With many investors running to so-called defensive assets (with ever diminishing returns), this week we look at why it pays to stay invested in equity markets.
Over the past fortnight we have been trying to grapple with the nature of valuations in the current environment. In doing so we have tried to clarify a number of reasons for bonds and other perceived defensive assets going up at the same time as equities. We have explored issues ranging from central bank policy to demographics, this week we continue our journey and dig a little deeper.
At TAMIM, we like to think of ourselves as realists or evidence-based investors but the problem is that investing is hardly an exact science nor is it easy to pinpoint with any degree of certainty the underlying causal relationships that operate in the markets. In philosophy and psychology, this phenomena has been heavily explored where, too often, we impose our pre-existing conceptions of the rational and only discern what we wish to. Added to this is the fact that the markets are inherently complex systems where the sum of the parts does not necessarily equal the whole, the problem of the atomists.
Imagine you have a toy boat which you let loose in a free-flowing river. If you wished to calculate the position and how far the boat will travel when you let it loose you could easily deduce it as long as you had the speed of the current and the time since you set it adrift. Since the river itself is linear. Now take that toy boat and set it in the churn around the pillars of a pier, its ultimate location will be much harder to predict because you cannot break down a whorl or vortex into simpler component variables. The system is complex and must be treated as a whole. And so, just as that toy boat, the individual investor is trying to navigate the markets and predict where his portfolio might end up. However, while we can be certain of the underlying components we cannot be sure how these components interact in a dynamic world to create a result.
In a similar vein, the markets evolve. That is not to say that they are not rational. In fact, looking through history from the early 20th Century to now, the markets have been exceptionally good at prophesying the future. The late Barton Biggs, of Morgan Stanley fame, in his book Hedgehogging showed the surprisingly good intuition of the markets in predicting the battle of Britain in 1940, or how the German markets peaked in December 1941 before German patrols even saw Moscow. It seems that, despite our individual frustrations and our inability to grapple or fully understand its behaviours, the sum of the whole has a much better predictive capability than any individual actors. Just as an ant colony has a memory of its own that enables the individual ants to behave in a rational manner even if each individual ant would get lost very quickly on the forest floor. This suggests that there is something to be said for staying invested, as indeed Barton Biggs accepted.
Another interesting thing about Mr Biggs was that he was also an eccentric and rather nihilistic, always predicting the next big catastrophe. As such, his lifelong quest or hobby horse (whichever way you’d like to see it) was to see the best way to preserve wealth in the face of the four great horsemen of the Apocalypse. His conclusion from this quest? Ownership of assets. To quote Christopher Mayer (for those of you interested, read 100 Baggers), “if you own stocks, you are part owner in a real business - with real people trying to figure things out and with real assets and real profits.” If you were to live through a calamitous event such as post-WW2 Germany, your best bet would actually be equities (we all know how things turned out for debt holders - even though that particular lot had shorter memories since most of them would’ve been alive during the Weimar Republic).
This is not to say again that all debt is bad, but there are differences between productive debt and outright fluff. We simply cannot wrap our head around the notion that sovereign debt is seen as a safe asset in the current environment or a fiat currency backed by, wait for it, nothing (okay maybe a promise) should be seen as safer than a real asset that generates productive output. If we can all accept that there is too much debt in the world and governments will not be incentivised or even have the capacity to actually tax enough to repay it, then we have to accept the notion that it is a hot potato. Eventually the only way you get out of it is to inflate your way out and the person left holding it last will be sorely disappointed when that warm and fuzzy feeling of safety all but disappears. Anyone who does not think this is likely to happen clearly hasn’t been seeing the modern monetary theorists and the mercantilists making headway both in Congress and media in the US. Where has all the outrage about fiscal deficits gone?
So, the point of it all? We will go out and say something that might seem rather unpopular given the amount of talking heads out there suggesting that it is time to go “conservative” and actually suggest staying fully invested. Invested in equities. This is not to suggest that we don’t think there are not headwinds, this is the opposite of what we have been suggesting over the past few weeks, we are suggesting that there really are no such things as defensives. Buy right and hold on.
We have seen some valuations driven to levels that might seem ridiculous but that does not necessarily mean that this is the case everywhere. Most of this drive has been to high growth and the highs are predominantly in US equities and, within that, technology stocks. The MSCI World ex US index hit an all time high in January of 2018 and has come off significantly even though bond valuations remain elevated everywhere (to be expected given stagnant global growth). We shall go out on a limb and suggest that investors are going towards increasingly crowded trades in the form of tech stocks and are hedging using more crowded and fully valued utilities/bonds (13.5 trillion in negative yielding). Diversification or sheer stupidity? Essentially what people have done is bought wrong and are holding on. The market will revert to the mean and there will be pain. Again, this will be mitigated if you buy right (stay away from the crowded trades) and hold on. Maybe even go the Buffet way, look at an equity as truly long-term bond with a 10% coupon and always be buying since there are always opportunities.
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.