The Great Humiliator is the phrase that Ken Fisher, my California-based money manager friend, likes to use to describe the stock market’s capacity to play with people’s minds and reputations. By that he means the market’s ability to confound, at regular intervals, the expectations of all investors, especially those with big wallets and lofty reputations. Nobody, feared or famous, professional or amateur, is safe from finding their predictions of what is likely to happen confounded by events.
Experience since the Brexit referendum has amply confirmed, for the umpteenth time in my career, the wisdom of that label. All the pundits who predicted immediately dire consequences from the UK’s decision to leave the European Union look a little foolish today. Yes, sterling has fallen by around 10% – which is certainly no small thing – and gilt yields have fallen sharply.
Both of those were predicted. Yet the major stock market indices (not just the Footsie but the 250 and All-Share indices too) are all trading higher than they were on the day before the vote. The Footsie is up by around 7%, thanks to the boost which a falling pound gives to the reported overseas earnings of its many large multinational constituents. That most definitely was not what the Bank of England, the IMF and many other reputable organisations were expecting.
Anyone with a typical balanced portfolio, a mixture of shares, bonds, cash and property, has come through Brexit remarkably well so far. According to Asset Risk Consultants, a consultancy which measures the performance of the great majority of UK private client brokers and wealth managers, the typical balanced portfolio in their sample returned more than 3% in the month of June. This was the best single monthly performance for more than five years – on that basis maybe we should have a referendum every year!
There is no better indication of the value of having a broadly diversified portfolio as insurance against both visible and unexpected risks. The whole point of diversification after all is to save you having to worry when supposedly bad things, such as our voting to leave was meant to be, do happen. For a while at least, it absolves you from the need to take any remedial action – which is helpful, since panicky reactions to unexpected events often turn out to be costly mistakes.
But what is new (or rather what the markets have just taught us once again) is that one of the biggest risks investors face is taking heed of experts who get things wrong. You need to insure against that too.
Everyone and no-one’s an expert
Of course it is early days, and the longer term fallout from the Brexit vote will take time to materialise. As we don’t yet know how or on what basis we will end up leaving the EU, many permutations are possible. (Don’t believe anyone who claims to know for sure). The most convincing of the many analyses I have ploughed through over the past six months is that of the independent think tank Open Europe, which concluded that after an initial setback, the long term economic impact of leaving will be somewhere between mildly positive and mildly negative, depending on how flexibly in practice we are able to adapt our trade and immigration policies. All the financial markets have really told us so far is that this judgment is probably correct.
But how then is it possible to explain the remarkable unanimity with which both official institutions and the great majority of professional economists have predicted that Brexit would be an economic disaster? The answer is that most economists work with similar mathematical models and share a broadly similar set of assumptions, which include the idea that uncertainty has economic costs and that anything which restricts trade is a negative. Feed those similar assumptions into a similar kind of model, and it is really no surprise that the results with an event like Brexit will be broadly the same.
But the trouble with all economic models is that the world economy is too complex for any one model, however sophisticated, to capture all the underlying dynamics of the billions of individual decisions that businesses, governments and consumers make every day. In reality, said the famous economist J.K.Galbraith, “economists make forecasts, not because they know, but because they are asked”.
Brexit is certainly not an isolated example of expert folly. Remember the well-publicised call by strategists at one of our leading investment banks back in January that clients should “sell everything except high quality bonds”? That too looks pretty dumb now (although the individual in question is still happily employed in his job, as far as I can see). It is always worth bearing in mind that there are so many media and City pundits competing for airtime these days that many feel they have to exaggerate in order to get noticed.
The underlying problem is a more fundamental one. A comprehensive study over many years by the political scientist Philip Tetlock discovered not only that experts generally make indifferent forecasters, but that the more high profile the expert, the more useless their efforts at prediction become – typically because they become over-confident in believing their own rhetoric. More recently he has suggested, in a new book, that ordinary people using intuition and common sense are more likely to predict the future successfully than any number of experts.
Lets hope that he is right. Personally, when thinking about the stock market, I prefer the approach of the late Jimmy Goldsmith, a successful investor who had a blunt approach when discussing investment ideas with his brokers or friends. “Don’t tell me what you think” he liked to say. “Tell me what you are doing”.He meant of course that while opinions may be interesting, deeds carry far more weight. An idea you have put your own money behind is a lot more convincing than one you merely talk about.
Once a contrarian….
On a similar theme, I am old enough to remember when regular monthly surveys of fund manager views were first introduced in the UK. At the time it seemed like a revolutionary move. At last we would know where the institutions which controlled most of the market were placing their money, making it easier for everyone else to know what to do. In practice it has turned out rather differently. Thirty years on the fund manager survey, now run by Bank of America Merrill Lynch, remains an invaluable source for gauging where professional consensus market opinion resides, but its greatest use is as a contrarian indicator.
In other words, where the big boys and girls in fund management have positioned their portfolios is often a good guide where not to put your own money. That is not necessarily a reflection on the fund managers’ skill or expertise (although there are certainly other reasons for challenging those attributes). If 80% of institutional investors are overweight in say the energy sector, and have placed their bets accordingly, it simply means that the weight of their money is already “in the price”, making it too late to follow them in.
Fund managers’ cash holdings are a particularly useful contrarian indicator. The more they hold in cash, whether because of uncertainty, fears about the level of the market or simply heightened risk aversion, the more positive the outlook for the equity market tends to be. In the latest survey, published this week, but completed shortly after the Brexit vote, cash holdings were at their highest levels since 2001. If past form is any guide, that could make for a positive market backdrop over the next few weeks. It may also help to explain why the dire warnings from the IMF and others have so far failed to dent the stock market’s performance.
Take a look at this chart
Current market conditions are also, it has to be said, throwing up some remarkable oddities. Take a look at this chart for example, taken from the HL website, using its charting tool. Care to hazard a guess what security this is, one that has trumped the performance of the FTSE All-Share index (shown by the red line) over the past three years? It certainly looks like that of a company – maybe in high tech – which has been on a roll or, like Arm Holdings perhaps, just attracted a takeover bid.
Well think again. This high-flying security is actually a Government bond, traditionally regarded as one of the dullest and safest places to put your money! To be more precise, the chart shows the price of the Treasury 4% 2060 gilt. This gilt is money which the UK government has borrowed from investors with the promise to repay in full 44 years from now. The bond has risen by 70% since it was issued six years ago. The price is up 31% in the last 12 months alone.
Those who say that government bonds have changed from offering “risk-free returns” to “return-free risk” clearly need to think again. There is actually plenty of return: it is just that it is coming through as unpredictable capital rather than as predictable income. The gross redemption yield on the 2060 gilt, the compound rate of return you would earn if you were to buy the gilt today and hold it all the way through to the day the Government pays you back in 2060, is a miserly 1.5%.
Students of finance know that the longer the life of a bond, the more volatile its price. A low-interest rate environment magnifies that effect even further. But the recent behaviour of long-dated gilts is still extraordinary. The question we all need to answer is whether these dramatic returns are merely the rewards for extraordinarily high levels of risk, or are trying to tell us some as yet unclear good news story? If it can go up this quickly, the price of gilts can of course also fall at the same pace.