This time it is different?
Recently I sat down with my colleague Andrew Baume to reflect on 2020 and what lessons can be drawn. As he says, with the dubious benefit of over 35 years in Financial Markets, "I have grown weary of commentators who do not accept that this time it is different.” The fact that market prices move from one day to the next is evidence that not only this time, but every day in markets is different, otherwise, we could crystal ball gaze and live the simple life.
The era of “democratisation of information” may be a new phenomenon, but as any student of history will know, change is a constant.
When Sir Thomas More walked across the iced-over Thames into the Tower of London he contemplated how cold London had become. In the early 1980s, Paul Volcker decided to massively manipulate the overnight cash rate and money supply. Mao Zedong was accused by Khrushchev of ruling via a “cult of personality”. Mark Twain famously said history does not repeat itself, but it rhymes.
The past 12 months of investment markets have rhymed in an often clanging disharmony with elements of times past, but they are clearly also different. George Soros took a view against the Bank of England in 1992 that was a blueprint for the Reddit warriors to take on hedge fund shorted stocks as a cause célèbre. Soros was backed by deep research and a conviction that the level of the GBP was wrong, but it was might and a squeeze that won the day for him. GameStop was just might and weight of numbers, so soon reversed leading to massive losses for the warriors who bought at either of the tops (so far).
The COVID-19 asset pricing crisis of March 2020 was another driven more by weight of numbers than by deep research or analysis of the future case given the events playing out. Once the liquidity picture became clearer, and the stance of central banks doing “whatever it takes” (rhyming with Draghi) prices responded.
Investment textbooks teach that there is an “optimisation” process that over time will lead to smoother and ultimately better outcomes. Academic investing has a tendency to argue away the times when correlations break down, referring to the long term nature of the ideal investment portfolio. The danger of that approach is shown with the more common incidences of increased correlations between many markets over the last 20 years or so.
Managers have sometimes found it convenient to be seen as having negative correlations to other asset classes (usually equities) and found that in times of stress that is hard to sustain. Not only does that idea get more regularly tested than historically, by allowing that implication to be held the sector as a whole suffers crises in confidence. How we long for an investment that looks the same once the can is opened as the picture on the label. Optimisation when measured in hindsight can look anything but optimal.
Despite that, innovative methods of investing are an essential response to the constant change in conditions. One example of truly uncharted waters is a global middle class saving for their own retirement (rather than receiving a government or employer pension). According to the OECD, the global retirement pool is over US$49 trillion and growing. Once added to the bottomless pit of liquidity being provided by governments globally, it is little wonder markets are staying well bid and commentators call for another crash (they have predicted 27 of the last 3 pullbacks).
It is certainly not the first time investors feel impelled to buy assets that feel expensive. FOMO is real as asset prices stay frothy and cash rates are below inflation. Bond rates have already reflected the policy of massive stimulation, the capacity for them to provide relief in the event of an equity selloff has diminished compared to times past. Most asset valuations have benefitted from low discount rates, and assets like bonds that may have a veneer of negative correlation lose that relationship in stress. There is an ongoing need to be invested when being in cash is so penalising.
In the midst of this, central banks tempt us with rhetoric that rates are not going anywhere for at least a couple of years. Investors can’t rely on an optimisation strategy that worked when interest rates were higher. Diversification of sources of return that don’t rely on low-interest rates is a difficult task, one that will improve portfolio outcomes particularly from a risk concentration standpoint. It was not just fixed interest that felt a shiver as US bond rates rose by 66% in the last two months.
There is no guarantee that any strategy is negatively correlated with any other during times of stress. Investors have to stay invested but perhaps the rhymes of history can be harnessed to build a more resilient dynamic asset allocation that reflects the way markets are behaving, not just reflecting expectations or hopes. Diversification through relatively static asset allocations needs “time in the market” to generate the academic outcome but can lead to wild rides in the interim. A 70/30 equity/others split works as the tide rises all boats, but clearly, the inverse is also true.
Diversification of return sources and an ability to dynamically reallocate has attractive characteristics because as Keynes said, “the market can remain irrational for longer than you can remain solvent”. There is no option to be out of the market waiting for a time for assets to “cheapen.”
Lastly, when markets move in ways that weren’t expected, history is clear; more money is lost selling at the lows that made by timing the entry point. 2020’s price action where the collapse and subsequent recovery of asset pricing on relatively low volume suggests participants are hearing the rhymes.
“Needing” to sell assets in the dip was painful. Funds that had large amounts of illiquid assets had the light shined on them when an externality such as government allowing access to the hitherto always growing superannuation balance of millions of members tested liquidity policies. Illiquidity is not a bad thing at all as it usually comes with a premium and investors with long term horizons can bank that. Strong inflows had a dampening effect on the liquidity drain, but there is a lingering question of equity between the members who withdrew for super at a very small discount to pre-Covid pricing (and potentially reinvested into markets down 20-30%) and those who remained in the fund with even lower liquidity and an asset that might well not have been realisable at the holding price. Access to higher liquidity assets also allow funds to make bigger strategic rebalancing decisions.
Although timing the market is hard, there are big events where the need to do that is clear. Entities that seek to maintain fixed weight allocations also need to find flows to do that and top up the allocations for the sector that has fallen most. Some interesting thought bubbles for allocators to ponder.
In summary, lessons we can glean from knowing our history and looking for rhymes (not rules) are multiple, but some are straightforward:
- Crises are inevitable but their manifestation will often be unique,
- No matter how “expensive” market conditions may be, an investor has to deploy funds,
- Correlation and dispersion in practice can be quite different to the textbook,
- Abandoning alternative sources of return as the traditional ones get more and more expensive seems brave,
- The human element (irrational exuberance or negative bias) can weaken our investment outcome, but many have rejected quantitative over discretionary investing,
- Stabilising strategies are more reliable than tactical (over)trading, but Fixed Income is losing its ability to stabilise, and
- Investors often conflate familiarity with understanding – they can be much more at risk with a “vanilla” 70:30 allocation strategy than one that has dynamic and dispersed sources of return.
This is the first of several pieces that will explore these lessons of 2020 while recognising the environment of 2021. The outcome will rhyme with the past, but history will not repeat.
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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.