was great for the player, but the process – hitting on 17 – was deeply flawed.
From our lens (this is the segue part of our missive), 2023 feels a bit like hitting on 17. Recession risks for the second half of 2023 are high. Is it possible that a recession is avoided and the economy, rather than having a hard landing or a soft landing, has no landing at all? Of course – employment remains remarkably strong. The U.S. created more than 500k jobs last month, while Canada created 150k (the equivalent of 1.5mn in the U.S. if we adjust for population differences). Neither of these numbers is remotely close to recessionary where job creation typically goes negative for a period of time prior to and during the recession. But, the yield curve has been deeply inverted (short-term rates higher than long-term rates) for more than 8-months, and the yield curve has a pristine record of predicting recessions (recessions are in grey in the chart below – note the inverted (negative) yield curve that precedes each one):
In January, the market staged a remarkably strong rally (it was the sixth strongest January in 68-years). While strong January’s usually mean a strong rest of the year, we were skeptical. With recession risks high, valuations that are broadly not all the compelling (above average in the U.S. and close to the average in Canada), and the likelihood that earnings come down in the second half of the year (which will make stocks more expensive) our view was and is that it feels a bit like hitting on 17. Our process dictates caution and patience when recession risks are high and valuations do not reflect those risks, even though there is some possibility that the market draws a four on seventeen. We would also note this:
While the rally in January already had our hackles up, the nature of the rally – which was driven mainly by low quality stocks (stocks with low or negative earnings, high debt levels and limited growth), increased this, err, hackle-ness state. Investors, far from hitting on 17, might have even been hitting on 18, 19, or 20.
Things can Change
An obvious question might be – so is this the tale of 2023? Our answer is no. We do believe at some point this year, the pathway to higher stock prices with a balanced amount of risk will develop. This is likely to come to pass in one of two ways: 1) either stocks get cheap enough such that even though the economic outlook is mixed, the opportunity to buy good businesses at attractive valuations is too great to pass up (hitting on an eleven when the dealer is showing a five); and/or 2) the economic outlook improves, which would not only improve the earnings outlook, but also the argument for higher valuations.
Until then, we are going to stand on 17.