The Alternative To Growth Is Decline. Europe Is Proof.
A shrinking population and inflated expectations are a damaging mix.
Growth, whether it is economic growth or population growth, has almost become a swearword in the modern lexicon. It now needs to be qualified by the adjective "sustainable", or no one will subscribe to it.
Whenever a phrase is so self-evidently correct that no right-minded person would call for the opposite, it is usually a good indication that it is meaningless.
This is true for "sustainable growth", because no one would call for unsustainable growth. It is also true for "moving forward", as only some crustaceans prefer going backwards, and for "real action", because few voters would opt for "fake action" instead.
Apart from these semantic peculiarities, it is remarkable that the idea of limiting growth is striking a chord with voters in many Western countries, or at least with focus groups in those countries. Canadians seem quick to judge our American cousins with their seeming preoccupation with growth (at any cost). Will this hubris cost us down the road?
After one of the longest periods of growth in Canada's recent history, it seems that many Canadians have obviously forgotten that there is only one thing that's more unpleasant than dealing with the side-effects of growth. It's dealing with the side-effects of decline. In order to remind ourselves about this, we should look at Europe.
The financial crisis has hit Europe hard. It mercilessly exposed the weaknesses of Europe's social and economic model. Over the past decades, Europe had developed into a place in which governments took on an ever-increasing role, consuming more and more of the national economic output.
Taxes were no longer sufficient to satisfy politicians' appetite for more generous spending commitments, so deficits had to fill the gap between tax revenues and political ambitions.
At the same time, Europeans ceased to reproduce. In industrialised nations, the birthrate needs to be 2.1 children per woman in order to keep the native population stable. In many European countries, however, it has been far below this figure.
In the worst year so far, Italy recorded a fertility rate of 1.19. It has since recovered a bit, but with birthrates in the region between 1.3 and 1.4 in countries such as Germany, Italy or Spain, it is still far from the level at which these countries would remain stable.
A shrinking population would be a challenge in itself, but in Europe's case the problems are multiplied by rapidly improving life expectancy. Although arguably today's older generations are far healthier and generally more active than previous generations, it is nevertheless true that older populations mean relatively fewer taxpayers, more pensioners and more people in need of health care.
The mix of high-spending governments, increased life expectancy and lower fertility had for a long time produced a Europe that was a rather pleasant place to live.
However, it was not economically sustainable. After the shock of the financial crisis, Europeans are slowly waking up to the fact that they have created a continent that is on the verge of shrinking, with regard to its economic significance and its overall population.
As a whole, Europe will lose more than 60 million people over the next five decades. The remaining population will be much older than any other population in world history. In terms of demography, Europe is entering uncharted territory. What it will mean to live in country where there are as many people over the age of 80 as there are people under the age of 20 is hard to imagine, but many Europeans countries will soon find out.
The challenges of this demographic change are going to be enormous. Fewer taxpayers will have to shoulder an unprecedented increase in healthcare facilities. Qualified labour will be in short supply as working-age populations are already shrinking across Europe. This in turn will push up wages and prices; inflationary pressures are increasing.
Meanwhile, it will become more difficult to service the existing debt burdens.
The European example is a clear indication of what happens if a society enters into the no-growth zone. It sucks the energy out of the economy, and politicians are condemned to managing the decline with little room for manoeuvre.
When comparing Canada's growth chances to the European predicament of shrinking and decline, it should not be hard to decide which path is more tempting.
Growth is not everything, but without growth everything is more difficult.
Until investors realise this, they won’t be offered "truly forward-moving real action" on investment choices.
Friday, July 23, 2010
Thursday, December 3, 2009
Year End Review
Looking Back - and Looking Forward
2009 was one of those years that reminded us what a roller coaster the stock market can be – and also of the dangers of conventional thinking.
After the collapse in global financial markets last fall and the resulting pummeling taken by stock markets around the world, the consensus in January was that the worst was behind us. That was a sharp reminder of the danger of conventional thinking – by early March, markets in Canada had declined by a further 15% and the U.S. was down by 25%.
At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one in five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact and we began seeing signs of an economic recovery. From the market’s bottom on March 9 to the end of November, global markets were up by 50% to 65%.
Thus, 2009 was a sharp reminder that it’s impossible to predict short term market movements.
Instead we need to focus on two key questions:
1. First, what do the prospects for economic and profit growth look like in the mid term – 12 to 18 months and beyond?
2. Second, to what extent are these prospects for growth accurately reflected in today’s prices of stocks and bonds?
Mid-Term Prospects For Growth
In building portfolios, we have to start with some core assumptions about the environment we’ll be in going forward.
Noted British historian Paul Johnson has written that at every given point in time, you can always point to good news and bad news – the only difference is the balance between the two and what the media pays attention to.
In early 2000 (at the height of the tech bubble) and the beginning of 2008 (at the top of the real estate and finance bubble), all we read about was good news – almost no attention was paid to any offsetting concerns. By contrast, during market bottoms at the end of 2003 and early 2009, all we saw was the bad news – it’s as if there were no positives on the horizon.
Despite the recovery in the global economy and markets since the early part of this year, the general sentiment and confidence level among many people today is quite negative. Much of that is driven by concerns about the U.S. economy – still the engine of global growth.
And certainly there are lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline) and Government deficits.
Without dismissing the short term challenges facing the US, it’s important not to lose sight of some important underlying positives.
In an August cover story on “The case for optimism” Business Week Magazine highlighted a number of reasons to be positive, among them the impact of technology and free markets in emerging economies.
Click here to read more about what Business Week had to say:
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And recently two respected columnists at the New York Times, Thomas Friedman and David Brooks, weighed in on both the positives in the U.S. and some of the challenges that America faces.
http://www.nytimes.com/2009/11/22/opinion/22friedman.html
http://www.nytimes.com/2009/11/17/opinion/17brooks.html
The bottom line is: In the mid term I believe the positives outweigh the negatives and that the dire predictions about America’s decline are overstated. It may not see the rapid growth we’ve seen in the past but it will see solid growth.
Today’s Valuation Levels
Being right on our midterm outlook for the economy only helps us if we buy stocks and bonds at attractive prices.
With regard to bonds, at current interest rates of about 3% it is hard to make a case for Government bonds as anything except a safe harbour against more market disruption.
The returns on corporate bonds are more interesting – especially toward the bottom of the investment grade category, which currently yield about 6%. Note that we do have to be very selective here, since companies with low investment grade ratings are susceptible to shocks and downgrades should the economy run into difficulty.
On the issue of valuation levels of stocks, there are lots of academics who have made a career of studying markets. Of these, I follow two in particular – Jeremy Siegel at the Wharton School at the University of Pennsylvania and Robert Shiller at Yale. Between them, they forecast both the technology and the U.S. real estate bubbles.
Robert Shiller believes stocks should be valued based on their average earnings over the past ten years, using what he calls the Cyclically Adujsted Price Earnings ratio (CAPE for short). Employing that measure, at the end of November Shiller calculates the U.S. market’s multiple is 19.5 x times average earnings for the past ten years, within the normal historical range (although at the high end of that range.)
Prior to 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below twenty times average ten year earnings. Throughout the period from 1997 to 2001, this multiple was in the thirties and forties – when the multiple was in its forties, you were paying twice as much for a dollar of earnings as you are today.
Jeremy Siegel is the best known researcher on long term returns in the stock market and author of Stocks for the Long Run, often cited as one of the all-time ten most influential books on investing. Among his claims to fame is an article in the Wall Street Journal at the peak of the tech mania in early 2000, predicting that sector’s collapse.
In September, Siegel did two interviews on long term returns and current valuations, in which he talked about his research and his opinion that stocks offered good value at the time. You can see those interviews below:
Professor Jeremy Siegel on today’s market outlook:
http://www.clientinsights.ca/video/today-s-valuation-levels-and-market-outlook/type:investor
Professor Jeremy Siegel on long term stock returns:
http://www.clientinsights.ca/video/stocks-for-the-long-run-and-long-term-returns/type:investor
The bottom line from these two experts: While stocks are not as cheap as they were in March, by historical standards they do offer reasonable value.
While we can expect continued volatility in 2010, we do believe that returns on stocks in the period ahead will be in line with historical levels.
The Right Approach For Your Portfolio
While my team and I spend a great deal of time focusing on the big picture, the most important issue is how we adapt that view to each client’s individual portfolio.
For older clients, we have always been believers in maintaining conservative, balanced portfolios – that stance protected our retired clients from the worst of the decline in 2008 and early this year. Today, we are focusing on higher quality stocks, as we believe that these will provide the best risk return trade-off going forward.
In summary, we are cautiously optimistic about the American, Canadian and the global economy’s ability to work through some of the current issues they face – and believe that valuations on stocks will make quality stocks an attractive investment in the mid-term.
We look forward to continuing to work with you in 2010 to ensure you have the portfolio that is right for you – and thank you again for the opportunity to work with you over the past while.
As always, my team and I area always available to talk about any questions that you might have.
In the meantime, best wishes for a relaxing holiday season – I look forward to talking in 2010.
2009 was one of those years that reminded us what a roller coaster the stock market can be – and also of the dangers of conventional thinking.
After the collapse in global financial markets last fall and the resulting pummeling taken by stock markets around the world, the consensus in January was that the worst was behind us. That was a sharp reminder of the danger of conventional thinking – by early March, markets in Canada had declined by a further 15% and the U.S. was down by 25%.
At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one in five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact and we began seeing signs of an economic recovery. From the market’s bottom on March 9 to the end of November, global markets were up by 50% to 65%.
Thus, 2009 was a sharp reminder that it’s impossible to predict short term market movements.
Instead we need to focus on two key questions:
1. First, what do the prospects for economic and profit growth look like in the mid term – 12 to 18 months and beyond?
2. Second, to what extent are these prospects for growth accurately reflected in today’s prices of stocks and bonds?
Mid-Term Prospects For Growth
In building portfolios, we have to start with some core assumptions about the environment we’ll be in going forward.
Noted British historian Paul Johnson has written that at every given point in time, you can always point to good news and bad news – the only difference is the balance between the two and what the media pays attention to.
In early 2000 (at the height of the tech bubble) and the beginning of 2008 (at the top of the real estate and finance bubble), all we read about was good news – almost no attention was paid to any offsetting concerns. By contrast, during market bottoms at the end of 2003 and early 2009, all we saw was the bad news – it’s as if there were no positives on the horizon.
Despite the recovery in the global economy and markets since the early part of this year, the general sentiment and confidence level among many people today is quite negative. Much of that is driven by concerns about the U.S. economy – still the engine of global growth.
And certainly there are lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline) and Government deficits.
Without dismissing the short term challenges facing the US, it’s important not to lose sight of some important underlying positives.
In an August cover story on “The case for optimism” Business Week Magazine highlighted a number of reasons to be positive, among them the impact of technology and free markets in emerging economies.
Click here to read more about what Business Week had to say:
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And recently two respected columnists at the New York Times, Thomas Friedman and David Brooks, weighed in on both the positives in the U.S. and some of the challenges that America faces.
http://www.nytimes.com/2009/11/22/opinion/22friedman.html
http://www.nytimes.com/2009/11/17/opinion/17brooks.html
The bottom line is: In the mid term I believe the positives outweigh the negatives and that the dire predictions about America’s decline are overstated. It may not see the rapid growth we’ve seen in the past but it will see solid growth.
Today’s Valuation Levels
Being right on our midterm outlook for the economy only helps us if we buy stocks and bonds at attractive prices.
With regard to bonds, at current interest rates of about 3% it is hard to make a case for Government bonds as anything except a safe harbour against more market disruption.
The returns on corporate bonds are more interesting – especially toward the bottom of the investment grade category, which currently yield about 6%. Note that we do have to be very selective here, since companies with low investment grade ratings are susceptible to shocks and downgrades should the economy run into difficulty.
On the issue of valuation levels of stocks, there are lots of academics who have made a career of studying markets. Of these, I follow two in particular – Jeremy Siegel at the Wharton School at the University of Pennsylvania and Robert Shiller at Yale. Between them, they forecast both the technology and the U.S. real estate bubbles.
Robert Shiller believes stocks should be valued based on their average earnings over the past ten years, using what he calls the Cyclically Adujsted Price Earnings ratio (CAPE for short). Employing that measure, at the end of November Shiller calculates the U.S. market’s multiple is 19.5 x times average earnings for the past ten years, within the normal historical range (although at the high end of that range.)
Prior to 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below twenty times average ten year earnings. Throughout the period from 1997 to 2001, this multiple was in the thirties and forties – when the multiple was in its forties, you were paying twice as much for a dollar of earnings as you are today.
Jeremy Siegel is the best known researcher on long term returns in the stock market and author of Stocks for the Long Run, often cited as one of the all-time ten most influential books on investing. Among his claims to fame is an article in the Wall Street Journal at the peak of the tech mania in early 2000, predicting that sector’s collapse.
In September, Siegel did two interviews on long term returns and current valuations, in which he talked about his research and his opinion that stocks offered good value at the time. You can see those interviews below:
Professor Jeremy Siegel on today’s market outlook:
http://www.clientinsights.ca/video/today-s-valuation-levels-and-market-outlook/type:investor
Professor Jeremy Siegel on long term stock returns:
http://www.clientinsights.ca/video/stocks-for-the-long-run-and-long-term-returns/type:investor
The bottom line from these two experts: While stocks are not as cheap as they were in March, by historical standards they do offer reasonable value.
While we can expect continued volatility in 2010, we do believe that returns on stocks in the period ahead will be in line with historical levels.
The Right Approach For Your Portfolio
While my team and I spend a great deal of time focusing on the big picture, the most important issue is how we adapt that view to each client’s individual portfolio.
For older clients, we have always been believers in maintaining conservative, balanced portfolios – that stance protected our retired clients from the worst of the decline in 2008 and early this year. Today, we are focusing on higher quality stocks, as we believe that these will provide the best risk return trade-off going forward.
In summary, we are cautiously optimistic about the American, Canadian and the global economy’s ability to work through some of the current issues they face – and believe that valuations on stocks will make quality stocks an attractive investment in the mid-term.
We look forward to continuing to work with you in 2010 to ensure you have the portfolio that is right for you – and thank you again for the opportunity to work with you over the past while.
As always, my team and I area always available to talk about any questions that you might have.
In the meantime, best wishes for a relaxing holiday season – I look forward to talking in 2010.
Wednesday, September 16, 2009
Quarterly Review - Cautiously Optimistic
As I write this new post, it’s two weeks from the end of the third quarter in what continues to be a most eventful year for stock markets and the economy.
It’s also one year since the weekend that shook the foundations of Wall Street and of the global financial system – when Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity and AIG was taken over by the U.S. government.
In light of that, I thought it might be worthwhile to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.
Where we’ve been
Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression like economy dominated radio, television and newspaper. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit.
Although no one knew it at the time, that turned out to be the bottom. Since then, we’ve seen the economy move back from the precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist magazine recently ran a cover story discussing the extent to which the economic recovery was led by Asia.
As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up 50%, retracing a good portion of the losses since last fall.
The second quarter of this year, from March to June, was especially strong – since 1956 the Canadian market has only had three quarters that rose more than this one.
In the meantime, here are six lessons from the last twelve months:
1. We were reminded of just how volatile stocks can be.
2. And of the importance of true diversification.
3. Many investors discovered that they’re less comfortable with risk and volatility in their portfolio than they had believed.
4. Investors were also reminded of the need to focus on what they can control – understanding cash needs and thinking through how much risk they can live with to fund those needs.
5. In some cases, investors began rethinking retirement plans as a result.
6. Finally, we were reminded that in today’s world, we need to expect the unexpected.
Where we are today
A year ago, the market was characterized by rampant optimism. The Canadian market had hit a new high in June of 2008 and any concerns were set aside as minor annoyances.
By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.
Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous.
As a general rule, I think a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be erring on the side of being a bit too pessimistic, I think being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia.
The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.
The outlook going forward
In August, Business Week ran a cover story called “The case for optimism.”
The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two and three years and beyond.
There are things happening under the surface that will drive economic growth … and with that economic growth will come growth in stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.
Click here to access all the Business Week stories on The Case for OPTIMISM :
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And here to view a three minute video with interviews with CEOs of Dow Corning, Eastman Kodak and Intuit.
http://feedroom.businessweek.com/?fr_story=34b1f5ab213d48a160a767c9c6c50d091f6cc7a3
Volatility
Let me close by talking about market volatility.
In 1907, U.S. financier J. Pierpoint Morgan almost singlehandedly averted a banking panic among U.S. investors by pledging large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. At the time, the United States did not have a central bank to inject liquidity back into the market.
Later in life, someone asked him his best guess on the direction of markets. His answer: “They will go up and they will go down.”
One hundred years later, that’s still the best answer to someone looking for a short term market forecast. No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination.
It’s also one year since the weekend that shook the foundations of Wall Street and of the global financial system – when Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity and AIG was taken over by the U.S. government.
In light of that, I thought it might be worthwhile to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.
Where we’ve been
Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression like economy dominated radio, television and newspaper. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit.
Although no one knew it at the time, that turned out to be the bottom. Since then, we’ve seen the economy move back from the precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist magazine recently ran a cover story discussing the extent to which the economic recovery was led by Asia.
As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up 50%, retracing a good portion of the losses since last fall.
The second quarter of this year, from March to June, was especially strong – since 1956 the Canadian market has only had three quarters that rose more than this one.
In the meantime, here are six lessons from the last twelve months:
1. We were reminded of just how volatile stocks can be.
2. And of the importance of true diversification.
3. Many investors discovered that they’re less comfortable with risk and volatility in their portfolio than they had believed.
4. Investors were also reminded of the need to focus on what they can control – understanding cash needs and thinking through how much risk they can live with to fund those needs.
5. In some cases, investors began rethinking retirement plans as a result.
6. Finally, we were reminded that in today’s world, we need to expect the unexpected.
Where we are today
A year ago, the market was characterized by rampant optimism. The Canadian market had hit a new high in June of 2008 and any concerns were set aside as minor annoyances.
By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.
Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous.
As a general rule, I think a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be erring on the side of being a bit too pessimistic, I think being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia.
The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.
The outlook going forward
In August, Business Week ran a cover story called “The case for optimism.”
The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two and three years and beyond.
There are things happening under the surface that will drive economic growth … and with that economic growth will come growth in stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.
Click here to access all the Business Week stories on The Case for OPTIMISM :
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories
And here to view a three minute video with interviews with CEOs of Dow Corning, Eastman Kodak and Intuit.
http://feedroom.businessweek.com/?fr_story=34b1f5ab213d48a160a767c9c6c50d091f6cc7a3
Volatility
Let me close by talking about market volatility.
In 1907, U.S. financier J. Pierpoint Morgan almost singlehandedly averted a banking panic among U.S. investors by pledging large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. At the time, the United States did not have a central bank to inject liquidity back into the market.
Later in life, someone asked him his best guess on the direction of markets. His answer: “They will go up and they will go down.”
One hundred years later, that’s still the best answer to someone looking for a short term market forecast. No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination.
Wednesday, July 15, 2009
An Unconventional Approach for Unconventional Times
An Unconventional Approach for Unconventional Times
In other words, everything you know about asset allocation is wrong.
Strong words indeed.
The unprecedented seems to happen all too frequently in financial markets. Is there something wrong with the way financial advisors build their clients' portfolios?
Modern Portfolio Theory (MPT) has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. To oversimplify, one might explain MPT in this way: It is literally a mathematical proof for the idea that you shouldn't put all of your investment eggs in one basket. According to MPT, a portfolio of non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.
Of course, MPT has been picked apart by legions of critics over the years. But suddenly, in the aftermath of the recent stock market debacle — in which nothing seemed to work at all — critics of MPT are gaining currency.
The very foundation of modern asset allocation just doesn't work, they say.
Enter “Post Modern” Portfolio Theory (PMPT).
The debate between believers in the two different approaches to portfolio construction centers around how they define risk, and how that risk influences returns. MPT models risk using standard deviation above and below expected returns (also called mean variance). PMPT models risk using only standard deviation below expected returns (semivariance). In other words, MPT assumes that there is such a thing as upside “risk,” whereas PMPT proponents believe that only downside risk matters to investors.
This difference seems to give PMPT modeling greater power to predict disasters. In fact, applying MPT's concept of standard deviation to the monthly returns of the S&P 500 indicates a monthly loss greater than 12.8 percent has nearly no chance of happening. But it has occurred 12 times since 1926.
PMPT, say supporters, allows for last year's upset because it measures asymmetrical return distributions.
It’s a Post Modern World.
When the world was presented with Mean Variance Analysis [the basis of MPT] for looking at risk/return, it was the first of its kind back in 1952. No one had seen nor done anything like that before.
However, problem with the mean variance approach and what is known as the Capital Asset Pricing Model was that it assumed that every investor has the same objective. And that's just not true.
What is risk? To many, it is essentially the fact that we don't know what's going to happen, good or bad.
In short, predicting the future is impossible — though both MPT and PMPT still try to do this with modeling.
A major difference is that MPT assumes all investors have the same investment objective: to maximize the expected return for a given level of risk as measured by deviations around the mean. And so, for example, many retirement calculators suggest that 40 year olds who claim to have moderate risk tolerance plunk 40 percent of their assets in fixed income — which assumes these individuals, whether janitor or executive, will have exactly the same goals.
Subscribers to PMPT say, conversely, that investors have different and often very specific goals. The focal point should not be the maximum return possible given a certain level of risk, but rather the rate of return that must be earned in order to accomplish these specific investment goals, such as retirement or paying for college tuition, with minimum risk.
The risk, then, is defined as the possibility that the investor will be unable to accomplish the goal. As a result, returns below the target rate of return (“downside risk”) incur risk; returns above the target do not. With client portfolios suffering some of the largest losses in a generation, wouldn't everyone want a better handle on downside risk?
Don’t get me wrong. I do not have the audacity (nor the post graduate degrees) to suggest that MPT is wrong. The trouble I have is in the input variables. We've been using long-term averages for inputs. Historic averages have no predictive power at all. We’re told that by the very same people who expound on the virtues of MPT.
Indeed the concept of average expected returns, a central assumption in MPT, has taken a huge whack in the wake of the worst bear market in years, a bear so savage that it wiped out 12 years of equity returns in 16 months. Until now, who would have imagined the following could be true: Between 1969 and 2009, investing in 20-year Treasury bonds yielded better returns than investing in the S&P 500, according to research provided by Standard and Poor.
So much for the idea that over the long term, greater risk means greater reward.
Just food for thought.
In other words, everything you know about asset allocation is wrong.
Strong words indeed.
The unprecedented seems to happen all too frequently in financial markets. Is there something wrong with the way financial advisors build their clients' portfolios?
Modern Portfolio Theory (MPT) has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. To oversimplify, one might explain MPT in this way: It is literally a mathematical proof for the idea that you shouldn't put all of your investment eggs in one basket. According to MPT, a portfolio of non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.
Of course, MPT has been picked apart by legions of critics over the years. But suddenly, in the aftermath of the recent stock market debacle — in which nothing seemed to work at all — critics of MPT are gaining currency.
The very foundation of modern asset allocation just doesn't work, they say.
Enter “Post Modern” Portfolio Theory (PMPT).
The debate between believers in the two different approaches to portfolio construction centers around how they define risk, and how that risk influences returns. MPT models risk using standard deviation above and below expected returns (also called mean variance). PMPT models risk using only standard deviation below expected returns (semivariance). In other words, MPT assumes that there is such a thing as upside “risk,” whereas PMPT proponents believe that only downside risk matters to investors.
This difference seems to give PMPT modeling greater power to predict disasters. In fact, applying MPT's concept of standard deviation to the monthly returns of the S&P 500 indicates a monthly loss greater than 12.8 percent has nearly no chance of happening. But it has occurred 12 times since 1926.
PMPT, say supporters, allows for last year's upset because it measures asymmetrical return distributions.
It’s a Post Modern World.
When the world was presented with Mean Variance Analysis [the basis of MPT] for looking at risk/return, it was the first of its kind back in 1952. No one had seen nor done anything like that before.
However, problem with the mean variance approach and what is known as the Capital Asset Pricing Model was that it assumed that every investor has the same objective. And that's just not true.
What is risk? To many, it is essentially the fact that we don't know what's going to happen, good or bad.
In short, predicting the future is impossible — though both MPT and PMPT still try to do this with modeling.
A major difference is that MPT assumes all investors have the same investment objective: to maximize the expected return for a given level of risk as measured by deviations around the mean. And so, for example, many retirement calculators suggest that 40 year olds who claim to have moderate risk tolerance plunk 40 percent of their assets in fixed income — which assumes these individuals, whether janitor or executive, will have exactly the same goals.
Subscribers to PMPT say, conversely, that investors have different and often very specific goals. The focal point should not be the maximum return possible given a certain level of risk, but rather the rate of return that must be earned in order to accomplish these specific investment goals, such as retirement or paying for college tuition, with minimum risk.
The risk, then, is defined as the possibility that the investor will be unable to accomplish the goal. As a result, returns below the target rate of return (“downside risk”) incur risk; returns above the target do not. With client portfolios suffering some of the largest losses in a generation, wouldn't everyone want a better handle on downside risk?
Don’t get me wrong. I do not have the audacity (nor the post graduate degrees) to suggest that MPT is wrong. The trouble I have is in the input variables. We've been using long-term averages for inputs. Historic averages have no predictive power at all. We’re told that by the very same people who expound on the virtues of MPT.
Indeed the concept of average expected returns, a central assumption in MPT, has taken a huge whack in the wake of the worst bear market in years, a bear so savage that it wiped out 12 years of equity returns in 16 months. Until now, who would have imagined the following could be true: Between 1969 and 2009, investing in 20-year Treasury bonds yielded better returns than investing in the S&P 500, according to research provided by Standard and Poor.
So much for the idea that over the long term, greater risk means greater reward.
Just food for thought.
Monday, November 17, 2008
I SEE GLOBAL OPPORTUNITIES
Everyday, I see unique opportunities for growth--for my clients, and for Global Securities Corporation.
With stabilizing markets and resurgent capital flows, in countries around the world, amidst constantly shifting conditions, I see new potential and new challenges.
As long term growth and global finance continue to transform economies even in challenging circumstances, capital markets will play an increasingly vital role as people, capital and ideas come together in new ways.
At Global Securities Corporation, we help our clients to allocate capital and manage risk, and thus collectively do our part to help foster entrepreneurship, drive efficiency and encourage economic reform. Our clients' aspirations and the investments they make drive change. Investors fund strategic initiatives, build new businesses and strengthen existing ones. They look for new ways to improve investment performance and take advantage of the opportunities that arise every day.
Our clients' objectives are often multifaceted and difficult to execute. But we are firm in the belief that the solutions to their complex problems can create significant value for corporations, investors, families, and the societies they serve, both domestically and abroad.
Global Securities Corporation and Alexander Teh advise, finance and invest in client initiatives in both established and emerging economies. We utilize tools and vehicles that allow us to operate at the center of the global markets, offering our clients products and services that help them manage and take advantage of the unique opportunities they face.
Our people and the culture and principles that they represent are the foundation of our ability to create value for our clients. Teamwork, integrity and a daily commitment are the hallmarks of our vision.
Clients both new and long-standing, in markets both emerging and well-established, through prosperous and challenging conditions, have valued our deep understanding of the ever-changing global markets as a source of advice and outstanding execution.
With stabilizing markets and resurgent capital flows, in countries around the world, amidst constantly shifting conditions, I see new potential and new challenges.
As long term growth and global finance continue to transform economies even in challenging circumstances, capital markets will play an increasingly vital role as people, capital and ideas come together in new ways.
At Global Securities Corporation, we help our clients to allocate capital and manage risk, and thus collectively do our part to help foster entrepreneurship, drive efficiency and encourage economic reform. Our clients' aspirations and the investments they make drive change. Investors fund strategic initiatives, build new businesses and strengthen existing ones. They look for new ways to improve investment performance and take advantage of the opportunities that arise every day.
Our clients' objectives are often multifaceted and difficult to execute. But we are firm in the belief that the solutions to their complex problems can create significant value for corporations, investors, families, and the societies they serve, both domestically and abroad.
Global Securities Corporation and Alexander Teh advise, finance and invest in client initiatives in both established and emerging economies. We utilize tools and vehicles that allow us to operate at the center of the global markets, offering our clients products and services that help them manage and take advantage of the unique opportunities they face.
Our people and the culture and principles that they represent are the foundation of our ability to create value for our clients. Teamwork, integrity and a daily commitment are the hallmarks of our vision.
Clients both new and long-standing, in markets both emerging and well-established, through prosperous and challenging conditions, have valued our deep understanding of the ever-changing global markets as a source of advice and outstanding execution.
Wednesday, October 15, 2008
Financial History In The Making
FINANCIAL HISTORY IN THE MAKING
So much has happened this month, it's hard to know where to begin. It’s been a month to end all months with one monumental crisis following another. At times, events were moving so quickly it was hard to keep up. Many analysts I know stayed up all night, several times, as developments and markets spiraled out of control in what’s being called a "financial tsunami".
What lies ahead is unknown because massive changes are still taking place as the worst financial crisis since the Great Depression unfolds.
We do know that this is clearly the end of an era and the beginning of a new one, and we’ll all be affected in one way or another.
LENDER OF LAST RESORT
For now, opinions are running rampant and although we can make some valid assumptions, no one actually knows how this will all end up. Here’s why…
As you all know, the bailouts this month were massive and truly mind boggling, but the big spending actually started before. First, there was the $150 billion in stimulus checks, booming money supply, super low interest rates and the Bear Stearns bust.
Then came the takeover of Fannie Mae and Freddie Mac, which made the government responsible for about half of the mortgages in the U.S. , totaling about $5 trillion. This amounted to the biggest bailout ever, costing $200 billion. But if just 10% of those loans have to be covered, it would mean another $500 billion and this alone equals the size of the entire annual defense budget...
Then things really intensified.
A HOUSE OF CARDS
Lehman Brothers went bankrupt, Merrill Lynch agreed to be bought and the foundation of the financial system took a serious blow. Wall Street started to panic and the Federal Reserve, along with the world’s largest central banks, poured unprecedented amounts of money into the banking system to provide ever more liquidity as stocks fell sharply and the banking situation grew more serious.
The government then took over AIG, to avoid the worst collapse in history of the U.S. ’s largest insurer. Money market funds, which have always been considered safe, came under pressure. Worried investors started pulling out of these to preserve their savings, resulting in the Fed also having to lend banks about $400 billion in guarantees to meet these withdrawal demands. The bottom line was that in just one week, the Fed spent over $1 trillion to keep things going.
Next, Washington Mutual failed, which was the biggest bank failure in U.S. history. While all this was happening, the bailout package was a top priority. Bernanke and Paulson were desperate to get it passed, and fast. The President pushed for it too as they all warned that the alternative would be far worse.
PANIC SET IN
But the House rejected it and this shocked the markets. The Dow plunged in its biggest one day loss ever, dropping $1.3 trillion, which was way more than the $700 billion requested in the bailout.
Seeing the market’s reaction, the package then passed quickly but stocks continued falling sharply anyway. The general feeling was that the $700 billion won’t be enough and the plan is insufficient. Some feel this could be like the initial low estimates for the Iraq war and the final bailout tally could be $2 to $5 trillion, or more.
REALITY HITS MAIN STREET
Meanwhile, folks on Main Street were generally against the package. They simply didn’t trust it or the politicians. Once they saw the stock market’s reaction to the no vote, however, many people changed their minds as it became more obvious that this wasn’t simply a plan to bailout the mistakes made by greedy Wall Street big shots.
People saw the writing on the wall and realized that this would affect everyone, resulting in a worsening economy, more job losses and no credit. And since U.S. retirement assets are already down $2 trillion in the past 15 months, dropping 401 and real estate values, bank failures and insecurity are also taking their toll.
The economy is the number one concern for most people and they’re irritated at the mud slinging direction the election has taken while the priority issues take a back seat. So it’ll be interesting to see how the election unfolds too.
DELICATE GLOBAL FINANCIAL SYSTEM
There’s no question these are dangerous times and the financial world is in uncharted waters. The global financial system is on very thin ice, teetering on collapse. Last week's coordinated interest rate drop by seven central banks clearly illustrates this because it was the first time ever that so many central banks lowered rates together and by half a percent. They’re literally pulling out all the stops to revive lending and the world economy. In Canada, there is another half-point drop in the Bank of Canada rate expected.
Will these efforts work? Will they be enough? Those are the most important unanswered questions of the day and only time will tell, but we should know much more in the critical month or so ahead. Why?
HYPER-INFLATION OR DEFLATION?
The Fed is spending money at an astronomical rate. It’s creating this money out of thin air by monetizing bad debts and whatever else it has to. Remember, this is on top of all the other ongoing government expenses and it’s extremely inflationary.
Normally, there is a lag of about a year or so between money creation and inflation but eventually, what’s recently happened will result in massive inflation, a much lower U.S. dollar and a soaring gold price. This is inevitable but not necessarily.
The bottom line is this, if the banks start to lend again, then the economy will be on the road to recovery and inflation. But we know the banks are scared and they’re being extremely cautious, for good reason. So if the banks decide not to lend and instead just sit on their cash, then the inflation process will freeze.
In other words, the risk of deflation has greatly increased. Inflation is not a given and much will depend on what the banks do, or don’t do in the period just ahead. The Fed is providing the ammunition but the banks have to use it. If they don’t, the outcome could be much different than what most analysts feel is a done deal.
WHAT TO DO
At this point, it’s best to be prepared for either outcome.
That means gold and commodities (despite their recent collapse) for inflation and cash for deflation, at least until we see how things unfold.
For now, important changes are taking place but that also means challenges and opportunities.
This may all end up differently than what we initially thought, but we’ll adapt and keep an open mind. Whatever lies ahead, the current challenge is getting safely from here to there relatively unscathed and we’ll do our best.
So much has happened this month, it's hard to know where to begin. It’s been a month to end all months with one monumental crisis following another. At times, events were moving so quickly it was hard to keep up. Many analysts I know stayed up all night, several times, as developments and markets spiraled out of control in what’s being called a "financial tsunami".
What lies ahead is unknown because massive changes are still taking place as the worst financial crisis since the Great Depression unfolds.
We do know that this is clearly the end of an era and the beginning of a new one, and we’ll all be affected in one way or another.
LENDER OF LAST RESORT
For now, opinions are running rampant and although we can make some valid assumptions, no one actually knows how this will all end up. Here’s why…
As you all know, the bailouts this month were massive and truly mind boggling, but the big spending actually started before. First, there was the $150 billion in stimulus checks, booming money supply, super low interest rates and the Bear Stearns bust.
Then came the takeover of Fannie Mae and Freddie Mac, which made the government responsible for about half of the mortgages in the U.S. , totaling about $5 trillion. This amounted to the biggest bailout ever, costing $200 billion. But if just 10% of those loans have to be covered, it would mean another $500 billion and this alone equals the size of the entire annual defense budget...
Then things really intensified.
A HOUSE OF CARDS
Lehman Brothers went bankrupt, Merrill Lynch agreed to be bought and the foundation of the financial system took a serious blow. Wall Street started to panic and the Federal Reserve, along with the world’s largest central banks, poured unprecedented amounts of money into the banking system to provide ever more liquidity as stocks fell sharply and the banking situation grew more serious.
The government then took over AIG, to avoid the worst collapse in history of the U.S. ’s largest insurer. Money market funds, which have always been considered safe, came under pressure. Worried investors started pulling out of these to preserve their savings, resulting in the Fed also having to lend banks about $400 billion in guarantees to meet these withdrawal demands. The bottom line was that in just one week, the Fed spent over $1 trillion to keep things going.
Next, Washington Mutual failed, which was the biggest bank failure in U.S. history. While all this was happening, the bailout package was a top priority. Bernanke and Paulson were desperate to get it passed, and fast. The President pushed for it too as they all warned that the alternative would be far worse.
PANIC SET IN
But the House rejected it and this shocked the markets. The Dow plunged in its biggest one day loss ever, dropping $1.3 trillion, which was way more than the $700 billion requested in the bailout.
Seeing the market’s reaction, the package then passed quickly but stocks continued falling sharply anyway. The general feeling was that the $700 billion won’t be enough and the plan is insufficient. Some feel this could be like the initial low estimates for the Iraq war and the final bailout tally could be $2 to $5 trillion, or more.
REALITY HITS MAIN STREET
Meanwhile, folks on Main Street were generally against the package. They simply didn’t trust it or the politicians. Once they saw the stock market’s reaction to the no vote, however, many people changed their minds as it became more obvious that this wasn’t simply a plan to bailout the mistakes made by greedy Wall Street big shots.
People saw the writing on the wall and realized that this would affect everyone, resulting in a worsening economy, more job losses and no credit. And since U.S. retirement assets are already down $2 trillion in the past 15 months, dropping 401 and real estate values, bank failures and insecurity are also taking their toll.
The economy is the number one concern for most people and they’re irritated at the mud slinging direction the election has taken while the priority issues take a back seat. So it’ll be interesting to see how the election unfolds too.
DELICATE GLOBAL FINANCIAL SYSTEM
There’s no question these are dangerous times and the financial world is in uncharted waters. The global financial system is on very thin ice, teetering on collapse. Last week's coordinated interest rate drop by seven central banks clearly illustrates this because it was the first time ever that so many central banks lowered rates together and by half a percent. They’re literally pulling out all the stops to revive lending and the world economy. In Canada, there is another half-point drop in the Bank of Canada rate expected.
Will these efforts work? Will they be enough? Those are the most important unanswered questions of the day and only time will tell, but we should know much more in the critical month or so ahead. Why?
HYPER-INFLATION OR DEFLATION?
The Fed is spending money at an astronomical rate. It’s creating this money out of thin air by monetizing bad debts and whatever else it has to. Remember, this is on top of all the other ongoing government expenses and it’s extremely inflationary.
Normally, there is a lag of about a year or so between money creation and inflation but eventually, what’s recently happened will result in massive inflation, a much lower U.S. dollar and a soaring gold price. This is inevitable but not necessarily.
The bottom line is this, if the banks start to lend again, then the economy will be on the road to recovery and inflation. But we know the banks are scared and they’re being extremely cautious, for good reason. So if the banks decide not to lend and instead just sit on their cash, then the inflation process will freeze.
In other words, the risk of deflation has greatly increased. Inflation is not a given and much will depend on what the banks do, or don’t do in the period just ahead. The Fed is providing the ammunition but the banks have to use it. If they don’t, the outcome could be much different than what most analysts feel is a done deal.
WHAT TO DO
At this point, it’s best to be prepared for either outcome.
That means gold and commodities (despite their recent collapse) for inflation and cash for deflation, at least until we see how things unfold.
For now, important changes are taking place but that also means challenges and opportunities.
This may all end up differently than what we initially thought, but we’ll adapt and keep an open mind. Whatever lies ahead, the current challenge is getting safely from here to there relatively unscathed and we’ll do our best.
Monday, August 25, 2008
Global Uncertainty -- The Credit Crisis Legacy
The recent gyrations in world capital markets have left investors exhausted. True, oil prices have fallen from their most vertiginous highs, the dollar is a bit stronger, and the stock market has actually risen over the past month. But none of those things have happened in a smooth and steady fashion. The stock market’s “ascent,” in particular, has come straight out a carnival's rollercoaster blueprint. Since the beginning of July, there have been six days on which the Standard & Poor 500 has gone up or down by at least two per cent, and daily moves of more than one per cent—like the ones we saw at the start of last week—have come to seem practically routine. Precipitous falls in the market have frequently been followed immediately by sharp rallies, and vice versa. And, while some of these moves have been occasioned by real news, more often it’s been impossible to tell just what made investors so damn exuberant or so gloomy.
Not that long ago, stock-market volatility appeared to be a thing of the past; between the end of 2003 and the end of 2006 there were only two days with moves of two per cent. But, ever since the credit crisis began, big moves have become common. The conventional explanation for this is “uncertainty”: investors’ sense of what the future holds is in constant flux, so stock prices are, too. But, in the dearth of new news, you might expect uncertainty to result in tentative oscillations, rather than in the huge waves of buying and selling that we’ve been seeing. In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm. If investors are unsure about tomorrow, why are they acting so certain about today?
Much of what’s happening is a function of what economists call “herding.” In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won’t diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors. That’s why, when a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. This can create a feedback loop: as more people buy the stock, the more certain others become that there must be a good reason to do so (even if they don’t know what that is). And these feedback loops have been accentuated by the spread of quantitative-trading strategies that explicitly aim at riding the herd effect. These strategies can magnify trends instead of countering them. The result is that an individual stock can move up or down ten per cent on a day with no real news.
Uncertainty also stimulates big moves because traders react to it in an unusual way. Work done by Daniel Ellsberg in the early sixties suggests that, faced with ambiguity, most people try to minimize possible losses. But there’s considerable evidence that many traders, by contrast, deal with ambiguity by trying to maximize potential gains—thus the familiar dictum that volatility creates opportunities. In part, this is because it’s the job of traders to trade. But it’s also because market professionals appear to be chronically overconfident. A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions. A 2002 survey of experienced foreign-exchange traders found, similarly, that they were far more sure of their market forecasts than performance justified. Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more. What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on twenty years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades.
Oddly, then, the very things—uncertainty and lack of information—that might seem to make less trading and smaller bets advisable are pushing stock-market traders in the opposite direction. And this tendency is exacerbated by the fact that we are in a down market: the S. & P. 500 has fallen almost fourteen per cent this year. Mebane Faber, of Cambria Investment Management, recently did a study showing that, historically, volatility is significantly greater in down markets than in up ones. One likely reason is that traders, like gamblers, often find themselves “chasing losses”—if you’ve lost a lot, it’s tempting to make big bets, in an attempt to get your money back.
So far, all this volatility has had little lasting effect on the value of the stock market. But in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets. As a corrective to the recklessness of recent years, this might seem desirable, but too much risk aversion makes capital more expensive for everyone from businesses to homeowners, and the economy less dynamic. Once we get a clearer idea about the future, today’s volatility should diminish. But for now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity. Let’s hope the center can hold.
Not that long ago, stock-market volatility appeared to be a thing of the past; between the end of 2003 and the end of 2006 there were only two days with moves of two per cent. But, ever since the credit crisis began, big moves have become common. The conventional explanation for this is “uncertainty”: investors’ sense of what the future holds is in constant flux, so stock prices are, too. But, in the dearth of new news, you might expect uncertainty to result in tentative oscillations, rather than in the huge waves of buying and selling that we’ve been seeing. In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm. If investors are unsure about tomorrow, why are they acting so certain about today?
Much of what’s happening is a function of what economists call “herding.” In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won’t diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors. That’s why, when a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. This can create a feedback loop: as more people buy the stock, the more certain others become that there must be a good reason to do so (even if they don’t know what that is). And these feedback loops have been accentuated by the spread of quantitative-trading strategies that explicitly aim at riding the herd effect. These strategies can magnify trends instead of countering them. The result is that an individual stock can move up or down ten per cent on a day with no real news.
Uncertainty also stimulates big moves because traders react to it in an unusual way. Work done by Daniel Ellsberg in the early sixties suggests that, faced with ambiguity, most people try to minimize possible losses. But there’s considerable evidence that many traders, by contrast, deal with ambiguity by trying to maximize potential gains—thus the familiar dictum that volatility creates opportunities. In part, this is because it’s the job of traders to trade. But it’s also because market professionals appear to be chronically overconfident. A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions. A 2002 survey of experienced foreign-exchange traders found, similarly, that they were far more sure of their market forecasts than performance justified. Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more. What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on twenty years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades.
Oddly, then, the very things—uncertainty and lack of information—that might seem to make less trading and smaller bets advisable are pushing stock-market traders in the opposite direction. And this tendency is exacerbated by the fact that we are in a down market: the S. & P. 500 has fallen almost fourteen per cent this year. Mebane Faber, of Cambria Investment Management, recently did a study showing that, historically, volatility is significantly greater in down markets than in up ones. One likely reason is that traders, like gamblers, often find themselves “chasing losses”—if you’ve lost a lot, it’s tempting to make big bets, in an attempt to get your money back.
So far, all this volatility has had little lasting effect on the value of the stock market. But in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets. As a corrective to the recklessness of recent years, this might seem desirable, but too much risk aversion makes capital more expensive for everyone from businesses to homeowners, and the economy less dynamic. Once we get a clearer idea about the future, today’s volatility should diminish. But for now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity. Let’s hope the center can hold.
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