OUR PERSPECTIVES


Are we due another crisis? What’s our prediction?

Last month saw the ten-year anniversary of the Lehman collapse come and go. This is notable, as the collapse of Lehman was the tipping point of the financial crisis of 2008 and heralded a new economic era. An era where interest rates in the Western World would remain close to zero for a decade and the global financial system would come under intense scrutiny and see a virtual tidal wave of new regulation.

The grand experiments of quantitative easing and ultra-loose monetary policy have continued, even to this day. Whilst the Fed is well advanced with its unwinding of stimulatory policies, the ECB is still at record low interest rates and is continuing with its monthly asset purchases.

And so too the extreme leverage in the financial system that brought about the crisis has remained. It has moved and morphed, but it has not been repaid. In fact, total debt in the system has expanded since 2008.

Whilst it is true that many nations and their governments endeavoured to be more austere in the wake of the GFC, most were forced to expand their balance sheets to keep their economies afloat. The state take-over of collapsing financial institutions, increases in welfare payments to the unemployed and economic stimulus packages increased expenditures. This brought about an increase in public debt to levels not seen in some countries since the 1940s.

The world’s seven major advanced economies (known as the Group of Seven), debt as a share of GDP increased by an average of 22.2% between 2008 and 2011. And as of 2016, Germany was the only G-7 country that had scaled its debt-to-GDP ratio back to pre-GFC levels.

Now, a decade on from the GFC, there are some guardrails in place to prevent a GFC 2.0 — but another crisis at some point is essentially inevitable.

Whist governments and central banks have gotten much better at regulating the economic cycle, their best efforts still only tend to moderate the cycle – rather than eliminate it completely.

The turning of the tide of an economic cycle tends to be more acute when it is accompanied by the bursting of an asset bubble. In 2008 two major bubbles burst at the same time. The first was the debt-financed housing bubble (mainly in the US) and the second was a financial market bubble comprised of new collateralized debt securities (riddled through financial institutions all over the world). The simultaneous bursting of these two large bubbles, created a financial crisis on a scale not seen since 1929.

The thing is with bubbles is that they’re obvious in hind sight but terribly difficult to see through the windshield. Even if you are one of the precious few who detect the bubble, determining when it may burst is just as hard as discovering it in the first place.

The other thing with bubbles is that they don’t repeat in a hurry. Markets have a habit of remembering the pain of the last bubble – the more painful it was, the longer they remember. So generally, the next bubble is different and therefore harder to spot.

The central question markets are asking today is whether there will be a day of reckoning for interest rates having been so low for so long.

Conventional economic wisdom would suggest that if you keep rates near zero for a decade you will ultimately see unintended consequences – most likely the inflation of asset prices and asset bubbles in sections of the economy. The logic is that if money is super cheap for a long time, people and businesses will borrow funds and use them to bid up the price of assets.

So there are good reasons to be concerned about markets today. But having said that, I can’t recall a time during my 25yrs in markets where there wasn’t good reason to be worried about something.

So what are investors to do? What will happen next?

 

Many people have asked me these questions recently, so here goes my answer:

My forecast

The business cycle will never end. We will forever go from boom to bust. Capitalism will continue to survive and prosper, but it won’t be without misstep. On average there will be about two years in every decade where stocks go backwards. Committed long-term investors won’t be able to avoid the down years, but if they stick with their investment programs they will be well rewarded.

Most investors will continue to spend a disproportionate amount of their time discussing, calculating, and speculating about when the cycle will turn. This colossal human effort in aggregate will add no net value whatsoever over the long term. In aggregate, the “horse trading” in and out of assets – cash to equities – equities to cash – will do more harm to investor portfolios than good.

 

What we’ve learned

A twenty-year study in the US found that investors in US stocks on average produced a return that is roughly half the market return. The main causal factor contributing to the underperformance was investors getting in and out of markets at the wrong times.

When it comes to investing, human behaviour can be very destructive. The message in academic circles is the same time and time again – “market timing” simply doesn’t add value over the long run. Practise it enough and you will fail.

Every year since 2008 certain “experts” have called the end of the market rally. Every year markets have continued to rise. Inevitably one year (perhaps soon) a certain cohort of experts will be right and claim victory. Afterall, markets must inevitably retreat at some point. But will those experts have shown some special skill or insight? Or is it more plausible that they happened to be the ones that got lucky?

Picking stocks and timing markets is hard because…….. well, quite simply: markets work.

That is, markets price in available news as well as the thoughts and opinions of market participants. That intel of the collective is assimilated into prices instantaneously. So, it is difficult for a singular investor to have some special insight that the market overall does not have. This makes “beating the market” very difficult indeed.

Another way to think about this is through mathematics. This Youtube is worth a look (please take the 5 minutes). It explains how the collective wisdom of the crowd is generally a better bet than a singular expert opinion.

 

Another way to think about it…… If you stack enough monkeys into a room and command them to roll dice repeatedly, invariably you will find one monkey that rolls a “six” ten times in a row. Does that make that monkey a genius? So it goes with picking stocks. Some fund managers will get lucky, some will get unlucky, others may have true skill. The tricky part is telling them apart.

On average around 70% of the professional stock pickers working in large cap Aussie equities under-perform the markets (over rolling five-year periods). In global equities the number is closer to 90%. Most of this underperformance is attributable to the cost of the manager’s fees. If you take their fees out of the equation their performance as a group looks very similar to that of markets. Or put another way, the scattergram would be almost identical to a cohort of monkeys in a room flipping coins to pick stocks – some would end up above the market return, some below, but most would congregate around the average (ie the market return).

That is a crude analogy and an oversimplification of reality, but the message is borne out in real life numbers.

So, what are investors to do? One option is to roll the dice – consider markets news and events – make a timing call and then implement. This is the popular wisdom, but it is stressful and the risk of getting it wrong is immense.

We think a better option is to remove speculation from the equation. Stop spending hours on things that you have very little chance of getting right. Instead, concentrate on strategies that have a high probability of adding value (both in terms of long-term return and risk management).

Sadly, these “evidenced based” strategies aren’t “get-rich-quick” strategies. They are text book approaches that sound less enticing than the “double-your-money” stock stories that stock brokers tell. A key difference though, is that given time, these strategies almost always work. They include:

  • Invest – not in specific stocks – but in capitalism itself. The risks of capitalism failing to deliver a sound long-term return is remote, while the risks of a singular company failing to do so is much, much higher.
  • Harness all the different streams of capitalism: enterprise risk (equities), credit risk (bonds), and others.
  • Avoid seeking returns from the dimensions of risk that have lower probabilities of success – manager risk, timing risk, etc.
  • Consider the correlations between the investments in your portfolio carefully – don’t own lots of assets that are highly correlated – look for alternative streams of beta that have lower correlations to the main.
  • Trim back investments when they deliver returns that are above long-term averages.
  • Top up investments when they post returns that are below long-term averages.
  • Seek to profit from the human behavioural factors that drive markets, such as:
    • the tendency of investors to crowd into “favourite” (growth) stocks, and the tendency of investors to avoid “unfashionable” (value) stocks.
    • the tendency of investors to dive into things that are going up, or to madly rush to the exits when things are going down (momentum).

In summary, speculating on single stocks and market directionality are not endeavours that are likely to bear fruit. If you want to have a punt, do so, but park that activity in the “fun and entertainment” bucket, don’t call it “investing”.