21 October 2019
By Julian Beaumont, investment director at Bennelong Australian Equity Partners. This article first appeared in Money Management, 20 September 2019.
Investors, advisers and their clients should be wary of worrying too much about the future when it comes to their investment strategies.
After all, does worrying about such things make them better investors? I’d argue no. Having some defensive strategies in place in case of a downturn is one thing; but continually anticipating the worst is quite another.
At the moment, it seems talk of a recession or stock market crash never goes away. This reflects human nature – we focus more on what might go wrong rather than what might go right.
For example, predictions of a market crash are far more prevalent than those of a boom, yet usually you cannot have one without the other. Type ‘market crash’ and ‘market boom’ into Google Trends and you’ll see the number of searches of the former far outweighs the latter.
Similarly, bad things from the past stick in the mind far more than good. Relevantly for investors, studies into the psychology of ‘loss aversion’ show we feel losses twice as much as we do gains.
The global financial crisis (GFC) in particular seems to have left us with deep psychological scars that are yet to fully heal.
You can see this in the elevated levels of investors’ risk aversion. By and large, since the GFC, investors have mostly targeted low-risk and low-volatility investments. The most obvious example of this is their preference for bonds and real estate. And when it comes to equities, investors have sought out the safety of defensives, yield and the momentum of whatever has most recently been working. More recently, REITs, gold stocks and ‘expensive defensives’ such as Woolworths have outperformed, even though not necessarily justified by the fundamentals.
Only in very recent times have fears of a repeat of the GFC calmed down. Predicting a repeat, however, is to imply it is a naturally recurring event. If so, what was the precedent for predicting the last GFC? Or the dot-com boom and bust? Or, for that matter, the 1987 stock market crash?
We have a tendency to fight the last war over again, making it unlikely something like the GFC repeats soon thereafter. Central banks have literally done ‘whatever it takes’ to avoid a relapse, to take the words of Mario Draghi, president of the European Central Bank during the euro crises in 2011. Likewise, regulators have lifted banks’ prudential capital, liquidity and lending standards worldwide. In Australia, banks’ capital positions are now about twice as strong as they were in 2007.
Market pundits are fond of quoting Mark Twain, that “history doesn’t repeat, but it does rhyme”. But depression rhymes with recession, and there is a big difference between the two. Each event is different in how we got there, and this means each is unique in how it unfolds.
What’s been interesting since the GFC is that bad economic news has often been taken as good news for markets. Any worrisome economic data point came with a greater probability that central banks would come to the rescue with further monetary stimulus. Thus, signs of a weakening economy have actually been good for both bonds and equities. So then why should we have feared what didn’t bring us harm? Indeed, research shows there is little correlation between economic growth – specifically GDP – and equity market returns. And to the extent there is any correlation at all, it is actually slightly negative.
Today, fears of another GFC seem to have given way to other fears, all while the scars of the GFC remain. These new fears reflect the unprecedented times in which we now live: disinflation and stunted wage growth; overbearing central banks and low/negative interest rates; de-globalisation and nerve-rattling trade wars; class wars and social inequality and disunity; populism and challenges to democracy itself. Of course, all these fears come with some sort of analogy to help us more easily consume the narrative, whether it’s Japan’s secular stagnation, Thucydides Trap, or otherwise.
But investors should remember the future has never been clear-cut. It is always the case that the circumstances of the day are somewhat unique, and unprecedented times are the norm.
Since Federation in 1900, Australia has seen two world wars, recessions, mortgage rates as high as 20%, the sacking of Prime Ministers – the list goes on. Over that time, however, Australian equities have returned over 10 percent per annum (to quote the RBA’s paper The Long View on Australian Equities). It has actually been less in the quarter century since 1993 – slightly less than 9 percent – which was a period without war or recession, and with an economic and credit boom.
Yes, these higher returns from equities come at a cost. This cost is higher volatility, which is really just a euphemism for price falls every now and again. However, while volatility presents risk of loss in the short term, the risk reduces the further one looks out, and becomes almost irrelevant over the long term, as any long term performance chart will attest.
In contrast to the negative news, the positive news has all but been taken for granted.
Few can remember the five year bull market that delivered us to the GFC. Over those five years, the market tripled investors’ money, adding far more wealth than was subsequently taken away by the GFC itself.
The market has doubled in the 10 or so years since the bottom of the GFC, reached in March 2009. And someone unlucky enough to have invested the day before the top of the last market high, in November 2007, has received a return of about 65 percent when dividends are included. Amidst all the doom and gloom, we’ve actually had it pretty good.
The copious flow of media, expert commentary and other ‘information’ is unhelpful in all this.
For a start, it focuses our attention on the risk du jour. Over the years, this has included taper tantrums, Brexit, Grexit and North Korean nuclear tensions, to name just a few. These got us all excited and speculating on imminent chaos.
But just as importantly, most of the media and expert commentary tends to focus on the negatives. For the media, it sells more newspapers. And for the experts, it looks considered and prudent.
As Steven Pinker, a professor in psychology at Harvard University, points out, the psychology of moralisation is such that people compete for moral authority, and critics are seen as more morally engaged than those who are apathetic. Those perceived as the most analytical and concerned about the risks are also perceived as the smartest.
However, being overly focused on the risks can mean you miss out on the opportunity.
Capitalism works its magic over time. People will be encouraged to work hard, to improve the way things are done, and to have more and seek a better life. This ‘invisible hand’ of capitalism is a positive driver that is difficult to see. And in part, this is why it doesn’t fill up newspapers. Meanwhile, the businesses that stand behind equities will earn, invest and grow for the future benefit of shareholders.
We cannot know for sure what the future holds. What we can do, however, is understand the present.
In contrast to what one might think by reading the media, markets are actually quite orderly and reasonable most of the time.
This is not to say they won’t have their ups and downs, as unpredictable as they are. Indeed, the Australian market has had a number of ‘corrections’ over the time it has doubled investors’ money since the bottom of the GFC. These included falls of 21 percent (April – September 2011), 20 percent (March 2015 – January 2016) and 14 percent (August – December 2018).
It is to say, however, that stocks will recover from such falls and chart back up with the market’s natural long term march higher.
In rare instances markets can stretch to their extremes, when excessive euphoria or despair takes hold. Unfortunately, most of us will have been too caught up in the boom or doom to be aware at the time.
In a boom, it is generally when the conversation at BBQs or with Uber drivers always comes back to stocks; our friends’ big win triggers too much envy not to partake; we are investing on margin; and ultimately, valuations detach from fundamentals. In the end, booms and busts require a group effort. Thus, literally only a handful of unique individuals depicted in The Big Short movie truly saw and positioned for the GFC.
In our view, the Australian market is at its normal orderly self. The best evidence of this is that we continue to climb a wall of worry. Investors are talking about recessions, corrections and the like, and this sentiment invariably makes its way into share prices.
Ironically, where there seems to be the most risk is where it is perceived to be the least. The rush into safety – bond proxies like REITs and ‘expensive defensives’ like Woolworths – might not prove so defensive given their popularity and stretched valuations.
At the very least, the current uncertainty in markets – and there is a lot – is good reason for investors to ensure they are genuinely diversified. Right now, bonds, property and term deposits are offering returns – whether interest rates, cap rates or deposit rates – that are far beyond historic norms. In contrast, Australian equities trade not far above historical averages.
So why worry about the future, and the apparent inevitability of a recession and market crash?
As veteran Fidelity manager Peter Lynch once said: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
As the old adage goes, it is time in the market rather than timing the market that works.
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