In 2007 former hedge fund manager Nassim Nicholas Taleb wrote The Black Swan: The Impact of the Highly Improbable, and the essence of that book has been inscribed into the risk management lexicon of the investing community ever since.
The metaphor of the black swan describes extreme outlier events that have a massive impact and are expected by a few, if any (like the Global Financial Crisis).
As we begin the new decade conditions seem rosy after stock markets globally capped off a stellar year that saw the Nasdaq 100 soar nearly 40% and the All Ordinaries 24% (inclusive of dividends). Policymakers remain supportive and most fund managers in our upcoming 2020 Outlook Series are predicting another good year for equities.
But what could go wrong and can it be predicted? For this wire, we invited Roger Montgomery, Chief Investment Officer of Montgomery Investment Management and Warryn Robertson, Portfolio Manager at Lazard Asset Management to discuss potential risks in markets.
We set the stage by getting Roger and Warryn to share the black swans which swooped them in the past. They then discuss potential events which could derail the current bull run and how they’re positioned for such scenarios.
2 lessons from the past
Montgomery’s big learning in how a view could be disrupted from left field factors came during the 2008 oil crash.
From 1999 to 2008, he personally invested in oil as its price surged from US$17.59 to US$165.00 amid the thesis that the world would run out of the commodity. The price then crashed to US$33 by February 2009 as energy demand collapsed amid the GFC.
While the GFC ended that bull run, it wasn’t the black swan, Montgomery says. The real black swan – something that nobody was talking about during oil’s rally - was the emergence of electric powertrains that caused investors to recalibrate whether the last gallon of oil would have a very high price or be left in the ground as new technology relegated it to prehistoric status.
“As a Saudi oil minister once quipped; ‘the stone age did not end because of a lack of stones’. Like the stones of the stone age, oil may very well be left in the ground worthless as it is replaced by superior materials or technology.”
Robertson’s big lesson also occurred during the GFC. Despite being wary of the amount of leverage in markets prior to the crisis, he was still shocked by the speed of Lehman Brothers’ collapse. That event taught him two major lessons that he shares here:
- Too much leverage can be dangerous for companies, consumers and ultimately economies, do not underestimate this risk. As investor, you must play close attention to the balance sheet and what is really driving profitability/growth.
- Situations can spiral out of control quickly. Do not be complacent about risks.
Inflation and political unrest could stop the bull
With those lessons in mind, are there forces lurking in the shadows that could shatter the seemingly nirvanic conditions for risks assets?
While it’s a “crazy idea”, Montgomery does not rule out accelerating inflation as a possible black swan. In the same way that most investors thought oil prices would rise indefinitely during much of the 2000s, the consensus view heading into 2020 is that central banks will forever print money.
“It’s a crazy idea and completely and utterly unexpected given general consensus is that unconventional monetary policy settings will be required to prevent stagflation as households and corporates are all in balance sheet repair mode rather than re-leveraging and consuming,” he says.
Another black swan would be tribalism as fuel for more political unrest. Montgomery notes that around the world citizens are increasingly segregated along education and occupation lines. In Australia, the US and Europe, urban or cosmopolitan elites offer “diminishing empathy” to the aggrieved who become more receptive to nationalism and right-wing and xenophobic leaders.
“Again, it’s a black swan only if nobody expects it,” he says.
‘There will be a reckoning’
For Robertson, the biggest risk is earnings misses.
The market is pricing in a return to trend growth, whilst also maintaining low interest rates, which is a “virtual nirvana” for the equity market. If this does indeed occur, then he reckons equity market valuations still make sense.
“However, if growth remains sluggish, as we expect, then it is likely that companies are not going to meet the aggressive earnings growth assumptions that are built into their valuation,” he says, adding that if this were to occur from mega-cap names in particular then it could lead to an equity market re-rating.
The other risk, at the opposite end of the spectrum, is that growth does indeed take hold and economies return to trend or above trend growth. That would force central banks to raise rates, which in the current environment - where low rates are the justification for high multiples - could be equally damaging for asset prices.
“I think either way there will be a reckoning. Either earnings are going to disappoint because growth is lower, or over time, rates must rise. Under both scenarios, the share prices of many companies will suffer, particularly those that are currently overvalued.”
Hedging strategy – quality, price and sensible diversification
So how do investors protect themselves from these risks?
Given they’re meant to be unexpected and unpredictable, a good starting point for investors is to minimise the risk of permanent capital loss. For Robertson, that approach entails:
- Focusing on higher quality names with more predictable earnings
- Focusing on valuation buying the right companies at the right prices
- Diversifying sensibly. A widely diversified portfolio perversely may be riskier than a concentrated portfolio
Hedging strategy – keep your powder dry
While it’s impossible to invest on the basis of attributing probabilities to the unknowable, keeping cash can be a good defensive measure when it’s becoming hard to find quality stocks at good prices.
Montgomery admits that while he’s been holding too much cash, his clients are more interested in capital preservation than “extracting the last few percent from a rally founded on momentum and the expectation that rates will remain low forever.”
He warns that it will take only a small shift in sentiment to “wake participants from their stupor", and for that reason it makes sense for a long-term investor to run an investment process that recognises high prices and allocates more to cash in response to the absence of value.
And to emphasise the lack of value, Montgomery points out that famed investor Warren Buffett’s Berkshire Hathaway is holding a record US$128 billion in cash, equivalent to between 30% and 40% of the conglomerate’s book value.
Certainly a growing concern among some fundies is that markets seem priced for perfection and have, for the better part of the past 11 years, climbed many walls of worry amid the bull run.
But nobody knows when unexpected or widely discussed risk events will eventuate, what specific damage they can do, and whether the result will be a broad correction, bear market or a sector-specific calamity.
But as Montgomery and Robertson indicate, focussing on quality companies at the right prices while having a buffer of cash to take advantage of adverse situations may help investors have some peace of mind from any pecking black swans.
Yet the ETF zombie keeps pouring millions into just any stock that is part of an index, sply tech. The ETF managers will rake in comm irrespective so who cares about performance.