Everything is so expensive
In a followup to our last wire on lessons from 2020, Andrew Baume and I discuss some of the challenges for investing when everything is so expensive.
Investors find it very difficult to feel enthusiastic about deploying capital in markets that are priced well above their historical norms and away from the investor’s measure of value. Compounding this unease are periods where the outlook seems so uncertain. If anything, 2020 taught us that this is no reason not to deploy that capital.
It also told us that an explicit expense such as a manager fee is very persuasive compared to the more subtle question of paying for a manager with a value or risk adjusted return focus.
Keynes is often quoted as saying “markets can stay irrational longer than you can stay solvent”, but the current asset inflation is by no means irrational. It is the only possible response to liquidity injections designed to combat the most scary of diseases – deflation – at a time when the global savings pool is bigger than at any time in human history, not only by amount but also per capita in the Developed World.
In March 2020 the immediate response to a global shutdown was market action presuming significant slowing of world GDP with concurrent massive unemployment and dissaving. Governments and central banks who have discovered the joy of free money responded incredibly quickly, pulling asset prices off the floor. The DAX dropped 35% and FTSE lost 30% by the time COVID shocks were fully priced. Despite a nearly 10% lower GDP in the UK and Europe for example, although the FTSE is still below Feb 2020 highs, the DAX is actually comfortably above.
So, the fundamental analysis that has been the backbone of the investment process for a hundred or more years is giving us signals that the weight of money seems to completely ignore. The deluge of liquidity means that most assets are now extremely exposed to the risk-free interest rate which drives the dividend discount model of valuation. Despite this, 2020 shows us we need to remain invested, the option of waiting for a buying opportunity is loaded against those allocated to zero rate cash.
Many allocators have been disappointed by the performance of their “liquid alternatives” allocations, partly because there had been a presumption that they would not behave in step with equities when there was a significant price pullback. This proved not always to be the case, some managers allowing the view they were un- or negatively correlated with equities in times of stress to persist even if not stating it explicitly.
In fact a symptom of the new low rates case is for the markets to tend towards a positive correlation (even towards 1) in both down and up markets. The sense that many “alpha” strategies were actually correlated with beta was borne out by performance.
Assets that were less liquid and tended not to be marked to market fared much better in March 2020 as new buyers vanished in the most liquid markets. Central banks managed the crisis via liquidity, bringing buyers back in to markets and evening out the performance gap between the liquid and less liquid. As the liquidity crisis was so short lived it is difficult to estimate how the less liquid asset classes would have performed under longer term redemption pressure.
Human nature is often seen in corporate behaviour as well. As people we often conflate familiarity with understanding, in fact it is much easier to act on our familiar triggers than to delve into the true nature of an event. Daniel Kahneman is a psychologist who won a Nobel Prize in Economics by recognising this trait.
A couple of easy but potentially dangerous learnings from 2020 may be to remove liquid alternative sources of returns from portfolios and focus more on illiquid ones. Both courses of action are understandable responses but need to be taken in the context of all scenarios, not merely the one we have just witnessed.
So disappointment needs to be viewed in context. We all fall into the common trap of analysing the performance of each component of a portfolio when the outcome of all of the components working together was within expectations. Disappointment should be confined to when the overall portfolio performed outside expectations (given every portfolio has layers of risk, this expectation needs to be realistic). Secondly disappointment with a particular allocation needs to be seen in the prism of how the allocation was designed to behave and whether the execution failed the design. It is no good complaining about a liquid alternatives not being negatively correlated with equities when the underlying design did not include that characteristic for example.
One of the hot topics in Equity and to an extent Fixed Income investing is the cost benefit of indexing rather than active management. The design of that strategy is to outsource your return to the momentum of everyone else in the market. It will be interesting to see whether the mooted return of the value investor puts a spotlight on that design feature.
The next article will cover diversification as it relates to whole of cycle investing.
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Mark is Co-CIO at Darling Macro. He specialises in multi asset strategies, which are designed to complement strategic and passive equity allocations, by tactically weighting risk across equity, fixed income, commodity and currency markets.