When the music stops and Buffett stops buying equities, what do you do?

Jerome Lander


What will investors do when they suddenly awaken to the fact that they are being fooled? Equity market price action has unquestionably divorced from underlying fundamentals in 2019, rising despite earnings and earnings prospects falling. The mantra of there is no alternative to equities has taken over. But in reality there are lots of better alternatives, and these are looking increasingly compelling.

Have we witnessed the last hurrah of a great secular and cyclical bull market? While extraordinary policy action has driven up the performance of nearly every plain vanilla investment strategy which is long equity risk and hidden equity risk, the market environment clearly poses great and ever-present danger to all investors. Make no mistake - this includes your big institutional super fund, your adviser, your portfolio. Furthermore, as we stand today, many investment portfolios today are not only structurally incapable of addressing the big challenges facing markets and investors, but are also active misleading their investors by pretending to be “defensive”, “balanced” or “diversified”…. In reality, given the underlying risks and market circumstances, they are anything but.

Equity markets have risen aggressively recently on the back of desperate attempts by policy makers to extend the late part of the economic cycle. Central banks are attempting to delay large end-of-cycle market falls from crushing the current happy paradigm. They are afraid of what might happen if and when a recession occurs and the music stops, such as debt deflation, collapsing asset prices, frozen credit markets and widespread illiquidity. They are afraid of losing perceived control of markets, and given their limited remaining traditional policy ammunition, they should be.

Hard reforms needed to fix fragile economies

Fundamentally, underlying economies are unquestionably fragile. Real growth is slowing and likely to disappoint for a long time, given the lack of implementation of the hard reforms necessary to fix the underlying problems facing our economies, and the increasing impotence of ever easier credit.

Many economies are laden by numerous problems including excessive public and private debt, combined with aging populations, profound wealth inequality and geopolitical challenges, environmental risks, along with maligned incentives and highly challenged institutional and political structures. There are numerous other massive structural problems not listed here in the interest of brevity. Unfortunately, while some protest, most governments and the public generally appear disengaged and unwilling to implement the much needed political and economic reforms necessary for the ongoing health and well-being of our economies and societies.

The bandage solution of easier money seems desirable, but it can only cover up the wounds for so long before the pus weeps through. Unfortunately, the substantial fundamental risks facing current markets and common investment strategies cannot be papered over for ever.

The dangers of short-termism

In essence, real productivity growth – an essential long-term prerequisite of a healthy economy and market - is low to non-existent, in no small part due to the short-termism of past and current government policies globally. In effect, governments have proven unable to implement genuine pro-real growth initiatives, or real solutions to problems fueled by poor policy, maligned incentives, misallocated capital and low interest rates. Instead, they are supporting further attempts at easy money which will likely only result in more misallocation of capital, further economic stagnation, and quite possibly eventual collapse of our markets and many assets. In the interim, unsurprisingly, many asset prices appear to be in a bubble driven by incredibly low current interest rates and widespread denial of the real issues.

Perhaps there is no better illustration of the current ridiculousness than the $14 trillion of global debt and bonds now offering negative yields. Indeed, investing traditionally safely is quite obviously incredibly problematic and highly policy dependent.

In essence, there is currently a huge boxing match going on between easy money in one corner, and the fundamentals and real economy in the other. Although this year’s market price action may superficially appear benign, many of the world’s most successful and reputable investors are understandably becoming greatly concerned and increasingly risk averse. Many are choosing to no longer play in the sandpit. Even Warren Buffett has stopped buying more equities. From here, market outcomes appear quite binary with most markets including equities highly dependent on the easy money team to keep their hopes alive. Prudent investors ought not rely purely on a coin toss continuing to come up heads, for a successful outcome to be achieved.

Investors are soon likely to realise that the paradigm of the last 10 years – almost everything simply going up – can simply no longer be relied upon, as markets divorced from underlying fundamentals are capable of doing anything, or everything together and almost simultaneously. The next few years are very likely to look very different from the last 10 years, and investors would hence be wise to rethink their investment strategies accordingly. The ability to move away from somewhat ‘crazy’ markets and policies which are divorced from fundamentals entirely determining one’s outcome, is not only highly attractive generally, but incredibly prudent and necessary today. An appreciation of the underlying market risks needs to be at the heart of every investment process.

As highlighted, many traditional assets are highly risky and excessively dependent on central planning keeping the music playing. For those who don’t like to, or can’t gamble with their money - such as many pre-retirees, retirees and all risk conscious investors - investing heavily in overpriced assets is a highly problematic basis on which to build a portfolio. Yet that is what most financial services products now effectively offer investors, even if they pretend otherwise. Hence, prudent investors need to look elsewhere to properly manage their exposure to these risks.

Time to pause and assess

Investors should reassess their own objectives, and just what they are aiming to achieve with their investments. Do they want to gamble on ever higher prices from traditional markets, even as market conditions have fundamentally changed and risks grow ever higher? While it has been a great benefit to many investors to experience years of an extended equity and bond bull market, they are equally capable of giving back much of these abnormal gains when market conditions change. Simply put, there are options open to investors which avoid the need to give back their gains.

Investors need to explore better strategies to invest for the next 10 years. Look to be forward looking rather than backward looking. Look for less market dependent approaches. Aim to align your investment approach with your real objectives. Focus on better risk/return outcomes, rather than speculative return outcomes alone. Few advisers offer solutions like this, but this is all I consider now worth working on and achieving for my clients. In contrast to the big is better camp, few large institutional portfolios can actually scale a truly compelling offering, as this serves as an affront to their highly profitable “low direct cost, large scale” business models. What has been in the interests of much of the financial services industry and the agents of large institutional super funds and lazy intermediaries, is now quickly divorcing from what is in the interests of investors themselves.

Skilful and active portfolio management can narrow the large range of potential outcomes to which investors are otherwise exposed, and in particular reduce the risk of large catastrophic losses from bear markets. This can be achieved while having much lower dependency on traditional market risks such as equity and interest rate risk. Yes, such an approach is research intensive and challenging, and requires real skill, and hence most will never do it. However, importantly, good growth outcomes and better risk adjusted returns are still possible from this point onwards, with relatively high consistency and much lower risk of catastrophic losses than one would achieve from investing in a traditional way. By thinking outside the box, it is possible to combine numerous complementary underlying investment strategies, and actively and dynamically adjust these through time, to better target investors’ preferred risk and return outcomes. There are real alternatives!

Investors need not miss out on any future gifts traditional markets will provide. When traditional asset prices become cheap again and less speculative in nature - as the bubbles will eventually collapse - a truly dynamic investor can reassess their prospects and re-weight them accordingly. In this way, investors can invest more safely and be capable of stepping up their exposures to market risk as is appropriate when the opportunity presents, and most importantly when the risk is likely to be adequately rewarded.

Central bankers can't fight gravity

Policy makers are quite likely to eventually fail in their attempts to levitate markets in real terms single-handedly or sustainably, without good underlying fundamentals and structural reforms. Simply put, the market circumstances reflect growing risks, and are simply too risky and highly uncertain for prudent investors to rely upon. Hence, low dependency on market outcomes should be considered a significant positive by investors seeking growth, yet recognising an equivalent need to manage risk and protect capital. Great results can be achieved today from skilled portfolio construction and active management of underlying investment strategies and exposures, while avoiding catastrophic market risks. In contrast, a traditional portfolio approach – which has worked so well in the past - is simply incapable of properly addressing key risks in today’s correlated and risky markets. While it is not impossible that a lazy static index-like long only approach continues to work for a while, it has now become a highly speculative proposition which is misaligned to clients’ objectives, needs and risk tolerances.

Our industry needs to do more to confront the dangers in today’s markets. For example, we can encourage real reforms in our investment approaches, and fundamental reforms from government to brighten our economic and market outlook. In the interim, successfully navigating what could shortly and will eventually become a potentially highly challenging investment environment for traditional portfolios won’t be easy, but it is absolutely necessary. Advisers who genuinely care about their clients need to rise up to the challenge and act in their clients’ best interests, even when it is not easy to do so. Personally, I sleep better at night because I run portfolios which are carefully risk managed and researched, and which adapt prudently and actively to the current market risks, even when the latter are substantive. I thoroughly recommend others do the same.

The good news is that real research, risk management and willingness to do the right thing by clients – as opposed to relying on increasingly speculative and highly market dependent investment portfolios - is likely about to differentiate itself.

In the absence of the political will to address our fundamental economic challenges, investing is about to move from ‘everyone wins a prize’, to a game of Survivor. Can you hear the bell ringing? Buckle up. You can retain your gains, even if almost everyone else loses theirs. You can adapt.

Important Notice Jerome Lander is Managing Director of boutique investment firm Procapital. He is a portfolio manager of exclusive outcome based portfolios, and a thought leader in the Australian financial services industry. This communication is for informational purposes only, and is a thought piece which represents the views of the author alone. It is not intended as an offer for the purchase or sale of any financial instrument. It does not constitute personal or formal advice of any kind and should not be relied upon as such – investors should consult their financial advisers before making any investment decision. This article’s accuracy cannot be assured. All opinions and views expressed constitute judgment as of the date of writing and may change at any time without notice and without obligation.

Jerome Lander
Chief Investment Officer

Dr Jerome Lander is a highly experienced, proven Portfolio Manager and a specialist in outcome-based and absolute return investing, which is a client centric approach aligned with many peoples' preferences - and one which is well suited to today's...

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