The South African Index Investor
Newsletter: December2008
Fooled by Complacency
By Daniel R Wessels
“The real mystery is just why both professionals and small investors think that asset management—active or passive—is so easy. No one in his right mind would walk into the cockpit of an airplane and try to fly it, or into an operating theater and open a belly. And yet they think nothing of managing their retirement assets. I’ve done all three, and I’m here to tell you that managing money is, in its most critical aspects (the quota of emotional discipline and quantitative ability required) even more demanding than the first two. I think that the reason for this is that unlike flying or surgery, investing seems easy—tap a few keystrokes, and hey presto, instant portfolio.”
–William Bernstein, author of The Four Pillars of Investing, quoted in an interview published in the Journal of Indexes, July/August 2008 edition
By tradition the month of December is synonymous with retrospection (or,if you like, introspection). December 2008 is no different.In fact I would argue this is one of the most important financial and economic retrospections one would likely undertake in many years since, economically speaking, the worldin which we live has changed dramatically during the last three months. Strategies once hailed as successful or beliefs and ideas once thought to be sanguine and soundwill need some overhaul to survive the new global economic order.Of course we do not know at this time how it will develop, but change it will.
In my January newsletter this year I sketched a rather bleak economic outlook for the global economy, at least for the foreseeable future. Little did I know that my pessimistic predictions at the time would turn out to bemuch worse in reality – incidentally I always emphasise that I do not take my own or experts’ predictions too seriously when it comes to investment decisions.
I based my pessimism at the time on the following premise: “History has time and again shown to those that are willing to see that cheap and easy credit always leads to irresponsible lending practices and major excesses at the end. When those situations unwind and credit becomes squeezed its consequences are widely felt across the economy. The bottom line is that economic growth goes hand in hand with a sound and healthy banking system; when the latter is in trouble the economy stalls.”
Today we are witnessing the rapid decline of once stable and developed economies as the full effects of the serious global financial crisis are jeopardising the real economy. Recessions are the order of the day, unemployment is rising, business and consumer confidence have hit multi-year lows. The IMF recently downgraded its expectations for global economic growth for the umpteenth time; this time below 2% growth – a figure which usually indicates a severe global economic slowdown. Economists for once agree we are facing the most serious economic crisis since the Second World War.
Commodity prices spectacularly collapsed since July this year in response to the expected major decline in global economic growth.Those commodity groups that rose the most in recent years, like energy and base metals, have experienced the steepest declines. The speculative bubble in commodities has been pricked as the carry-trade – typically borrowing in Yen to invest in commodity assets –came to an abrupt end. The US dollar strengthened remarkably and unexpectedly as investments were repatriated to safe assets, such as US treasuries.
China’s economic growth miracle – a primary reason for the surge in many commodity prices in latter years – is in question. The “decoupling” theory that China would continue to grow unabatedly despite a major slowdown in the developed economies seems to be misplaced. The Chinese authorities realised that their economic growth momentum would only be more or less sustained if domestic economic activities (demand) are boosted dramatically. Subsequently they have announced huge stimulus packages,totalling more than $500 billion,to bolster domestic demand in their economy.
Central banks and governmentsworldwide responded swiftly to the latest worsening economic output figures and embarked on an aggressive loosening monetary policy framework. Inflation, not too long ago a major concern in the wake of rapid commodity price hikes, has taken a backseat as deflationfears – a much more serious economic problem – is the latest concern for central bankers. Hence they will do anything in their power, even a zero-interest rate policy, to prevent a prolonged deflationary environment as was seen in Japan for more than a decade.
In a nutshell, this is going to be a long, hard battle for central bankers and governments to steer the global economy, at least as we know it today, out of the doldrums back to its winning ways. I believe we will get out of this hole, but under different playing rules and regulatory frameworks as we know them today.
If we should view matters from a distance, say Mars, we would conclude that we have experienced in recent times an unusual economic event which will have a profound influence on how the corporate business culture will evolve in the future or what the average investor, say, Joe the plumber,expects from companies and their top management when he invests his hard earned savings in their businesses.
In January I wrote: “Markets also experience from time to time the eruption of so-called 'black swan' or unforeseen events. They typically relate to some economic or socio-political phenomena that can seriously dent investors’ confidence and sentiments in markets which previously were considered to be relatively stable (and profitable) while we seemed to be living in a seemingly predictable (event-free) world. At the start such an event may not seem to pose any real threat, but in time it becomes clear that the extent of 'casualties' was initially severely underestimated. Suddenly a major problem is at hand with seemingly not much time to rectify the situation. Emotions run high.”
In recent times we have witnessed a “black swan” event as the foundation for the modern Western (Anglo Saxon) economies’ growth model – a leveraged financial system – has broken down. Perhaps we have become too complacent with the status quo, i.e. we believed that if things worked in the past, theywill continue to work well. Undoubtedly we have placed,as Alan Greenspan did,too much faith in the operation of capitalism to secure a better world for us all. While we could have justified the theoretical merits of deregulation to enhancethe benefits of capitalism to our greater society, we ignored the reality, namely that markets are fuelled by greed and fear, and not by academically sound arguments or assumed altruistic behaviour by corporate leadership. Perhaps our grandchildren will chuckle –as we sometimes do at the “obvious” mistakes of previous generations – at the sheer naivety of our current generation to allow capitalism,while being the only viable economic system,to run completely out of control. We have virtually allowed a few corporate players and leaders who derived unbelievable monetary benefits from the current economic regime of excessive financial leverageto cause hardship among us allthrough their short-sightedness and reckless risk-taking behaviour.
Consequently, let me share some thoughts where I think we may see some changes in our perceptions and expectations of economical and financial issues. The list is by no means exhaustive and offers merely a glimpse of what to expect going forward:
Firstly, expect a profound change in the global economic balances with the USA on the one side, as the world’s major current account deficit country, and surplus economies, like Japan and China on the other side. For many years it was assumed that US households are the world’s ultimate consumer – consuming much more than they earn while their spending spree on credit were financed by the export orientated or current account surplus economies.
However, it is likely that the endgame has arrived for global imbalances as we know them. The US consumers will be forced to cut their spending within their income levels as credit standards have become much more stringent and conservative. Basically, while the savings rate (as a percentage of GDP) of UShouseholds for many years declined to virtually nil, it will revert once again to more prudent levels. Furthermore, expect the improvement of the savings rate to be secular, not cyclical.Thus do not anticipate that US households would resume their spending frenzy once the financial crisis has subsided and the recession has come to an end. The harsh lessons of the 2008 crisis will not be forgotten any time soon.
On the other hand, many of the Asian countries largely depend on the propensity of US households to consume their exports. In the changing economic environment they will have to stimulate domestic demand much more in their own economies,otherwise they may face dire consequences. Commentators who argue that the Asian economies and markets are the best place to invest in the next decade or more should bearthis in mind before making too optimistic predictions.
Secondly, expect some changes in our views of corporate leadership and their remuneration in relation to that of ordinary earthlings. Jeremy Grantham, the well-respected chairman of GMO Asset Management and one of my favourite market analysts, recently wrote an excellent article, titled “Career Risk and Bubbles Breaking”in which he proposed two very plausible reasons why CEOs of investment banks walked straight into the lion’s den despite clear signs that bubbles were forming in the US housing market.
Firstly, it is a matter of career risk.If everybody else is doing it (leveraging) and making a lot of money in the process, woe the CEO who misses the party and does not want to risk his company’s financial well-being. Sadly, it seems that managing a business has become a short-term, maximising profits at-all-costs objective, instead of a ten-year or more strategy orientation.
The second reason Grantham proposed, relates to the intrinsic capabilities of top management. Very often CEOs are selected for their left-brain skills, such as persuasiveness, decisiveness, charisma and analytical skills. Right-brain skills people on the other hand are much more intuitive and patient in making decisions, thinking carefully about the past and the long-term future. Typically, they are much more interested in outlier events and unique combinations of factors driving markets than their left-brain skills counterparts.Those who exhibit right-brain skills would most likely have averted the meltdown risk of their firms during the financial crisis. Ideally, leadership should have both types of brain skills at their disposal, more specifically at the Board of Directors to stimulate a healthy debate, and not only to be a CEO fan club.
Remuneration of CEOs is always a contentious issue.One group would consider their pay as ludicrous, for others it may be justified in terms of their responsibilities and shareholder value added (Wow! I wonder how that argument would stand up in current market conditions?). Nonetheless, there seems to be some serious disconnect between the arguments for enormous packages and the financial realities that most hardworking people must endure. Then, if something goes horribly wrong, one can always blame the firm’s demise on “irrational” markets, whileCEOs could still walk awaywith a “golden parachute” without ever having to contemplate enjoying anything else than a comfortable retirement lifestyleNeither does he or she have any obligation to repay the vast bonuses earned during the “good times”.
Thirdly, the world of financial leveraging and derivatives has simply become too excessive and complex without regulators and market participants fully appraising the systemic risk that such instruments have caused. Derivatives were originally designed to limit downside risk, yet they became a gambling instrument with bets placed on the future prices of stocks, interest rates, currencies, credit instruments, etc. The explosion in derivative trading is best illustrated by the annual trade in derivatives that increased from $1 billion in the early 1980s to $1000 trillion last year. Furthermore, it is estimated that only 2% of monetary transactions involved actual goods and services in the past year! Many investors paid a significant price by investing in hedge funds and not understanding the risk of the highly leveraged bets they took. Once these positions unwound investors faced the grim reality of losing everything. Financial engineering – once the very lucrative playing field of many PhDs in mathematics – became virtually an abundant profession as the fallacy and folly of applying statistical concepts, such as the bell curve in real markets, became apparent.
Fourthly, a fresh appreciation is needed of the necessity of risk premiums in investment decisions. Market analysts chronically underestimate the downside to markets, especially when bubbles break. For instance it would not be surprising to see companies reporting higher losses than expected, unemployment figures rising above consensus forecasts, and stock markets reaching lows way below reasonable expectations. We are simply not very good at discounting bad news.
Moreover, high risk strategies do not necessarily lead to higher returns, even over long periods of time, and investors may easily end up with nothing at all. The best downside protection for investors is to diversify their assets; not only by investing in many stocks across various sectors of the market, but also in other asset classes, such as property, bonds and cash. Too often investors are told that one should have an aggressive equity exposure (75% plus) while one is young with many years to accumulate wealth. In reality, however, there is little difference in the end values between a portfolio consisting of 50% equitiesor one with 80% equity exposure. Thus, why bother with the latter strategy if more or less the same returns are going to accrue to you with the former, but with much less volatility?
Finally, equity investing is a risky proposition and markets are sometimes priced irrationally both on the upside and downside.Especially in the latter case you will not get good value for your money.
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