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When average becomes good

The effect is always the same. I just say the words, “it’s the availability heuristic” and their eyes glaze over. What might have been a halfway intelligent conversation about the western world’s response to Covid-19 is over. Mentally, they’ve gone. Quite likely, you’re about to do the same, to turn the page or click on a link. You hear the phrase, ‘availability heuristic’ – laden with the threat to make a listener think and, worse, to quantify – and you want to escape.

Yet the availability heuristic is really important and, actually, if you are a serious investor, you should know about it anyway. It explains much about the way people behave; in particular, how they respond to uncertainty, such as the future path of the stock market or the course of a virus through a susceptible population.

Granted, the phrase is cumbersome and forbidding. But what do you expect from a notion formalised by psychologists? Let’s strip it down. A heuristic is a fancy word for an intuition; more formally, a mental device we use to make instant assessments when there is not the time or information to do more. We use heuristics without even knowing it. But academics have listed them into a seriously long taxonomy – from A for ‘agent detection’ to Z for ‘zero-sum bias’.

The availability heuristic is especially important because we use it so much. Put simply, it is where we make an assessment based on the ease with which similar occurrences spring to mind. As a result, the present and the dramatic dominate our assessments of what’s likely to happen. We see a recently-crashed car on the motorway hard shoulder and exaggerate the chances of a car crash. That’s good because it makes us slow down. We see a crashed-out stock depressing the performance of our portfolio and exaggerate the likelihood that others will do the same. That’s bad if it causes us to shun good opportunities.

What’s worse, however, is the tendency of the availability heuristic to become self-reinforcing. That’s when we get locked into a cycle of fear or euphoria we have largely contrived for ourselves. This happens continually in securities markets. So much so that, years before the availability heuristic was formalised, the great Benjamin Graham had created an anthropomorphic version, ‘Mr Market’. Here was – and is – a confused little market maker, always ready to offer prices both to buy and to sell all securities but whose prices follow his manic-depressive moods – rising when good times can only get better and falling when bad times must get worse.

Because the securities markets are a microcosmic take on all human life, so Mr Market morphs into Mr Maninthestreet, a character with a view on anything so long as he does not have to think about it too much. Like Mr Market, he gets locked into cycles of misery or ecstasy, simultaneously creating, following and amplifying trends. He goes with the flow. In stock-market terms, he is a momentum player. Going into 2021, both Mr Market and his in-the-street alter ego have lots of momentum to worry about, but that seems which to be powering SARS-CoV-2 through the northern hemisphere’s winter and the course of the UK’s economy will take once the nation is properly outside the European Union.

Yet momentum has an obverse, which is labelled ‘mean regression’. Where momentum assumes the direction of travel stays constant, mean regression assumes it will return whence it came; that the bad will improve and work back to its long-run average and the good will provide a mirror image. Mean regression might be too dull to prompt its own caricature, although, if it did, it might be Mr Contradicter, intuitively contradicting the ideas that, say, tech stocks will only ever rise or, apropos Covid-19, that we will be wearing face masks to shop in Sainsbury’s for decades and will never again attend Old Trafford at full capacity. “It’s the availability heuristic talking,” is his cautionary response to such sentiments.

Arguably, everyone is either a momentum player or a mean regresser because these are stances that intuitively attract some and repel others. If so, in both the assessment of stock markets and Covid-19, while momentum players have the upper hand, can mean regression followers make a comeback?

First, take Covid-19 both because its effect on financial markets has been muted but may not have run its course. The momentum assessment is that Covid-19 is the worst peace-time event to hit the western world in 100 years. Maybe. Without wanting to trivialise it, Table 1 attempts to assess Covid-19 to date, looking at the most striking data – some would say the only data that matter – the death toll. It does this by comparing 2020 with what has happened in the 15 years 2006-19 and it uses the weekly mortality tables for England and Wales because these are the most up-to-date figures.

 

Table 1: The grim figures 
Total deaths in England & Wales (2020 est)603,385
Change on year (%)14
Percentage of previous five years114
Deaths per 10,000 pop'n (2020)101
Deaths per 10,000 pop'n (ave of 2006-19)90
Excess deaths (over ave of 2015-19)72,250
Excess deaths (over 2020's feasible outcome)*46,400
Source: Office for National Statistics, Investors Chronicle estimates; *See text

 

Almost certainly, the annual death toll will exceed 600,000 for the first time. With just three-weeks’ worth of data to be reported for 2020, and assuming mortality rates continue to be 18 per cent higher than the average of the past five years (as they have since the Covid-19 death count topped 100 in March), then the figure will exceed 603,000, 14 per cent higher than the average for 2015-19.

That is a shocking rise. It means 114 deaths per 10,000 people, whereas the previous highest was 93 per 10,000 in each of the years 2006-08 and the average for all of 2006-19 was 90. Put another way, 2020’s excess deaths over the five-year average will be about 72,000, the equivalent of the Suffolk town of Lowestoft disappearing.

In anecdotal terms such as that, the effect seems ghastly. On the other hand, it is reasonable to conjecture that 2020’s death count was likely to be high anyway. The count tends to oscillate and last year’s was 2.2 per cent down on 2018’s, the biggest percentage drop since 2009. Given also that the death rate has not touched the highs of the 2000s for 12 years, then a bad year was due. If deaths in 2020 had returned to 93 per 10,000 then the excess deaths would have been 46,000. Express that number in its coldest form and it equals four weeks’ worth of deaths at the UK’s normal rate. Is that sufficient to turn the world upside down? Granted, these are morbid thoughts, but they serve to examine the misery of Covid-19 through another lens – whether the misery of the treatment, both economic and social, is worth the cost of the disease? The more such questions are asked in the coming months, the more that momentum may give way to mean regression; the plea that we must find a way back to ‘normal’.

And, switching tack, mean regression is, as it were, likely to gain its own momentum the more that Brexit becomes an accepted fact and less a political play thing.

Of course, the world’s financial markets gave their assessment of Brexit long ago. Without any ideological axe to grind, they judged it to be a colossal self-inflicted wound. Table 2 shows the gory details of what the UK did to itself when electors decided the nation would be better off outside the world’s biggest and most effective free-trade market. Since that sunny day in June 2016, the FTSE All-Share index has risen just 6 per cent, although it has dished out about 12 per cent-worth of dividends. Over the same period the MSCI World index of big companies has risen 57 per cent and the tech-heavy S&P 500 index of US stocks is up 76 per cent. Lagging behind, or what? Even those UK investors who held capital in those overseas indices, or something like them, have seen their gains trimmed by sterling’s 11 per cent fall against the dollar and its 17 per cent drop against the euro.

 

Table 2: UK's pariah status since Brexit vote
   Change (%)
 23-Jun-1621-Dec-20Local currencySterling
FTSE All-Share3,481.73,689.86.06.0
MSCI World1,270.11,994.857.140.2
S&P 5002,113.33,709.475.556.7
MSCI Europe1,355.01,609.718.8-1.1
Source: FactSet    

 

As a result, in a global context, UK equities are approaching pariah status. It is debatable whether that is justified. True, Covid-19 is hitting the UK’s economy harder than most other developed nations. The Office for Budget Responsibility (OBR), the public-spending watchdog, suggests national output will drop by 11 per cent in 2020, the biggest hit in 300 years, and the deterioration in the public-sector finances will be £340bn as government spending soars while its receipts fall.

Then there is the reality of Brexit for which UK companies remain badly prepared, says the Institute for Government, a think-tank. Obviously, their preparation has been hindered by the government’s chaotic and high-risk approach to an exit treaty. Yet, whatever the drama of the M20 motorway becoming a lorry park in January, a black market in avocados in Kensington and a very merry time for smugglers, the real damage to the UK economy will accrue over the longer term. The OBR reckons the full impact will not be clear for 10 years.

That would be an exceptionally long time for UK equities to stay shunned. Not that it is impossible – ask investors who put capital into Japanese equities around 1990. However, in response to the question, how will UK equities fare in 2021, I would give the mean-regression answer, for which Table 3 provides some data.

 

Table 3: UK equity returns by decade
% pa (average)All-ShareUK inflationReal return
1960s*8.43.64.8
1970s14.112.02.1
1980s18.56.512.0
1990s11.13.37.8
2000s0.31.8-1.5
2010s*3.22.11.1
Total period9.24.94.3
*1960s - 1963-69; 2010s includes 2020 
Source: FactSet, Office for National Statistics 

 

The best guess must be that London’s shares will produce an average sort of return. If so, that would be about 4 per cent for the real return, maybe 2 per cent for inflation (although Brexit might effect that big time) and 3 per cent for dividends, making 9 per cent. Obviously, that’s a central band around which there will be lots of variance. Basic statistics also tells us that, given the All-Share’s returns over its 59-year life span, there is about a one-in-six chance that 2021’s gains will be 35 per cent or that its losses will exceed 15 per cent.

Besides, 9 per cent seems a bit ambitious since Table 3 shows that equity returns have been trending downwards since those heady days of ‘loadsamoney’ Britain in the 1980s. And, frankly, even 6 per cent or so would seem nice in comparison with the 12 per cent loss that the All-Share is likely to serve up in 2020. It would be enough to feed the notion that momentum is giving way to mean regression and I don’t have to keep muttering that perplexing phrase, “It’s the availability heuristic”.