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15/02/2017

What’s love got to do with it?

Our Valentine's special

Last Valentine’s Day, investors were out of love. The FTSE 100 and the S&P 500 – bellwether equity indices – were both deeply negative on the year; some believed a 2008’esque cataclysm was on the cards. Headlines screamed “SELL EVERYTHING[1]”. Many complied, dumping risk assets, falling in love with government bonds and other safe-haven securities, which shot upwards. But from Valentine’s Day 2016 to the end of the year, the FTSE 100 and the S&P 500 rallied 22% and 20%, respectively. Over the same period, US government bond prices plummeted, with 10-year yields jumping from about 1.5% to 2.5%.

Part of the reason many investors made poor decisions is simply because, as emotive mammals, we are filled with inbuilt predilections. We tend to give recent events – good or bad – more weight than long-term history. We feel intuitively safer in the middle of herds, comforted by the throng, but blind to if it is headed over a cliff. We want to act on stimulus; screaming heads on television, for example, trigger an impulse to fight, to flee, to do something, anything. And we fall in love, but often at the wrong time, to the wrong thing.

All of these instincts are useful, indeed necessary, in the wild. A bear may not have been hostile all through the winter, but if it suddenly becomes so in spring, best to discount months of observed behaviour and focus on what just happened. A herd of buffalo may be going over a cliff, but a lone calf has no chance of survival alone. A rustling of leaves behind you better be taken seriously; ignoring it has little upside, and a messy downside. And love, of course, is crucial to the survival of our species.

But when it comes to long-term investment decisions, mammalian instincts are best turned off, and love is best turned on its head.

Love hurts

Love can lead to absurd investment irrationality. Take, for example, the incredible tale of the mid-17th century Dutch tulip. In 1636, investors were buying single bulbs for the same price as houses. Hordes of investors clamoured over each other to buy at any price. With quick profits to be made, what could go wrong? Well, everything. Soon enough, the love started to wear off and investors realised the ridiculousness of paying the same amount for a house as a single tulip bulb. Prices collapsed, and tulips fell back to par with the humble onion.

And with every new love, we tell ourselves this time is different. The roaring 1920s saw innovations such as liquid equity markets and mass consumer finance. Many investors believed these innovations justified preposterous growth projections. Of course, the Great Depression followed, along with staggering financial losses, and profound human ones. The same can be said of the tech bubble of the late 1990s, when many fell in love with the seductive promises of companies that would change the world by harnessing the power of something called the internet. The result: brokenheart.com. Just a decade ago, we believed home prices would never break our hearts by always going up, and we kept buying houses with money we did not have. It nearly ended the world as we knew it.

But it’s not just falling in love that can have disastrous consequences, but also what we overlook because we deem it unlovable, an ugly duckling. Between 1999 and 2002, Gordon Brown, the former British Prime Minister and Chancellor of the Exchequer, sold 60 per cent of the UK’s gold reserves for a price of $3.5 billion. Mr. Brown believed he had sound reasons for wanting to sell this gold: up to the beginning of the 21st century, it had ugly five-year, ten-year and 20-year returns of -25 per cent, -31 per cent and -35 per cent, respectively. Furthermore, it yielded nothing, particularly painful at a time when 10 year gilts were paying 6%. Of course, none of his friends liked it, and encouraged him to get rid of it. But Mr. Brown did not see how cheap it was compared to its history. Or that, with an equity market beyond overvalued, gold’s defensive characteristics could prove priceless. The ugly duckling was a swan in waiting, and that gold is worth over five times that today.

Only love the process

At our firm, we recognise the infallibility of instinct. Instead, we focus incessantly on an investment process centred on valuation, momentum and sentiment. When something is unloved, and cheap, we look kindly upon it. History shows the best returns are to be harvested from undervalued and unloved positions, particularly as momentum starts to trend upwards. Furthermore, when others are deeply in love, we recognise the romance has probably run its course, and we are at our most prudish.

This Valentine’s Day, we encourage our clients to take three important tenets to heart.

One, be optimistic. There are lots of causes for concern in the current macro environment. We are in the midst of an unprecedented paradigm shift due to populist political pressures. If that were not enough, another tremendous transition is taking place in global monetary policy. Love is hard to come by, which is precisely why our hearts are still open to risk. Over the past five years alone – through the Eurozone crisis, US debt shutdown and downgrade, slowdown in Chinese growth, and lately Brexit and Trump – the global equity market is up 66.5 per cent (or 10.5 per cent per year).

Second, be selective. In the US, unprecedented monetary support is coming to an end; other central banks will eventually follow. Therefore, the “rising tide” of liquidity driven asset price increases will no longer “lift all boats”. Furthermore, valuations across a number of assets classes and sub-asset classes are no longer cheap, led by the second longest equity bull market in history, and the continuation of a three-decade strong bond bull run.  From this stage, we must be ready to accept a lower return for each level of risk than we have historically. Not too long ago, cash in a savings account yielded 5%; today, equities may well struggle to achieve that. Still, opportunities are ever present; when they arise, one should maximise them: increasing dispersion in market returns simply means investors should be more discerning than in the recent past. We will only love those who earn it.

Finally, be disciplined. We live in a world where events unfold very quickly and markets can move with staggering speed. It is therefore easy to want to react. Often, that emotional impulse is wrong. A disciplined and robust investment process that seeks to evaluate the long-term fundamentals rather than focus on short-term movements is key to navigating the uncertainty. It is critical to disregard the “noise” which inevitably surrounds periods of great change. By focusing on indelible drivers of long term asset returns such as valuation, momentum and sentiment, the short-term movement and uncertainty can be prudently managed. Love that is mature, evolved and built on respect stands the test of time


 [1]The Telegraph, 11-Jan-2016. (http://www.telegraph.co.uk/finance/economics/12093807/RBS-cries-sell-everything-as-deflationary-crisis-nears.html)
 

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