Making sense of chaos

Looking at a broader canvas of human experience illustrates this. The idea that an individual can, at 20 years old, plan for a healthy and wealthy retirement 50 years later is one that would be laughable in most of human history. Only in the past 60 years and only then in the most developed countries and among the better off did it ever seem a reality. As Nassim Nicholas Taleb might observe, there are black swans everywhere – yet we cling to our certainties, because for the previous few decades they seem to have worked.

We’ve had the best part of 70 years, since World War II, to turn these assumptions into iron truths, and just half a dozen years, since the banking crisis, to start to doubt some. But our questioning isn’t yet deep or fundamental enough and is still tainted by the island of security that the post-war years represented in our greater history. “People think in linear terms, but this is a non-linear world,” said Joseph Lampel, a professor at Cass Business School in London. “Extrapolation [of past trends] is a seductive temptation, for politicians and the public. It is often wrong.”

 

The end of certainty

There are many reasons to believe that chaos is creeping back up on us once again, and which would indeed suggest that the years of post-war stability and growth were more a blip than the norm. Not least of these is that the great revolutions that underpinned 20th century economic progress – technology, globalisation and healthcare – appear to have reached their zenith, to a point where the incremental benefit they can deliver is proving ever more marginal.

Meanwhile, the massive central banking experiment that has taken place over the past six years has made it harder to predict with any certainty which way markets will turn – especially now that signs of economic improvement in the US will prompt a ‘tapering’ of quantitative easing. Such a day was always going to come, but the turbulence of the last fortnight suggests that the markets could react very badly indeed as words become deeds over the next few years.

In such an environment, in which the investment truisms that have guided our thinking through the past half century no longer hold true, we need to rethink our investment approach, and develop strategies that can cope with such uncertainties. Yet to do this, we must first understand what the certainties that can no longer be relied upon are. Here are six of them.

 

1) Faith in the durability of markets

Our faith in the survivability of security markets over a human lifetime is touching, but misplaced. Spain’s debt experience in the eurozone hasn’t yet caused it to default, and it may not. But that would be historically unusual. Spain defaulted on its bonds in 1809, 1820, 1831, 1834, 1851, 1867, 1872, 1882 and from 1936-1939. As a London Business School 2002 paper demonstrated (Elroy, Dimson & Marsh: Triumph of the Optimists), survivorship bias, our temptation to ignore the effect on historic investment performance of markets or securities that failed, has substantially overstated the performance that those investing in the past could actually have achieved.

That isn’t just the bankruptcy of individual companies and the voiding of their securities, but the failure of investments held through intermediaries, such as Lehman’s derivative contracts, and of the markets themselves. Dozens of security markets, from Cuba to China, from Russia to Hungary, have failed entirely in the past 100 years. Add to those the near-disasters in Latin America in the 1980s, and more recently in Greece and Cyprus. It is no longer just revolutions that kill markets, but financial convolutions and financial interconnectedness. A single trader has the power of an army.

We think of these as exceptions to a ‘normal’ stability, but there are good reasons for doubting it.

The rise and propagation of novel financial instruments, globalised capital markets and ultra-rapid trading have given individual traders, corporations and markets more ways to kill themselves. The risk junkies – from Parmalat to RBS, from Icelandic banks to Greek governments – have broken into a well-stocked global financial pharmacy in pursuit of thrills, and have rolled up their sleeves. The horsemeat scandal illustrated the lack of control big supermarkets had over product provenance when the supply chain became extended. But this is exactly what happened in the banking crisis too, when the length of the banking food chain between ultimate lender and ultimate borrower became so long that banks with collateralised debt obligations (CDOs) didn’t know what they owned or who they had lent to. So while human life expectancy has increased radically in the past 20 years, there are reasons to fear that the life expectancy of financial systems has shortened. If so, the chance of a single individual experiencing a systemic financial meltdown in her lifetime is multiplied.

This is just the first of many dying truths. Here are another five, plus four more that are already dead and buried.

 

2) Economic growth is inevitable

The belief that economic growth is the natural order of things is deeply ingrained. Few of us have known anything else. Post-war experience has been that every dozen or so years, the West gets a recession that causes a year or so of economic contraction – an economic sniffle – and then bounces back to trend growth.

The last crisis has been more like ’flu than a sniffle, but many still assume growth will resume. Why should it? First, we have unprecedented environmental challenges: climate change, overpopulation and risks to sustainable food and water supply. While growth from the value of human ingenuity (think Apple or solar panels) tread lightly on the earth, exploitation of tar sands and fracking are the environmental equivalent of tearing the sofa apart looking for loose change.

Second, western economies are being eclipsed. The long history of China and India illustrate a cycle of expansion, over-stretch, decline and fall which has been seen again and again over history. The fact that we call them emerging, rather than re-emerging, economies shows how readily we forget history.

While the substitution of trade for military competition in the past 70 years might be argued to ameliorate that brutal cycle, the relative economic decline that Britain is currently experiencing may well be a more enduring experience. Decline may be relative not absolute, but we should still expect longer periods without growth in the new cycle, and shorter periods with it. Upside: growth is over-rated anyway, ask those in buoyant Beijing who battle smog every day.

 

3) We can expect to live longer than our parents

Longevity is the bane of actuaries and pension trustees, but there is nothing inevitable about ever-longer life-spans. Russia, for example, has never managed to get life expectancy above 70. Poorly educated white women In the US lived five years less, and equivalent men three years less, in 2008 than they did in 1990. There are similar pockets of disadvantaged groups in many countries, buried under more cheery-seeming averages.

Medical progress may be inevitable, but will occasionally be offset. Look at antibiotic resistance. “If we don’t take action, in 20 years’ time we could be back in the 19th century where infections kill us as a result of routine operations,” UK Chief Medical Officer Professor Sally Davies told the World Health Assembly in May. “In the last five years we’ve seen a step-change in the level of resistance… and in some cases a doubling of the death rate.”

4) Mankind can overcome environmental challenges

Those anxious about climate change already accept this assumption is dead, but optimists and naysayers do not. Textbooks say environment is a spanner in the works of the engines of business, investment and consumption, and a cost that sits outside the control of enterprise. Yet, we have precedents that show governments can act together. The Montreal Protocol of 1987, which brought together 116 nations to phase out chlorofluorocarbons, was, according to former UN chief Kofi Annan, “perhaps the single most successful international agreement to date”. It might also be the exception that proves the rule.

 

5) Globalisation will march onwards

Globalised trade has largely been a boon, causing a steady fall in the costs of household goods in the west in the past three decades, undermining the economic might of organised labour and building rising incomes in China and beyond. How far can it go? The theoretical limit is when real wages across the globe equalise, or at least aren’t sufficient to overcome trading and transport costs. We aren’t there yet, but other factors intervene. “We are reaching the high point of globalisation,” Mr Lampel said. Extending free trade agreements is getting ever harder, running up against the last national refuges (rice in Japan, films in France, genetically modified foodstuffs, farming subsidies).

Any military conflict, of course, smashes free trade hopes among affected countries. If globalisation steps back, the global economy loses and we all feel poorer. As Mr Lampel notes, a British parliamentary committee was once asked to look at the prospect of European war, and smugly concluded it was unlikely because of the trade interconnectedness of the continent’s economy. The year? 1913.

 

6) The Internet will remain a free and global network

Cultural and political influence has already eroded the experience that internet users in various parts of the world can expect. In China, Burma, North Korea and parts of the Islamic world, free expression and content choice are filtered. But given the web’s capacity to be a conduit for espionage and cyber attacks there may be those who eventually see the disadvantages of connectedness outweighing the advantages.

Expect it to be a rougher ride from now on: more policing of what you buy and from where, by the intellectual property owners; more attempts to gather your personal data for commercial and security reasons, and state attempts to assert control (read: taxes and regulation) as more commerce migrates to the net. That covers everything from sales taxes to bureaucratic liabilities imposed on websites and service providers.

 

The certainties that already died 7) Banks can be trusted Old hat, of course, since the collapse of Northern Rock in 2007, the implosion of Lehman Brothers a year later and the state-sponsored rescue of banks all over Europe and North America. This week’s refinancing plan for the Co-operative Bank is a reminder that it isn’t over. Everyone now accepts that banks are at least as fallible as any other institution. But for the previous 140 years, from Overend & Gurney in 1866, not a single British bank collapsed. It is important to remember how safe we felt, and how poorly based that perception turned out to be. One related truth I didn’t even bother to include, because few ever accepted it: That regulators can protect us.   8) Governments pay their debts The eurozone crisis has seen to that one. But actually, across Latin America, Africa and the Caribbean there have been hundreds of defaults since the 1800s. While we haven’t seen an absolute sovereign default since Argentina’s in 2001, we now better understand the relationship between overblown banks and underfunded states, and prudent governments and imprudent ones. We’ve long not believed what they say. Now we don’t trust them to pay their bills either.   9) Our children will be better off than we are Those UK babyboomers who retired with good final-salary schemes have been the big winners of the past few decades. Their state pensions are – quite unsustainably – triple-locked, to match the best increase of average earnings, prices or 2.5 per cent. Their education was free, even the living expenses at college were covered by a grant. And because they were few, they got real gains from a degree. Today’s kids, educated or not, live in a tougher world – and that’s before you even consider the future of the planet. Collateral damage has been done to one related certainty…   10) Higher education is always a good investment Education isn’t immune to supply and demand. When everyone is a graduate, there is a smaller premium for those not-so-rare skills, and one increasingly insufficient to dent the rising cost of going to university and other fees in acquiring those skills. “Politicians love to sell linear stories, higher education participation as a cause of growth. But even people who undertake the education are not always getting the value,” Mr Lampel said. While elite institutions will always earn a premium, that is as much about restricted intake as true value. If you really want to see the bad effects of ‘diploma disease’, Mr Lampel says, look at the surfeit of angry graduates in Egypt, Nigeria and Kenya. There’s material for a revolution, if you want one.

 

INVESTING FOR A NEW PARADIGM

All of these factors have serious implications for investors – but the one most likely to set alarm bells ringing is the idea that we have entered a low-growth world. Certainly, the fight against deflation is the one that occupies the thoughts of most policy makers – for mankind at large, it’s a scenario that raises the troubling prospect of declining living standards and a subsequent rise in social unrest. For investors, it means working harder for ever more meagre returns.

Certain investment truths will hold firm – such as the power of reinvested dividends over a long-term horizon. But it is wise to remember the truism that the long term is made up of a series of short terms. And if we can look forward to greater volatility ahead, then perhaps the ‘fire and forget’ approach to investing – where, having placed our bets, we stay invested through thick and thin and hope the markets do the hard work for us – may no longer prove as profitable as it once did.

Investors, then, will need to be more nimble and take a more tactical view. As Dominic Picarda has demonstrated in his new Market Tactics series (for more information, visit: www.investorschronicle.co.uk), even in a century when markets could be relied upon to deliver growth, returns could be significantly enhanced by avoiding the worst of the downside even if that meant occasionally missing some of the biggest up days (which exponents of staying invested suggest we cannot afford to miss). In a low-growth world, simple index trackers may prove to be disappointing investments, even if they are cheap.

The economic case for equality

The current unrest in Brazil is, perhaps, a precursor to what is likely to evolve into a greater global struggle for improved equality of wealth. Prompted by increases to public transportation costs, a million people there have marched in protest at high taxation and wasteful government spending while millions still live in poverty.

Such a struggle matters to investors for two reasons. First, it is increasingly accepted that such income disparity is economically harmful. Economists, led by Joseph Stiglitz, have noted that wealth being transferred into the hands of the few is often wealth that ceases to become economically productive.

Gini coefficient

While the world has become wealthier over the last 60 years, it has latterly been marked by growing disparities between the haves and the have-nots and a great redistribution of wealth from the many to the few – most noticeably, as measured by the Gini coefficient, in developed economies (see chart, right), but also in developing economies where rising living standards for the masses somewhat masks the phenomenon. In the US, one of the worst offenders according to the Gini measure, the richest 1 per cent of its population earns a fifth of its national income, a proportion that’s more than doubled in a decade.

Second, it is apparent that much of this wealth is being extracted from all of us, in many ways; low interest and bond rates have proved particularly damaging to private wealth, forcing annuity rates to plummet and investors seeking income to take more risks. Western wage growth, meanwhile, has stagnated in real terms since the 1980s for all but the corporate clique.

 

On a charge

Another certainty, then, is that in a low-growth environment it doesn’t pay to give half your returns to someone else. The investment industry has continued to inflict high charges upon its customers, with a huge detrimental impact on performance, while the management of many public companies have extracted vast salaries and bonuses from shareholders, all too often without delivering the shareholder value to justify it.

Yet investors are often silent on such matters, partly through apathy, partly – in the case of some sections of the fund management industry – through vested interest, and partly because our system makes it very hard for private investors to make their voices heard – despite repeated calls from the likes of economic historian John Kay to repair our broken system.

So, in the same way that financially oppressed populations are taking to the street, private investors must instead take up arms themselves in the struggle to improve shareholder democracy. Just as investors need to become more tactical, they also need to become more hands-on to shape the investing world immediately around them. That means putting pressure on the companies they invest in by participating in annual meetings and corporate votes on pay and acquisitions.

Strength in diversity

Even if, in aggregate, economic growth will be elusive, there will be growth in pockets – the World Bank expects developing world GDP growth to remain above 5 per cent for the next three years, more than twice the rate of developed economies.

Of course, GDP growth and market performance don’t always go hand in hand, easily demonstrated by the poor performance of Bric stock markets even as their economies have continued to power ahead. According to Jeremy Grantham at US investment management company GMO, that could be because expectations of rapid economic growth often lead to shares being overvalued – put simply, too much was expected of them by investors, and when that performance didn’t arrive, they sold out. Still, it is generally accepted that where there is improving economic activity share prices will follow over the long term.

Globalisation has resulted in the world’s myriad economies being more interconnected than ever before. Yet, despite this, markets still don’t always move in tandem with one another – correlations clearly exist, but they can be loose and relationships break down from time to time. This is why market diversification is likely to be more important than ever in a low-growth world – because, while there will be financial or market failures, they won’t happen everywhere at once.

Investors, then, need to overcome their parochialism to take in a much broader investment horizon and embrace the unfamiliar. Doing so needn’t involve taking on huge risks, either, even if the current emerging markets sell-off suggests otherwise. Exchange traded funds, for example, provide a low-cost route into many markets – we’ll be investigating a tactical strategy that can use ETFs to play emerging markets in a forthcoming issue of Market Tactics.

Making a PEST of yourself

While many believe that although markets have been driven higher by central bank intervention, the apparent demise of a 30-year bond bull market means equities remain the best game in town – even if valuations remain somewhat stretched, especially in the US.

And, just as there will be regional pockets of growth, there will be growth opportunities at a microeconomic level. Chaotic markets and disruption at an industry level create much more scope for mispricing, which means watchful investors can still profit by improving their stock-picking abilities and hunting for value. Shares may be the best game in town, but in a stock-pickers’ market it still pays to be selective.

In a recent feature, we outlined the tools that you can use to identify such value stocks – at its simplest, finding low PE shares trading at a substantial discount to book value. But it also makes sense to borrow some approaches more commonly used in the management consultancy industry to help assess the merits of the companies that, while appearing financially robust, may be competitively weak or operating in industries that are in the midst of structural upheaval.

Porter's five forces

There are two basic tools that are useful to investors in this regard: Porter’s ‘five forces’ model to determine a company’s competitive position and therefore pricing power, and a PEST analysis to assess how political, economic, social and technological factors can affect companies’ prospects. Fundamental analysis may have fallen out of favour in a QE-driven world, but in a low-growth, stock-pickers’ market, it can mean the difference between avoiding a value trap or getting badly bitten by a stock market dog. JH

 

Enduring certainties 1. Uncertainty will remain If the evaporation of the truths that have underpinned our investment thinking for the last 60 years tells us just one thing, it should be this – that change is perpetual, and that the only certainty is uncertainty. A long-term historical perspective would suggest that this has been the case for millennia, as civilisations have risen and fallen, and wealth and power has shifted from place to place. Throughout this, there has been one constant: precious metals have proved a remarkable store of value. So, whatever the current uncertainty surrounding the gold price suggests, it should only be considered in the context of the current monetary system within which it is being traded. Gold and silver is seen by many as the only true money in a world of fiat currencies – that may be an extreme view, but in its physical form it certainly remains a useful insurance policy against economic upheaval.   2. Populations will keep growing An ageing population and declining living standards may put the brake on population growth in developed economies, but emerging and frontier markets still have a lot of catching up to do. Whether you believe in supercycles or not, the implication is that we will need more so-called ‘consumption commodities’ – food and energy – as a result. According to the US Energy Information Administration, world energy consumption will rise by 50 per cent between 2008 and 2035. But we don’t believe this will result in ever spiking food and energy prices, or indeed a Malthusian population crash – more likely, new technologies will evolve to use the resources we have more efficiently, and buying the companies at the vanguard of this process is a good hedge against uncertainty elsewhere.   3. The state will not fund your retirement If governments can no longer be relied upon to pay their debts, it seems equally likely that they will not be able to ensure their citizens are comfortable in dotage, either. Our retirement expectations are being tempered – we will retire later, and will receive less from the state. That’s why investors need to take greater control of their retirement savings. And even if we have started to see a reversal in life expectancy in some parts of the western world, most of us will still live longer, and require much more cash than we plan for.