Second-Level Thinking

The right way to be contrarian... European defense stocks have soared... The better European opportunity today... Trade wars are bad for both sides... The challenge of second-level thinking...

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You never know what the stock market will do...

That's one reason investors should learn what author/investor Howard Marks calls "second-level thinking."

That's the title of the first chapter in The Most Important Thing, Marks' 2011 book.

In it, Marks says investors who want to do better than average need better thinking than others – "both more powerful and at a higher level." To think things others haven't thought and do things others don't do, "by definition means your thinking has to be different." He explains...

First-level thinking says, "It's a good company; let's buy the stock." Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell."

First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!"

Marks says first-level thinking is "simplistic and superficial," while second-level thinking is "deep, complex, and convoluted."

Second-level thinking is an excellent lens through which to understand what makes a good contrarian. A good contrarian doesn't simply do the opposite of what everyone else does. I'd call that "knee-jerk contrarianism."

A good contrarian understands investments and markets at a deeper level and can find attractive opportunities in places others don't even look. He goes against the consensus, but in a way that requires the deeper, more complex, and more convoluted thinking Marks says is essential to outperform the average investor.

For example, if you bought European defense stocks three years ago, you made a fantastic contrarian call...

And if you're still holding them, you successfully exercised good second-level thinking skills – twice.

The first time, in early 2022, it meant buying a beaten-down sector that, as far as anyone could tell, would always be somewhat redundant. After all, the U.S. military has been in Europe since World War II, with its own supplies of U.S.-made equipment.

And yet, this was a generally high-quality group of companies that investors were ignoring, mostly due to the fact that U.S. investors don't care about European stocks generally and knew little of the defense industry there. That makes for a classic contrarian call.

The second time, you'd have needed to hang on to your European defense stocks. Through your second-level thinking, you'd have avoided taking gains during the stocks' run-up from 2022 to 2024... And you'd have avoided selling when Donald Trump won the presidency a platform that seemed bad for European businesses.

This second, fresher episode is worth a deeper look, since it's still ongoing...

As it happened, markets have responded to Trump's "America First" policy by buying foreign stocks so enthusiastically that they've consistently outperformed U.S. stocks since early February, when Trump's trade war shifted into high gear.

But it makes sense when you think about it more deeply...

Trump's tariff policies make it more expensive to import foreign goods to the U.S. But other countries have reciprocated with tariffs of their own... which drive up the price of goods they'd been importing from the U.S. That boosts demand for their own domestic products.

In areas where there's a big 'catch up' effect, this could create significant new demand...

Beyond tariffs, Trump wants Europe to pay its own way in the world. He has long accused the European Union of ripping off the U.S. by counting on American funds for European defense.

Now that Trump is cutting off that support, European governments are ramping up defense spending for the first time in decades. For example, Europe's largest economy – Germany – recently said it's planning to spend 500 billion euros on defense, and it has changed the rules on its constitutional fiscal restraints to allow for the extra spending.

As a result of both the Ukraine war and, more recently, Trump's policies, German automotive and defense bellwether Rheinmetall (RNMBY) has been one of the best-performing examples of this new reality.

Rheinmetall was trading below 11 times earnings on February 23, 2022, the day before Russia invaded Ukraine. Three trading sessions after invasion day, shares had risen by 60%. By the end of the year, they were up nearly 79%... by year-end 2023, up 187%... by year-end 2024, up 468%... and as of yesterday's close, up 1,159% since the Ukraine war began.

While it had done incredibly well through early February of this year, the stock shifted into overdrive just days after Trump's trade war rocketed into the headlines... more than doubling in little more than a month. The moment of liftoff is dramatic and easy to spot on the following chart...

If you'd bought the stock in early 2022, you'd have been justified selling it at virtually any time since the end of that year. And yet, it has continued higher. It has been a rocket ship since February.

Now, I don't recommend buying Rheinmetall today, even for a short-term trade. I recommend avoiding any asset that has such a wild trajectory.

Holding a broader basket of European stocks makes more sense to me right now...

Given that tariffs affect far more than defense companies, it's a good bet that a basket will do better from current prices than a focus on European defense stocks, which have become exorbitantly expensive. Rheinmetall now trades at nearly 120 times earnings.

European exchange-traded funds ("ETFs") include defense stocks, but they also tend to be much more equally weighted than the S&P 500 Index.

The top 10 S&P 500 stocks make up about 35% of the index today – slightly below the recent all-time record of 37%. Some of the European stock ETFs I've found have just 18% of their assets in the top 10 names – roughly half the S&P 500's concentration.

And as I've been writing for months, the S&P 500 is very expensive. The index currently trades for around 25 times current earnings. Meanwhile, the largest Europe ETFs trade around 17 to 18 times current earnings, roughly 30% cheaper.

Is this really second-level thinking... or knee-jerk speculation?...

European stocks' performance since November is just short-term market action. It wouldn't take second-level thinking to jump onto that uptrend. Here's the distinction I'm drawing...

In the case of Europe, you have to figure out what the market might be seeing that you're not. And few people would jump to the conclusion that Trump's trade war could raise enough domestic demand in Europe to make up for lost U.S. demand.

To be clear, I don't think the trade war is wise, but I don't pretend to know how it'll turn out.

Some folks have said Trump's trade war is a 3D chess move to show the world how wrong tariffs are... for the long-term goal of removing global trade barriers. If that's your take as well... feel free to write in and point out that my second-level thinking skills failed me.

For now, I continue to believe that politicians, including Trump, overwhelmingly focus on getting and keeping power. So they tend to be more nonsensical than sensible, meddling in our lives and running around the globe swatting every hornet's nest in sight, causing and exacerbating conflicts. As a group, throughout our history, the political class has done a first-rate job of pursuing policies that generate horrendous unintended consequences.

Trade wars have tended to work out poorly for folks on both sides of them...

Tariffs were part of what was called "beggar thy neighbor" economic policy in the 1930s, meaning a country was attempting to improve its own lot by trying to harm another country... often only making its own situation worse.

Worse still, tariffs have also occasionally led to total disasters that rocked the entire globe.

A trade war between the U.S. and European countries has been widely acknowledged as one of the primary causes of the Great Depression. And rather than recognizing tariffs' damaging effects, politicians increased them rather than dialing them back. The notorious Smoot-Hawley tariff of 1930 contributed mightily to the 66% decline in global trade from 1929 to 1934.

And while this one wasn't a tariff, the U.S. froze U.S.-based Japanese assets in July 1941, effectively cutting off more than 90% of its oil supply. This was in response to Japan's invasion of Indochina. Tensions had been growing between the two countries for two decades, and this was the final straw for Japan. After much negotiation, it responded by attacking Pearl Harbor on December 7, 1941. Japan thought the U.S. would respond to the attack by relenting... Instead, America geared up for all-out war, and the rest is well-worn history.

I sincerely hope the U.S. government doesn't enter another war over its current trade policy. I once thought Trump was more or less antiwar, but that's clearly just rhetoric, as his decision to bomb Yemen has shown (one of four U.S. presidents to do so). Time will tell how it all works out.

An import tariff is easy to understand...

It's a tax imposed on importers. When Walmart imports from China, it has to cut the U.S. government a check for whatever percentage of the value of the tariffed goods. Given its thin profit margins, it will have to pass the lion's share of that cost onto its customers. So they now pay more.

And Walmart isn't importing Rolls-Royces and Gucci purses. It's importing cheap goods that its core customers can afford.

So once again, a policy intended to "make America great again" will make America more expensive for millions of folks who can't afford to pay more for anything. I wish the government would learn to butt the hell out and leave us all alone.

Second-level thinking leads me to believe that when U.S. stocks are near their most expensive levels in history, they will likely offer poor returns, despite their overwhelming popularity. It also tells me that U.S. trade policy is already generating unexpected outcomes (like European stock outperformance) and is changing constantly. Since it's impossible to predict the policy changes, predicting the effects on the economy and markets is equally impossible.

So rather than beat your brains out trying to predict anything, you should, as we described last week, hold a truly diversified portfolio. (See last Friday's Digest for the types of assets I recommend to achieve that.)

That includes not holding the most popular, bubble-fied assets: Magnificent Seven stocks, market-cap-weighted S&P 500 and Nasdaq ETFs, all but a very few cryptocurrencies, and anything you don't understand.

Everyone still wants megacap U.S. stocks today, and it shows in their high valuations. Running that through a Howard Marks lens gets a conclusion like: "Yes, they're great companies but everybody knows it and it's more than baked into their current prices. By definition, what everybody thinks is great can't possibly outperform for very long."

It might sound easy, but no matter how you define, explain, or try to apply it...

Second-level thinking is hard...

In his book, Marks acknowledges the difficulty here:

The difference in workload between first-level and second-level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former.

And here:

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That's not easy.

He also points out that first-level thinkers all think the same way about the same things and tend to reach the same conclusions. Though he doesn't say so, he's clearly implying that second-level thinkers don't necessarily think the same way about anything... and often reach vastly different conclusions about the same subjects.

I'm sure many such investors reach their own conclusions about subjects nobody else even cares about. For example, I'm the only person I know who even thinks about the likelihood of the S&P 500 declining 20% or more in a single day. And I'm certain that most knowledgeable, experienced folks, if asked about it, would tell you it's so highly unlikely as to be impossible and not worth thinking about at all.

The fact that I disagree purely on philosophical grounds, not financial ones, will likely have me alone even among those few individuals on Earth that might acknowledge this is a real risk. But I see zero reason to abandon my viewpoint.

Learning the underlying fundamentals that give investments their real value is too costly in terms of time and effort. So most folks don't do it. They'd rather join the herd and focus on short-term market action.

It makes sense, because that's the single most ubiquitous piece of information about the most popular investments today. Stock prices are everywhere. It's hard to make your way through any large city in the world without seeing them on a TV screen or the side of a big building.

So when you first become interested in investing stocks, it's only natural to focus on the first and most easily attainable piece of information about them: the price.

Folks who obsess about every price-tick up and down are showing that they never really got past that stage of their development. They believe in buying what goes up and hoping it goes up some more very soon. And they generally lose money doing so.

I admit I've been guilty of this trap... paying too much attention to short-term price moves. I can't tell you how many fantastic businesses I've mistakenly sold over the years just because the price wasn't necessarily doing what I wanted it to. I'd have likely done a lot better if I'd just never sold anything at all.

Holding great businesses for the long term is the surest way to build real wealth in the stock market. But man, it's hard. And without second-level thinking, it is impossible.

Finally, Marks notes...

The good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers.

Second-level thinking is like having enough wealth to enjoy life in our modern world...

It takes a fair amount of money to live an active life full of learning, travel, and other valuable experiences, and to have a comfortable home in a nice place that's safe enough to raise a family and walk the streets at night. Lots of folks struggle to afford anything close to this lifestyle... The solution is to not be one of them.

Likewise, if your path to sufficient wealth lies in the stock market, you'll need to master second-level thinking.

First-level thinkers will struggle and destroy capital in the stock market. The solution is simple: Don't be one of them.

New 52-week highs (as of 3/20/25): Berkshire Hathaway (BRK-B), CME Group (CME), Cencora (COR), Franco-Nevada (FNV), Intercontinental Exchange (ICE), Kinross Gold (KGC), Royal Gold (RGLD), Sandstorm Gold (SAND), Tradeweb Markets (TW), VeriSign (VRSN), and Vanguard Short-Term Inflation-Protected Securities (VTIP).

In today's mailbag, feedback on a note in yesterday's Digest from Chaikin Analytics founder Marc Chaikin about "extreme fear" in the market today... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Howdy, It would not surprise me at all that many citizens are afraid of more than just the markets. With the GTC conference [the Nvidia GPU Technology Conference] wrapping up, the message of robots and autonomous cars is scaring people who want their jobs..." – Subscriber Rodger G.

Good investing,

Dan Ferris
Medford, Oregon
March 21, 2025

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