With the strong 9% rise in the S&P 500 in the fourth quarter and the 31.5% return for the year, the dismal fourth quarter a year ago all but faded from memory. Indeed, from the perspective of the strong performance of the last ten years, any bouts of weakness look more like uninteresting footnotes rather than important premonitions.
There are reasons for investors to be on alert, however. Two phenomena, in the forms of continued implementation of ultra-loose monetary policy by all major central banks and the migration from active to passive management have coincided with this span of strong performance. While many commentators argue that these forces are benign, there is no doubt that they affect the way investors interact with the economic landscape and with each other. In order to make an objective assessment, it helps to look elsewhere for clues.
As it happens, another venue in which people regularly interact with their environment and with each other is in traffic. Tom Vanderbilt's book, Traffic: Why We Drive the Way We Do (and What It Says About Us), reveals some fascinating insights into these interactions that also prove surprisingly useful in the context of investing.
One regards the concept of safety. The conventional approach to safety has focused on engineering design so as to "compensate for the driving errors [the driver] will eventually make." The case of T-intersections provides an excellent example:
"Engineers use the factor of driver reaction time to determine what the appropriate sight distance should be—that is, the point at which the driver should have a clear view of the intersection. The sight distance is typically made longer than needed, to accommodate drivers with the slowest reaction times (e.g., the elderly)."
"Railroad crossings where the sight distance is restricted—that is, where you can see less of the track and the oncoming train—do not have higher crash rates than those with better views."
Once again, the situation that appeared more complicated and prone to accident was actually safer. The "livable" section, with its narrower lanes and more challenging conditions, was "safer in every meaningful way". Vanderbilt describes, "The wider lanes and lack of any roadside obstacles in the comparison section make the 45 miles per hour seem optional, and some drivers are hitting near-highway speeds as other drivers are slowing to enter Wal-Mart or coming out of Wendy's."
The main lesson is that safety cannot simply be engineered because it also depends on the reaction functions of drivers to their environment and to one another. When there are lots of obstacles and other vehicles, drivers intuitively slow down. When there is a wide, clear road, people instinctively speed up. As a result, perfectly well-intended efforts to make roads safer and more "forgiving" actually make them more "permissive" by giving "license to people to drive more quickly."
Another interesting insight derives from efforts to control traffic. A wide array of signs, signals, and markings are used to control and direct traffic. Just as with road design, however, drivers also interact with signs in some interesting ways. By way of comparison, when roads do not have signs, drivers are normally perfectly capable of safely navigating them by taking in cues from the environment. It takes focused attention to do so, but drivers can do this.
When signs and signals are present, however, drivers tend to disengage from the active effort of assessing road conditions and instead become overly reliant on those signs and signals. As Vanderbilt describes, "We have a strange, almost fetishistic belief in the power of signals."
This reality is borne out by the surprising fact that "more urban pedestrians are killed while legally crossing in crosswalks than while jaywalking." The reason is that "perfectly sober drivers who have paid slavish attention only to their own green light" fail to notice pedestrians who legally have the right-of-way.
"Researchers have long known that inexperienced drivers have much different "visual search" patterns than more experienced drivers. They tend to look overwhelmingly near the front of the car and at the edge markings of the road. They tend not to look at the external mirrors very often, even while doing things like changing lanes. Knowing where to look—and remembering what you have seen—is a hallmark of experience and expertise."
For example, ultra-loose monetary policy (in the form of low rates and substantial and frequent liquidity infusions) are intended to reduce volatility and therefore make the investment landscape safer. Just as with roads, however, those benefits quickly get consumed by investors who take on more risk. As a result, efforts to make markets more forgiving actually just make them more permissive.
In addition, efforts by the Fed to provide "forward guidance" have a parallel with traffic signs. Both are intended to control and direct traffic. Both invite people to slavishly follow the signs at the expense of engaging with the situation and making their own evaluation of risks.
Finally, just as experience helps with driving, so too does it help with investing. Inexperienced investors tend to focus too much attention on things right in front of them such as daily news, short-term price movements, and incessant commentary. They also have trouble incorporating context such as how much risk they are exposed to as indicated by valuations and expected returns. Such weaknesses, especially in the presence of permissive markets, create absolutely treacherous conditions for less experienced investors.
These observations also put the skills of central bankers in a different light. While some view central bankers as skillfully engineering safe "roads" for investment, the research from Traffic suggests otherwise. Even though such efforts may well have been made with good intentions, they actually have facilitated more permissive markets and greater risk-taking while simultaneously distracting investors from the risks at hand. Such conduct reveals a striking obliviousness to the learnings from other fields and to the harmful effects of their policies.
Further, the challenges of these conditions are amplified by the trend towards passive investing. More specifically, since people interact with, and take cues from, their environment, passive funds shield them from many of the useful signals and information content that arises from underlying securities.
As it stands, people already have a hard enough time maintaining situational awareness. For example, in the traffic world, "drivers often do not have a clue about how fast they're actually traveling—even when they think they do." This shortcoming is exacerbated by larger, heavier vehicles that don't bounce around as much and that tend to be higher off the ground. As a result, "SUV and pickup drivers speed more than others." In exactly the same way, passive investing distances people from the investment road and reduces their perception of risk.
Fortunately, this particular tendency is easy to keep in check. Vanderbilt explains this is why we have speedometers and recommends that "you should pay attention to yours". By the same token, investors should also find reliable gauges of investment risk to make sure they don’t inadvertently end up going too fast.
So, investors face plenty of challenges and they are not being made any easier by central banks. Rather, the Fed is advocating greater risk for investors with no consideration of what appropriate risk levels might be. It is equivalent to pulling people over on the highway and telling them to drive faster. Some younger, more aggressive investors will find this exhilarating and run with it. Many others, such as retirees, people with families, and people who just can't afford an accident will find the new highway speeds frightening.
This environment of ever-higher speeds is unlikely to change until the Fed learns to incorporate a reaction function for investors into its policy making considerations or until there is a big accident. Until then, investors will do well to look out for themselves and simply stay off the roads if they appear unsafe.
In sum, the new year provides a convenient milestone by which to look back and make some assessments. Clearly, loose monetary policy and the migration from active to passive management have been dominant investment themes. As the insights from Traffic also make clear, these forces have also been making the investment environment progressively riskier. In order to accurately assess and manage that risk, it will help a lot to re-establish a connection with the individual companies that ultimately drive economic growth and create wealth.