• Stuart Fowler

Calling the bear market: how did we do?

We are not economists but we need to rely to some extent on economic insights in order to advise families on finance or manage their portfolios. Sometimes, economics are not necessary and all the information is in asset valuations. Not this time: seeing this bear market coming was all about economics. So how did we do? Pretty well, actually. Because we share our views with blog readers, our record can be scrutinised. In this post, I have linked some of Stuart’s past blog items to examine our record, starting with our investment strategy as we spelled it out in October 2006.

26th October 2006 “Market Commentary”

In this client newsletter, posted on the blog, we set the scene like this.

“The focus is on the risks facing financial markets in the late stages of an unusually long expansionary phase of the business cycle. These are conditions in which investors with low risk aversion can still make good short-term returns but unwary investors with lower risk aversion tend to get caught out with excessively risky exposures when the cycle turns. And the timing is never predictable. If you thought the business cycle had been condemned to the history books and that monetary and fiscal authorities are working in sophisticated harmony to ensure well-balanced growth, you might find these ideas challenging.”

The consistent theme of our economic analysis up to this point had been unsustainable sector financial balances. This comes from an approach to cyclical analysis which has a long historical pedigree. Either memories are short or market participants too young because it was quite wrongly overlooked during the ‘Great Moderation’ or ‘non-inflationary consistent expansion’. We explained this in this piece.

“We can speculate what it is that might bring the bull phase to an end from a level at which equities are not greatly overvalued….The most likely cause is related to the cumulative economic ‘sector balances’ that have developed after some 15 years without a full recession – in other words a recession in which the balances between the main economic sectors (personal, corporate, government and foreign) are restored to more normal relationships. This might have happened at the start of the new century had 9/11 not triggered a massive injection of stabilising liquidity by the Federal Reserve Bank, thereby extending the growth phase of the cycle which at that stage was already a decade old. The cumulative effect is not so much apparent in the level of inflation as in the record government and foreign surpluses, lower personal surplus and exceptionally flush corporate sector. These US sector balances are mirrored in the UK.”

For clients with goal-based ‘Defined Outcome’ portfolios, which are limited to those assets with the best evidence of long-term real returns, it is a quantitative model that determines the scope to hold equities rather than risk free assets and it is individual goal-specific risk tolerance that determines the actual equity allocations. The model calls for a gradualist approach rather than big market timing bets. But for clients with multi-asset class ‘Defined Path’ portfolios, where liquidity often does not allow gradualism, we have to take bets and we have to rely on our own judgement. In October 2006, here’s how.

“Our judgement is that for property and private equity (particularly leveraged buy-outs) the expected returns are already cyclically very low and that the premium for illiquidity is inadequate.

“UK commercial property has fully made up its underperformance in the 1990s and yields are discounting unrealistic rental growth…

“Because we reject the notion that private equity returns, pre-leverage, are largely highly-incentivised returns to management skill, in favour of the view that they are mainly a leveraged bet on a change in the terms set in the public market for buying and selling equities, our cyclical view is bound to make us cautious.

“We are avoiding bets much above or below the strategic allocation to commodities [20% is the ‘neutral’ weight, by the way]. Energy and metals have enjoyed a bull market for several years…[but] we are also mindful of a more secular view of trends in real (or relative) prices of industrial inputs which offers the possibility of a reversal of the 20-30 year decline in the terms of trade between producing and consuming nations. Both secular and cyclical trends in raw materials prices underpin the empirical evidence of low correlations between commodities and equities. This ‘hedge’ argument is important in meeting an overriding objective of the diversified strategy, which is smoothing the nominal short-term path of…returns.

“One aim of these portfolios that follows from that objective is to hold assets or strategies that offer equity-type upside but with appropriately-timed downside protection. It is this aspiration, and the fact it was generally well met in the last bear market, that makes hedge funds popular with both private and institutional investors. Putting clients into a hedge fund can look indistinguishable from us delegating the timing decisions to a third party but it is actually more than that: we look for strong trading disciplines learnt over many years that include stop-loss rules. As ever, we retain a healthy skepticism about market timing skills – ours or anyone else’s.

“Both [types of No Monkey Business] portfolio are holding more in risk free assets than ‘normal’. If markets continue to rise, we will cut back exposure to risky assets further, in the first case consistent with the client’s goal-based model and in the second as a matter of judgement.”

24th March 2007: “Drowning in debt: can it be true?”

Our focus on credit analysis informed several of Stuart’s posts before the credit crisis broke, including this.

“We have enjoyed a long period of much stronger growth in money and credit than the economy as a whole. One of the features of this massive monetary expansion is that credit creation has not been constrained by bank capital.

“Until this present cycle, and in all the previous manuals on central banking, asset growth on bank balance sheets was assumed to be constrained by the rate of increase in their shareholders’ funds. In a ‘modern’ world where loans (or separate elements of the risk exposure) can be packaged and passed on to the likes of hedge funds and insurance companies, liquidity outside the banking system (itself expanded by bank credit growth) becomes an almost unlimited base of equity to support new loans.

“This process has been great for borrowers and for financial institutions eager to find new assets with different income streams. It has been great for financial intermediaries able to bundle the highest risks in an obfuscated product and flog it to wealthy individuals (not our clients, of course). But the process is a nightmare for central banks and bank regulators because it weakens their control. The banana skin they most fear is always the one they may not be able to do much about.

“We are living through a period of unprecedented debt-driven liquidity growth that is making a lot of us a lot of money, even if many trying to keep up have failed in trying and should never have tried. Debt-fuelled expansion contains the seeds of its own reversal. We do not know when or why but we will surely benefit from being alert to the consequences. These are directly related to the level of accumulated debt, even if only in particular pockets.”

04/09/2007: “Drowning in debt: the American way”

Some of the most important pockets affected are in America.

“America’s insecurity after 9/11 showed in a desperate attempt to prevent recession by cheap and easy credit. Now the chickens are coming home to roost. An unprecedented house price boom was in large measure fuelled by this monetary expansion but it was also aided by lax lending standards from mortgage bankers and by new sources of liquidity from hedge fund investors – now as big as banks. In recent weeks we have seen the first signs of this foolhardy liquidity drying up, with several lenders to the dodgiest borrowers going bust and others shutting up shop.

“Two weeks ago I wrote about UK consumer debt. In America, the position is even worse: US consumers are overstretched and overconfident. But it is not just credit card debt that looks vulnerable: over-extended mortgage debt is the bigger problem. There is a significant risk of contagion spreading from dodgy mortgages to Wall Street investors via debt-based hedge-fund strategies. This is scary stuff – and not just for holders of American investments. The American authorities may have bought growth but only at the expense of a much deeper recession later.”

12th August 2007: “Update on the real house price cycle”

UK house prices have been a consistent focus of the No Monkey Business blog. Consistent with the British obsession with housing, this is the most frequent search string directing traffic to the blog.

“Our way of measuring house prices focuses on house prices as a cycle in real terms, in common with our approach to other assets…Both ratios show extreme overvaluation and have been rising rapidly for the past four quarters.

“The data through June was still reflecting buoyant lending conditions… This may change very quickly, now that bank balance sheets and wholesale capital markets are so globally integrated. What the real house price cycle chart shows is the extent of the potential fall in real terms, given previous cycles. We have repeatedly argued that the previous down cycles have been concealed by high general inflation. This time round, ‘real’ will mean ‘for real’.”

3rd March 2008: “Japan’s ‘lost decade’: the new bogeyman for post credit-crisis stockmarkets”. As recession fears started to take hold, Japan’s ‘lost decade’ of the1990s became a popular theme in the press as well as among investment professionals.

“The same fate supposedly awaits the US (and UK too) as payday for a decade of binge banking and mass delusion by bankers and their customers about house prices. In a new position paper, wealth manager No Monkey Business examines the relevance of Japan’s dire experience of the ’90s for other countries today.

“The key distinction is the duration of the underperformance against expected growth in economies and equity real returns, rather than the cumulative degree. Prolonged underperformance is possible in Anglo-Saxon markets because of the specific effects of a bursting housing bubble, even if Japan is not a close parallel.

“For wealth managers, the lesson of Japan is that both the degree and duration of underperformance against rationally-expected returns need always to be a part of the realistic outcomes we tell clients about: they are more likely than people think.

“For Japan itself, the lesson is that the rational ‘mean reversion’ model of real equity returns is not broken and because of low expectations it now offers the best long-term returns of the major markets. And the yen looks cheap against sterling.”

The last word Because of our skepticism about forecasting in general, it is unusual for us to be so focused on economics. In our last client newsletter (not on the blog) we felt this needed an explanation.

“Our recent newsletters have been so dominated by economic commentary that we may start to look like all the other pundits trying to use forecasting as a means of placing winning bets in financial markets, something we think plays to investors’ (and advisers’) natural weaknesses rather than their strengths.

“The justification for focusing on economic developments is not that they have made markets more predictable… Rather, heightened economic risks make it more important to be sure that they lie within the tolerances agreed with clients or, in a modelled approach, are ‘in the model’.

“The desire to avoid risks also needs to be balanced by awareness of the cost of that protection. Being realistic about the true uncertainties of the payoffs to risk-taking and the true cost (in returns and resources required) of eliminating uncertainty are things we think we are good at.”

#markettiming #performance


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