At the beginning of this year many market participants saw the fall in equity prices as a precursor to the end of this economic cycle. Even in the absence of a recession, many forecasted a further slide in equity prices, as markets were seen as too expensive.
Residents of the United States, please read this important information before proceeding
We had a different view and saw this downturn as an opportunity to tilt further towards risk assets. Our main arguments were that economic cycles don’t die of old age but mostly end due to excesses, and we couldn’t find sufficient excesses to call an end to this cycle yet. We also considered the fall in oil prices as a net benefit for economic growth over time, and the economic downturn in China as manageable.
As always, when you go against the crowd you have to make sure your analysis isn’t flawed or biased. The best way to do that is to test the arguments that could undermine your views. And to do this with an open mind, making sure you give these arguments a fair hearing with best interpretation. Karl Popper for investors.
In this second quarter Compass, the theme is growth and equities. In the first article, William Hobbs, Head of Investment Strategy in UK and Europe, has written about the key driver of global growth – the US consumer – and to what extent we can continue to rely on this driver. One concern about recent income growth is that it is so unequally distributed that it will translate into lower consumption growth, as the higher savings rates of the wealthier suck spending growth out of the economy. Even though this inequality can have social and economic ramifications, we currently don’t see it having a sufficiently strong impact on US consumption patterns to change our tactical positioning.
Our second article outlines our tactical exposures relative to our long-term strategic asset allocation and the major reasons for our positions. We are currently overweight equities, with a strong overweight in Developed Markets Equities and neutral in Emerging Markets Equities. We are underweight within the overall fixed income area, with the underweights being expressed in Investment Grade and Emerging Markets Bonds, while being neutral Developed Government Bonds and Cash & Short-Maturity Bonds, and slightly overweight High Yield Bonds. We continue to be underweight Commodities and neutral Real-Estate and Alternative Trading Strategies.
In the following article, the Investment Strategy team addresses the argument that the equity market might be so overvalued that we will see a substantial downturn in prices, even if we manage to avoid a recession. Equity valuation is an area with a wide range of models and views. To stay objective, it is important to check the full range of approaches and assumptions and realise that no one has the definitive answer. Based on this type of effort we come to the conclusion that stocks are not expensive.
Finally, anyone interested in counter-cyclical investing who would go against the crowd, should have a close look at crowd behaviour. Greg Davies, Head of Behavioural Finance, has written an article about crowd behaviour and what this means for investments. Even though crowds can provide short-term momentum that can generate returns, this momentum can turn into a dislocation where the price has moved far away from what is justified by reality. This is when the comfort of staying with the crowd can quickly turn into the discomfort of losing money.
Buying low and selling high, being ‘counter-cyclical’, is much easier said than done. The economist John Maynard Keynes said that “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” However, in our jobs we should be more concerned about generating stable long-term returns for clients than to protect ourselves with the cloak of conventionality.
From an investment point of view it is also worth remembering that it can be safer to go with what is unpopular than with the latest trend or perceived wisdom. However, to do that you have to communicate with clients and explain your investment philosophy and process. You also have to build a team-oriented investment culture supporting counter-cyclical investing. The final point is to make sure that unconventional or unpopular ideas are as diversified as possible. Collecting a premium for taking on the unpopular can be similar to writing insurance. And just like an insurance company you don’t want many things to go wrong at the same time for the same reason.
However, while it often makes sense to go against the crowd, there is a risk that this turns into an irrational urge to be different. The best way to inoculate yourself against behavioural biases in general is to have a strong investment process that you follow objectively and dispassionately. Even though this process should constantly evolve, it is important that the developments are driven by objective research and not by the crowd.