The Perception Gradient: Buy Bad-to-Less-Bad
Position for the shift in sentiment, not the shift in fundamentals
- Difficulty
- Moderate
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 78%
Slimmon's mechanism starts from a base-rate observation: the S&P has been positive in 67 of the past 93 years and has produced back-to-back down years only eleven times, so a down year raises rather than lowers forward odds. Layered on top is Templeton's sentiment cycle, from pessimism through skepticism and optimism to euphoria. The tradable insight is that returns are largest at the earliest transition, when perceptions move from very bad to less bad, because that pivot is the biggest and comes with the least volatility. Fund flows confirm rather than lead: they stay negative for roughly a year after a bear low because of rear-view-mirror bias, and when investors finally return they buy what has not already worked. The symmetric warning is that the largest losses occur when a story slides from great to merely good, since price already embeds perfection.
Origin
Distilled by Andrew Slimmon across more than thirty years at Morgan Stanley and published in his 'Slimmon's Take' notes, drawing on Sir John Templeton's sentiment cycle and on flow data around the 2020 and 2022 market lows.
Core principles
- 01The most money is made when perceptions move from very bad to less bad, not from good to great
- 02Macro conditions change every cycle; investor behaviour does not
- 03Fund flows lag the market by roughly a year, so flows are a sentiment reading, not a signal to follow
- 04The first year off a bear market low delivers the biggest return with the least volatility
- 05The largest losses come when things move from great to merely good
How to run it
- 1
Establish the base rate
Before forecasting, count how often the outcome has actually happened. Positive years are the norm and consecutive down years are rare.
Pro tip Write the historical frequency down before you read any commentary.
- 2
Place the market on the sentiment cycle
Decide whether the prevailing mood is pessimism, skepticism, optimism or euphoria, using what clients and headlines actually say rather than valuation alone.
Pro tip Consensus certainty about a hard landing is a pessimism marker, not an analysis.
- 3
Read flows as a sentiment gauge
Persistent outflows a year after a low tell you the crowd is still anchored to the last drawdown, not that the market is unsafe.
Pro tip When flows finally turn positive, expect the money to chase what has not yet worked.
Watch out Never use flows as a directional signal to follow; they are a year behind.
- 4
Add when the news stops getting worse
Buy into deep drawdowns on the arithmetic of forward returns, accepting that the exact bottom is unknowable.
Pro tip Size adds in tranches so being early is survivable.
Watch out Adding at minus twenty percent can feel idiotic a month later at minus twenty-five.
- 5
Trim what has become flawless
Reduce positions where the story has been priced as great, because the move from great to good is where the biggest losses live.
Pro tip Ask what has to keep going right for the current price to be justified.
- 6
Budget for the volatility rebound
After an unusually low-volatility year, plan for a more gut-wrenching one even if returns are still positive.
Pro tip Pre-agree drawdown responses with clients while the market is calm.
In the wild
With the S&P down about twenty percent, Slimmon published a note arguing investors should add money. The market fell further to roughly minus twenty-five percent, which he said made him feel like an idiot, so he published again noting that the average one-year return after a twenty-five percent drawdown was just over twenty percent. The return off the October 2022 low landed close to that historical average.
→ Acting on the base rate rather than the mood captured the first year off the low, the biggest and calmest leg of the recovery.
During the 2022 bear market, investors piled into dividend, low-volatility and defensive strategies. That popularity pushed the safety factor to an expensive extreme, and coming out of the bear market consumer staples, healthcare and utilities lagged.
→ The hot product of the drawdown became the laggard of the recovery, exactly as the great-to-good rule predicts.
Common mistakes
Waiting for the news to be good
By the time headlines improve, the pessimism-to-skepticism pivot that produces the biggest return has already happened.
Treating flows as confirmation
Flows lag the market by about a year, so following them means selling lows and buying after recoveries.
Assuming a calm year repeats
Low volatility pulls hesitant money back in just before volatility normalises, which is when those investors get shaken out.
Is it for you?
Best for
Long-horizon investors and advisors who need a repeatable way to act against their own recency bias at market extremes.
Not ideal for
Short-term traders needing precise entries, since sentiment can stay depressed well past the point of value.
From the transcript
“by Sir John Templeton. Bull markets are born on pessimism,”
“because that's the biggest pivot and has the least volatility.”
“first year because of that rear view mirror recency bias.”
From the episode
Andrew Slimmon on Quantitative Factors in Markets
Andrew Slimmon