by David Robertson, CFA
April 2015
Much like politics has become especially polarized, so too it seems has investment analysis. There are either perma-bulls or perma-bears and each seems to describe the other as clueless, hapless souls. The unfortunate consequence is that investors who are less partisan and more curious often have to sort through a lot of name calling in their efforts to learn what is really going on.
In such an environment, John Dizard's blunt and objective evaluation of the markets comes through like a breath of fresh spring air. He recently noted in the Financial Times [link], "The policy regime has now made it mathematically impossible for fiduciaries [e.g., investment advisors and pension managers] to meet the beneficiaries' future needs through the prudent buying of securities."
This statement packs a lot of punch. On one hand, Dizard recognizes that despite massive appreciation in the markets since the financial crisis, the gap between assets and liabilities of beneficiaries is still too large. He actually takes his position on valuation one step further for emphasis: "In these market circumstances, short selling by prudent fiduciaries is not about cynical greed but an attempt to preserve the beneficiaries' capital."
On the other hand, by constraining his assessment to "prudent" buying, Dizard also highlights an investment conundrum: investment advisors must either resort to imprudent and speculative buying of securities to try to meet their clients’ needs or face the music that there will be a shortfall.
While this conundrum plagues most investors, at least we have some precedent to guide our thinking. Jim Grant recently recounted the experiences of William McChesney Martin Jr. as chair of the Federal Reserve in the 1950s, at the close of a similar period of financial repression in his piece, “Janet Yellen, say hello to Bill Martin” [link].
According to Grant, "Martin observed that the bond market had become a vassal of the central bank. It had lost its independence of thought even as the Fed had gained its independence of action. 'After 10 years of a pegged market,' said the chairman, 'we found that once the market was freed a little bit, many of the devices and techniques we had been using tended to work in reverse. We found that the dealers, the brokers, the individuals—that composite that makes up the market—instead of making market judgments for themselves were chiefly interested in trying to find out what the Federal Reserve planned to do and how it was going to operate'."
How little has changed! After years now of hearing commentary as to how long the Fed will keep rates low, who the Fed’s hawks and doves are, and how the Fed’s forecasts for interest rates have changed, there is no doubt that many market participants have been "chiefly interested in trying to find out what the Federal Reserve planned to do."
Even more poignantly for investors, however, is the observation that many market participants relinquished "making market judgments for themselves." Since managers are hired expressly for the purpose of “making market judgments,” this peculiar consequence of financial repression may help explain the widening chasm between the unease of many investors and the bullishness of many of their investment managers.
Of course this period of financial repression is not exactly like the one following World War II so it’s important to identify relevant differences. Perhaps the biggest difference since then is that the investment industry has exploded into one that affects a lot more people. Brad Jones picked up on this trend in his working paper for the IMF, “Asset bubbles: Re-thinking policy for the Age of Asset Management” [link].
According to Jones, "the business risk of asset managers acts as strong motivation for institutional herding and 'rational bubble-riding'." Zerohedge clarifies the implication [link], "Simply put, it can be entirely rational—from the perspective of business and compensation risk—for asset managers to knowingly ride bubbles because of benchmarking and the short-term performance appraisal periods often imposed on asset managers by asset owners." Jones concludes that, “procyclicality could intensify as institutional assets under management continue to grow.”
So one consequence we seem to get from an ever-growing investment industry is more herding which causes bigger and bigger swings in the market. Indeed this may go a long way in explaining why stock prices are still going up despite high valuations and deteriorating internals. It’s not “unsophisticated” individual investors chasing performance; it’s “sophisticated” institutional investors riding bubbles for fear of losing their jobs if they miss out. Insofar as this is the case, it would represent a massive deviation from what most investors want and from what Howard Marks described in his 2006 memo [link], "Dare to be Great."
If only the market were subject to wider swings, that would be reasonably manageable, but there is also good evidence that the financial and economic system is more vulnerable to crises. Michael Pettis wrote on the subject in his book, Volatility Machine [link]. It was published in 2001 in response to the spate of crises in emerging markets in the 1990s, but his insights are incredibly valuable in better understanding financial crises in a more general way.
Pettis argues persuasively that financial events that devolve into crises (as opposed to just posing transient problems), are ultimately about "balance sheet mismanagement and not economic mismanagement." As he describes, "The problem is not the actual shock or its causes but rather the way the shock is transmitted into the real economy. In other words, currency adjustments or other shocks may reflect economic pressures, but the mechanism by which a small adjustment becomes a market break is everywhere and always a problem of corporate finance, not economics." Since the robustness or fragility of a system is contingent upon capital structure, that structure ought to be "primarily defensive."
How defensive? As Pettis elaborates, "Markets can be structured in ways that automatically increase or reduce the volatility caused by random information changes. These structures have an important effect on the way market players behave to diminish or exacerbate the initial effect of information changes, so that price changes end up reflecting more than just changes in the underlying prospects and can, in fact, cause additional self-reinforcing price movements." The "rational bubble riding" behavior of investment managers that Jones observes certainly seems to argue for a capital structure that is extremely defensive.
Unfortunately what we actually have is a national capital structure with record amounts of corporate and government debt and precious little capacity to absorb future shocks. We also have a system that, by all accounts, is subject to self-reinforcing behaviors that will make things even worse when the shock(s) hit. If and when the next market crisis occurs, it cannot be argued that it was impossible to see coming.
Armed with this perspective, what can investors do? For one, this background goes a long way in explaining the ever-widening gap between what investors see and what investment managers see. Investors are rightly concerned about preserving their capital in light of what appears to be a poor risk/return environment. Investment managers are desperately trying to keep their jobs by maintaining or even increasing exposure to risk. Hopefully by identifying some of the causes behind such disparate views, investors can find the help that is best aligned with their goals.
A second implication of this analysis is that the exercise of asset allocation is probably going to need to be revisited. Given increasing correlations among all conventional asset classes, there is simply very little opportunity any longer to materially reduce risk through diversification. The consequence is that an unchanged asset allocation policy now entails much greater risk than it used to.
Nowhere was this made clearer than in a recent article in the Economist [link]. According to the note, "Government bonds have typically been used as ‘shock absorbers’ within portfolios." At exceptionally low yields, however, they fail to operate this way. “Since prices move in the opposite direction to yields, it is thus difficult to imagine investors buying bonds at current yields making much of a capital gain. It is easy, though, to imagine them making a big loss. If inflation returns, nominal yields would rise sharply and prices would plummet. Government bond returns seem likely to have a negative skew." In short, in a low rate environment, investors not only can't rely on bonds to cushion portfolio volatility, they may add to it – and this turns the whole asset allocation exercise upside down.
All of this points to an industry at a crossroads. While a sustained period of low rates is difficult for anyone trying to save and invest, it is especially difficult for those constrained in their ability to adapt. Large institutional investors may well be hamstrung by herding and rational bubble riding behaviors and will have a hard time changing their stripes. Interestingly, this environment may actually favor individuals and small institutions who can gather relevant information and think independently, and, in Howard Marks’ words, dare to be great.
April 2015
Much like politics has become especially polarized, so too it seems has investment analysis. There are either perma-bulls or perma-bears and each seems to describe the other as clueless, hapless souls. The unfortunate consequence is that investors who are less partisan and more curious often have to sort through a lot of name calling in their efforts to learn what is really going on.
In such an environment, John Dizard's blunt and objective evaluation of the markets comes through like a breath of fresh spring air. He recently noted in the Financial Times [link], "The policy regime has now made it mathematically impossible for fiduciaries [e.g., investment advisors and pension managers] to meet the beneficiaries' future needs through the prudent buying of securities."
This statement packs a lot of punch. On one hand, Dizard recognizes that despite massive appreciation in the markets since the financial crisis, the gap between assets and liabilities of beneficiaries is still too large. He actually takes his position on valuation one step further for emphasis: "In these market circumstances, short selling by prudent fiduciaries is not about cynical greed but an attempt to preserve the beneficiaries' capital."
On the other hand, by constraining his assessment to "prudent" buying, Dizard also highlights an investment conundrum: investment advisors must either resort to imprudent and speculative buying of securities to try to meet their clients’ needs or face the music that there will be a shortfall.
While this conundrum plagues most investors, at least we have some precedent to guide our thinking. Jim Grant recently recounted the experiences of William McChesney Martin Jr. as chair of the Federal Reserve in the 1950s, at the close of a similar period of financial repression in his piece, “Janet Yellen, say hello to Bill Martin” [link].
According to Grant, "Martin observed that the bond market had become a vassal of the central bank. It had lost its independence of thought even as the Fed had gained its independence of action. 'After 10 years of a pegged market,' said the chairman, 'we found that once the market was freed a little bit, many of the devices and techniques we had been using tended to work in reverse. We found that the dealers, the brokers, the individuals—that composite that makes up the market—instead of making market judgments for themselves were chiefly interested in trying to find out what the Federal Reserve planned to do and how it was going to operate'."
How little has changed! After years now of hearing commentary as to how long the Fed will keep rates low, who the Fed’s hawks and doves are, and how the Fed’s forecasts for interest rates have changed, there is no doubt that many market participants have been "chiefly interested in trying to find out what the Federal Reserve planned to do."
Even more poignantly for investors, however, is the observation that many market participants relinquished "making market judgments for themselves." Since managers are hired expressly for the purpose of “making market judgments,” this peculiar consequence of financial repression may help explain the widening chasm between the unease of many investors and the bullishness of many of their investment managers.
Of course this period of financial repression is not exactly like the one following World War II so it’s important to identify relevant differences. Perhaps the biggest difference since then is that the investment industry has exploded into one that affects a lot more people. Brad Jones picked up on this trend in his working paper for the IMF, “Asset bubbles: Re-thinking policy for the Age of Asset Management” [link].
According to Jones, "the business risk of asset managers acts as strong motivation for institutional herding and 'rational bubble-riding'." Zerohedge clarifies the implication [link], "Simply put, it can be entirely rational—from the perspective of business and compensation risk—for asset managers to knowingly ride bubbles because of benchmarking and the short-term performance appraisal periods often imposed on asset managers by asset owners." Jones concludes that, “procyclicality could intensify as institutional assets under management continue to grow.”
So one consequence we seem to get from an ever-growing investment industry is more herding which causes bigger and bigger swings in the market. Indeed this may go a long way in explaining why stock prices are still going up despite high valuations and deteriorating internals. It’s not “unsophisticated” individual investors chasing performance; it’s “sophisticated” institutional investors riding bubbles for fear of losing their jobs if they miss out. Insofar as this is the case, it would represent a massive deviation from what most investors want and from what Howard Marks described in his 2006 memo [link], "Dare to be Great."
If only the market were subject to wider swings, that would be reasonably manageable, but there is also good evidence that the financial and economic system is more vulnerable to crises. Michael Pettis wrote on the subject in his book, Volatility Machine [link]. It was published in 2001 in response to the spate of crises in emerging markets in the 1990s, but his insights are incredibly valuable in better understanding financial crises in a more general way.
Pettis argues persuasively that financial events that devolve into crises (as opposed to just posing transient problems), are ultimately about "balance sheet mismanagement and not economic mismanagement." As he describes, "The problem is not the actual shock or its causes but rather the way the shock is transmitted into the real economy. In other words, currency adjustments or other shocks may reflect economic pressures, but the mechanism by which a small adjustment becomes a market break is everywhere and always a problem of corporate finance, not economics." Since the robustness or fragility of a system is contingent upon capital structure, that structure ought to be "primarily defensive."
How defensive? As Pettis elaborates, "Markets can be structured in ways that automatically increase or reduce the volatility caused by random information changes. These structures have an important effect on the way market players behave to diminish or exacerbate the initial effect of information changes, so that price changes end up reflecting more than just changes in the underlying prospects and can, in fact, cause additional self-reinforcing price movements." The "rational bubble riding" behavior of investment managers that Jones observes certainly seems to argue for a capital structure that is extremely defensive.
Unfortunately what we actually have is a national capital structure with record amounts of corporate and government debt and precious little capacity to absorb future shocks. We also have a system that, by all accounts, is subject to self-reinforcing behaviors that will make things even worse when the shock(s) hit. If and when the next market crisis occurs, it cannot be argued that it was impossible to see coming.
Armed with this perspective, what can investors do? For one, this background goes a long way in explaining the ever-widening gap between what investors see and what investment managers see. Investors are rightly concerned about preserving their capital in light of what appears to be a poor risk/return environment. Investment managers are desperately trying to keep their jobs by maintaining or even increasing exposure to risk. Hopefully by identifying some of the causes behind such disparate views, investors can find the help that is best aligned with their goals.
A second implication of this analysis is that the exercise of asset allocation is probably going to need to be revisited. Given increasing correlations among all conventional asset classes, there is simply very little opportunity any longer to materially reduce risk through diversification. The consequence is that an unchanged asset allocation policy now entails much greater risk than it used to.
Nowhere was this made clearer than in a recent article in the Economist [link]. According to the note, "Government bonds have typically been used as ‘shock absorbers’ within portfolios." At exceptionally low yields, however, they fail to operate this way. “Since prices move in the opposite direction to yields, it is thus difficult to imagine investors buying bonds at current yields making much of a capital gain. It is easy, though, to imagine them making a big loss. If inflation returns, nominal yields would rise sharply and prices would plummet. Government bond returns seem likely to have a negative skew." In short, in a low rate environment, investors not only can't rely on bonds to cushion portfolio volatility, they may add to it – and this turns the whole asset allocation exercise upside down.
All of this points to an industry at a crossroads. While a sustained period of low rates is difficult for anyone trying to save and invest, it is especially difficult for those constrained in their ability to adapt. Large institutional investors may well be hamstrung by herding and rational bubble riding behaviors and will have a hard time changing their stripes. Interestingly, this environment may actually favor individuals and small institutions who can gather relevant information and think independently, and, in Howard Marks’ words, dare to be great.
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