For most of the quarter, markets were fairly placid after rebounding nicely from a China scare early in the year. Unemployment remained low and while economic indicators were mixed, the economy continued to plug along.
This fairly benign state of affairs came to an abrupt halt when the UK decided to leave the European Union (EU) on June 23. The decision, which virtually nobody predicted, struck a chord of fear and uncertainty into markets that seemed to come out of nowhere and begs at least a couple of questions. Why did such a seemingly innocuous event have such a big impact? If Brexit was such a big deal, why was there so little discussion of it before the referendum vote?
One of the best analyses of these events comes from Ben Hunt [here]. As he describes, "In the short term, the risk is a liquidity shock, or what's more commonly called a Flash Crash. That could happen today, or it could happen next week if some hedge fund or shadow banking counterparty got totally wrong-footed on this trade and — like Bear Stearns — is taken out into the street and shot in the head."
He continues, "In the long term, the risk is an acceleration of a Eurozone break-up, which is indeed a Lehman moment (literally, as banks like Deutsche Bank will become both insolvent and illiquid). There are two paths for this. Either you get a bad election/referendum in France (a 2017 event) or you get a currency float in China (an anytime event). Brexit just increased the likelihood of these Humpty Dumpty events by a non-trivial degree." John Authers shared similar sentiments in the Financial Times [here]: "By setting a precedent, it [Brexit] emboldens the various nationalist movements throughout the EU, and sharply increases the chances that the eurozone will fracture."
Investors may nod in vague agreement with these assessments, but after watching prices fall sharply, and then rebound just as sharply, may still be left wanting some explanation as to why and how such violent activity could happen.
For longer term investors who are less interested in being jerked around from one sensationalist account to another and more interested in managing long term conditions, Neil Postman provides a number of useful insights in his book, Amusing Ourselves to Death. Although the book was originally published in 1985, its messages regarding media and information content are arguably even more applicable today.
Postman's general thesis is that the form of media fundamentally shapes the nature of consumers' interaction with it and, therefore, the types of messages that can be effectively delivered by it. More specifically, he argues that print is a far superior medium for conveying serious messages and information and that this is almost impossible to do through more modern forms of media such as television. He explains how print, which requires so much more effort and engagement by its consumer, encourages thought and reflection. Television and other more contemporary media platforms, by contrast, work through images and evocative sound tracks. Their effect on consumers is quite different. As Postman says, "television speaks in only one persistent voice—the voice of entertainment."
He drives home his point by describing one of the historical interchanges between Stephen Douglas and Abraham Lincoln. "For example, on October 16, 1854, in Peoria, Illinois, Douglas delivered a three-hour address to which Lincoln, by agreement, was to respond. When Lincoln’s turn came, he reminded the audience that it was already 5 p.m., that he would probably require as much time as Douglas and that Douglas was still scheduled for a rebuttal. He proposed, therefore, that the audience go home, have dinner, and return refreshed for four more hours of talk. The audience amiably agreed, and matters proceeded as Lincoln had outlined."
Postman rightly asks, "What kind of audience was this? Who were these people who could so cheerfully accommodate themselves to seven hours of oratory?" Clearly they had a radically different attention span than audiences of today. Postman asks rhetorically, "Is there any audience of Americans today who could endure seven hours of talk? or five? or three? Especially without pictures of any kind?" And yet at the same time, the 1854 audience was one of normal Americans that was unique only in their intense curiosity to learn more about the serious and pressing issue of the day, that of slavery.
While technology has brought many advantages to media platforms, that progress has also come with its costs. Postman makes the case that, "as typography moves to the periphery of our culture and television takes its place at the center, the seriousness, clarity and, above all, value of public discourse dangerously declines," or, as he also notes, "we are getting sillier by the minute." One can hardly argue the point judging by the nature of what passes for public discourse today and highlighted by the presidential campaign thus far. Conversely, imagine how ridiculous and inappropriate it would seem to have discussed a topic as important as slavery on "Entertainment Tonight" or through a theater production.
Interestingly, the distinction Postman makes in regards to the expositional capacity of various forms of media parallels the distinction that John Hussman makes in regards to the causes of certain events such as market declines [here]. As Hussman describes, there is an important contrast between proximate causes, or "triggers", and ultimate causes, or "latent risk".
Hussman illustrates, "Imagine the error of skating on thin ice and plunging through. While we might examine the hole in the ice in hindsight, and find some particular fracture that contributed to the collapse, this is much like looking for the particular pebble of sand that triggers an avalanche, or the specific vibration that triggers an earthquake. In each case, the collapse actually reflects the expression of sub-surface conditions that were already in place long before the collapse - the realization of previously latent risks."
Hussman goes on to note, "Finding the specific trigger that causes the skaters to plunge through the ice isn’t particularly informative. The fact is that catastrophe is inevitable the moment the skaters ignore the latent risk, or rely on faulty evidence to conclude that the ice is stable."
This model of triggers and latent risks is relevant to Postman's thesis because it is the triggers which tend to be exciting and "newsworthy" even though they aren't "particularly informative". Conversely, it is the latent risks, or ultimate causes, which are often complex and nuanced, and can lurk unrealized for long periods of time. In other words, they tend to be dreadfully unexciting topics for most news venues, even though they are incredibly important in regards to longer term outcomes.
This perspective provides some useful context from which to assess market related events. In the case of Brexit, for example, one lesson is that the UK's vote to leave the EU is a proximate cause and is not really very informative by itself. This isn't to trivialize the reality that any significant reconfiguration of the EU wouldn't have significant global implications, but rather that the tensions within the EU have been present almost since its inception. The common currency was always suspect and the Greek saga since 2011 has highlighted structural flaws in the EU's financial arrangements.
There are more information lessons from the UK's vote to leave the EU, however. Although it was widely suspected that the vote would be close, virtually nobody expected the Leave vote to succeed. Indeed, as John Authers noted, "the hubris with which speculators bet that the British would stay in the EU was spectacular. As the polls closed, the pound topped $1.50 - it's highest in a year." In other words, considering the margin of error of polls and the expected value of outcomes, the value of the pound should have incorporated a higher chance of leaving. It seems as if something else was going on.
Political pundits were also shocked by the results which suggests there were some significant disconnects between their view of the world and that of the electorate. We know now that the results clearly demonstrated patterns along demarcations of age and socioeconomic condition. Older and poorer people predominately voted to leave. The fact that these voices came out much louder than expected in the vote suggests that public discourse about important issues has been ineffective and has now also become a political problem. Too many people realize that the system isn't working for them and in too many cases, the problems are not even being seriously addressed.
Meanwhile, millennials have been expressing their outrage at the result claiming, rightly, that it affects them more harshly. However, Roula Khalaf notes in the Financial Times [here] that the outrage did not translate to action during the election: "Financial Times data shows that areas with young populations recorded low turnout and one poll suggests that only 36 per cent of 18-24s voted ... The same poll points to an 81 per cent turnout among 55-64 year-olds and 83 per cent among the over-65s." She hypothesizes, "Perhaps the fight to preserve what they have does not fire them up as much as changing the world or reaching for some utopian ideal." Regardless, it is fascinating that parties that had much to lose simply did not act in their own interest to prevent the loss.
Long term investors can apply these findings to their own research efforts in at least two ways. One is to focus on the longer term, ultimate causes of investment moves and to avoid getting caught up in the shorter term, proximate causes. The second goes hand in hand with the first; focus primarily on sources of research and advice that have strong expositional qualities, i.e., that explain things, have high information content, and can inform decision making. This does not suggest avoiding all entertainment, it just suggests not confusing entertainment with the serious business of investing.
That said, the most important ultimate cause of long term returns is valuation and therefore that should be the main focus for long term investors. On this point, Hussman illustrates nicely in a recent analysis [here] that stocks are extremely overvalued. In his words, "investors should understand that beneath the surface ... is singularly the most extreme point of overvaluation for the broad equity market in history."
While valuations have been extremely high for some time, a deeper look at corporate fundamentals reveals that they have been deteriorating. Sales for the S&P 500 were down 2.6% year over year for 2015 and down 1.7% year over year in the first quarter. Operating income was down 7.7% for the year and 1.0% for the quarter. Total debt, on the other hand, was up 2.4% in 2015 and up 4.0% in the quarter. An important consequence is that firms are less and less capable of being the buyers of last resort of their shares through share repurchase programs. The distinct contrast between the downward momentum of fundamentals and the buoyancy of stock prices was observed by John Burbank in a Real Vision TV interview in May in which he noted, "From February to May we had multiple expansion in many things with essentially declining earnings. It's very hard to invest responsibly when that's happening."
Hussman provides an illustration of this market dynamic: "The greatest danger comes when investors insist on speculating even after market internals have deteriorated and momentum has rolled over. Following a long period of speculative success, they may be tempted to ignore latent risks, and to keep speculating on the time delay between the emergence of latent risks and their abrupt expression. They fall victim to the delusion that, in the words of Citigroup’s Chuck Prince just before the global financial crisis, 'as long as the music is playing, you’ve got to get up and dance'."
Although the combination of extreme overvaluation and noticeable degradation of fundamentals suggests positioning for a "big short", monetary policy has served as a strong, but increasingly unpredictable, crosscurrent. Having been applied repeatedly since 2008, monetary policy has overwhelmed, at least temporarily, every major risk in the last five years including the eurozone crisis in 2011, the taper tantrum, China slowing, and the US slowing. In the process, these policy responses have rewarded all of the would be Chuck Princes out there and taught many investors exactly the wrong lessons about managing risk.
Mohamed El-Erian summed up these conditions in the Financial times [here] ,"For quite a while investors have been comforted by the notion that central banks are willing and able to shield them sustainably from the detrimental effects of unusual economic and political development," but continued, "Few, if any, of the tools that central banks have at their disposal can effectively deal with the complications that Brexit entails. Markets face an even bigger 'fat tail' of potential policy mistakes and/or market accidents." In addition, Burbank describes the policy changes as "not analyzable" and as "making investing really hard". He concludes that "not playing [i.e., not investing] has been the right call this year."
As a result of these complexities, investment strategies for most investors should remain defensive. High levels of valuation signal both low expected returns and the distinct potential for significant market declines. For those managing retirement funds, caution is the word. In addition, while cash does not provide returns, it does provide an option to buy assets more cheaply at some time in the future. While this investment "purgatory" can wear on one's patience, long term investors are best served to keep their attention on the long term and to be patient.
Finally, Postman provides a societal perspective on his thesis by comparing the visions of George Orwell as represented in 1984 and Aldous Huxley as represented in Brave New World. Postman notes, "What Orwell feared were those who would ban books. What Huxley feared was that there would be no reason to ban a book, for there would be no one who wanted to read one." In slightly different terms, "In 1984 ... people are controlled by inflicting pain. In Brave New World, they are controlled by inflicting pleasure." Ultimately, "Huxley feared the truth would be drowned in a sea of irrelevance."
For better and worse, these words have been incredibly prophetic. In an important sense they help explain both how a population of eyeballs glued to smart phones can fail to show up to vote on a very important issue to them and how a different segment of the population was so disenchanted with being ignored that they finally "acted out" at the voting booth. They also point to a way for things to improve. Difficult problems require analysis, understanding and discussion for successful resolution. We have the tools if we choose to use them. If we don't, good ideas and potential solutions will "drown in a sea of irrelevance." Either way, the quality of discourse and problem solving are quite likely to be ultimate causes of many important future political and economic events.