Investment newsletter - October 2017

Investment Newsletter October 2017

Markets Behaving Badly Glamorous pop star Selena Gomez leans across the black jack table. She scoops up her winnings, a giant stack of betting chips. She wins again. The crowd builds, there’s a buzz.

A grey-haired professor is sat next to her. Selena wins once more. The crowd loves it.

Neal Foundly Investment Analyst

The professor turns to the camera and explains the analogy with the property boom ahead of the 2007-9 Credit Crisis, pointing out that the crowd, “…think it will go on forever. It’s called extrapolation bias. People see something happening and they extrapolate that it will continue to happen.” Regardless, Selena continues to win.

The crowd want a piece of the action. One spectator bets that Selena will carry on winning and another takes the bet. Others make bets based on the original wager and then more make bets on the secondary bets, and so on.

At the time of the Credit Crisis these bets on bets on bets, known as synthetic credit default obligations were massive (totalling $1.47 trillion or about 10% of the US GDP).

The crowd are really behind Selena now. She’s a lucky lady but perhaps more than that, something special?

The professor dryly points out that this is the ‘hot hand fallacy’, seen so many times in fields such as sports and finance, and drives the belief that the success will continue because of recent wins.

The good times roll on and the crowd is loving it. Then Selena loses. Big. The crowd is crushed, mentally and financially.

The professor, hitting the nail on the head, sums it up that, “The one loss becomes thousands of losses… The crazy part is assuming people will act logically all the time.”

Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.

Investment Newsletter October 2017

Nobel cause

This is one of the classic scenes from the excellent 2015 film^, ‘The Big Short’, one of the clearest explanations of the underlying causes of the Credit Crisis we have seen and well worth a watch.

Thaler is the third behavioural scientist to win the prize, following Daniel Kahneman (2002) and Robert Shiller (2013), underlining the importance of this field of economics.

The wise, grey-haired gentleman sat next to Ms Gomez in the film is Professor Richard Thaler.

Before their research, it was a basic historical tenet of economics to assume that humans would act in their own best interest. These researchers showed that biases, human traits and the way brains are wired are the main reasons why this is not the case and we are not homo economicus.

This week Dr Thaler was awarded a Nobel Prize for his work that (according to the press release) “has incorporated psychologically realistic assumptions into analyses of economic decision-making …. showing how these human traits systematically affect individual decisions as well as market outcomes”

Sense check

How does this relate to markets today?

If you are a regular reader of our output, you may be aware of our caution given that many bond and equity markets are fully or over-valued in our opinion. We put a lot of store in historic data that shows the higher the valuation of the market, the lower the subsequent returns from the market. In the parlance of the markets, we are not outright bears – we do not think a crash is imminent but we are certainly cautious at the current valuations.

But what if we are wrong?

What if it is different this time and bonds are now at structurally lower yields? And what if equities deserve

Sharing the sentiment

Of course, measuring sentiment is difficult as human emotions by nature are ephemeral. However, there are research groups that use surveys and other indicators to try to gauge the market mood.

The Leuthold Group, a boutique research company, analyses this data on a regular basis and recently Ten highest average sentiment years

Average sentiment reading (%)

1976

83.7

2014 1965

Subsequent year gain or loss in S&P 500 (%)

higher valuations given the cash flows from companies are discounted at the lower yields?

Playing devil’s advocate, what other indicators apart from valuations can we use to indicate that markets are nearer the top or the bottom?

Well, what about the quote from the legendary investor, Warren Buffett, who pointed out that, “Two supercontagious diseases, fear and greed, will forever occur in the investment community.” This chimes with the work of Richard Thaler and colleagues that point to the human element in markets are often as important, or maybe more important, than the economic statistics.

produced some interesting findings. In a similar vein to our analysis that shows that the higher the value of the market, the lower the subsequent returns (and vice versa), their numbers show that the higher the sentiment in the market, the lower the subsequent returns (and vice versa). Clearly Messrs Thaler and others have a strong point.

Ten lowest average sentiment years

Average sentiment reading (%)

Subsequent year gain or loss in S&P 500 (%)

-11.5

1994

41.4

76.3

1.38

1969

42.4

0.1

75.6

-13.1

1974

42.7

31.5

34.1

1964

75.0

9.1

1982

42.8

17.3

1983

72.3

1.4

1988

44.7

27.3

2013

71.0

11.4

1968

44.8

-11.4

1972

70.8

-17.4

1981

45.2

-14.8

1971

70.5

15.6

1990

45.4

26.3

2004

70.3

3.0

1970

47.0

10.8

1986

68.9

2.0

2008

47.2

23.5

Source: Leuthold

Average return

0.6

Source: Leuthold

Average return

17.4

Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.

Investment Newsletter October 2017

Canaries in the coalmine

So, where are we now? Well, a weekly survey with a long history of measuring sentiment in the US is the Investors Intelligence Advisors’ survey. Recently, the survey response hit a 30-year high indicating extreme bullishness. Clearly this is a red flag regarding sentiment, but does it translate into real money?

Put bluntly, yes it does. On average, fund managers in the US now have their highest ever weightings to (relatively risky and highly rated) equities. Further, households in the US have more money in shares as a proportion of their total assets than at any time except the peak of the Dot Com boom in 2000, as the graph shows:

Households’ Equities as a % of total financial assets 1Q 2000 42%

2Q 2017: 35.7% 2nd only to 2000

Source: The Lyons Share https://lyonssharepro.com/2017/09/u-s-households-are-loaded-up-with-stocks

The Big Short – The sequel?

Other ‘canaries’ give us cause for concern. Remember Professor Thaler’s explanation about those funny bets on bets called credit default obligations (CDOs)? Surely they’re dead and buried since the Credit Crisis?

high credit ratings. A decade on, welcome to its close relation, the collateralised loan obligation (CLO) which does the same thing. We are watching this closely but headlines in the Financial Times stating, “European CLO issuance at decade high”* tells you the way it is heading.

Yes and no. CDOs’ big deception was that they bundled risky low-grade loans into attractive packages with

The end

Instead of steadfastly holding onto statistics and bare numbers that back an entrenched view, we embrace broader thinking from great minds like Professor Thaler and employ them in our analysis. Thus far, these are serving to reinforce our cautious outlook.

The content contained in this blog represents the opinions of Equilibrium investment management team.

The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader. The value of your investments can fall as well as rise and are not guaranteed.

Investors may not get back the amount originally invested, Past performance is never a guide to future performance.

^ See 3 minutes 26 seconds into this clip: https://www.youtube.com/watch?v=A25EUhZGBws *Financial Times, 11 October 2017, Capital Markets Report

Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.

Investment Newsletter October 2017

General Economic Overview Economic indicators point to positive demand growth in the major economies although several have weakened slightly over the last month.

Growth over recent years has resulted in a steady rise in employment with UK and US unemployment rates now standing at multi-decade lows. That said, demand growth has pushed up inflationary pressures resulting in falling real wage growth which may serve to curb consumer spending going forward.

The Federal Reserve recently indicated that it is inclined to raise interest rates in light of the improved economic outlook and markets now expect an increase at the meeting in November.

Asset class key + positive - negative = neutral (normal behaviour)

+5 strongly positive -5 strongly negative

Asset Class

Score

Equity Markets Most western equity markets, especially the US stockmarket, are overvalued. Stock prices are rising without corresponding earnings growth, pushing up valuations. In contrast, in markets like Asia, including Japan, earnings are keeping pace and the markets offer better value. Our score has moved down from -4 last month to reflect these generally higher valuations.

-5

Fixed Interest

-4

Rising cost pressures give us caution for interest rates, especially in the US and UK, with portfolios positioned to reduce sensitivity to higher rates. Given the financial health of the private sector and the higher yields, we favour corporate bonds to government stock. The score is unchanged over the month.

Commercial Property Returns from commercial property are likely to be low but positive. Rental income will be the main component of returns rather than the capital growth seen in recent years. Brexit raises particular issues

Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.

-4 -5

Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and equity, and hold only a small amount of property. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.

A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.

These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.

Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.