Instead of explaining how economic conditions have further deteriorated this week (as detailed in the Global Outlook document), we have decided to pause the technical commentary and focus instead on why we are defensively positioned, our strategy going forward, and the potential impact of us being wrong. This starts with explaining why the above statement from Sir John Templeton is so important given current market conditions and investor behaviour.
What is a real market capitulation?
For those of us that can remember what real volatility is (as experienced in both 2001 and 2008/2009), no reminder is necessary, but for those that need a bit of a jolt, the following facts emphasise the potential damage of a market capitulation:
In the last two global recessions and subsequent bear markets, the US S&P 500 index fell 47% in 2001 and 51% in 2007 – 2009. As a result of the 2007 – 2009 market decline, the net worth of US households fell from $69 trillion in 2007 to a low of $55 trillion in 2009, reflecting a $14 trillion reduction in the value of US household assets. From that position, growth of 25% was then needed to recover the loss. The age-old advice is “buy low”, “sell high”, however a huge amount of investors fell into the trap of buying high and selling low during this period, eroding the value of their assets.
Given current economic conditions, we see the recent rally in markets as creating a trap for investors to do the same, particularly when we look at current elevated equity valuations. At OCM, we refuse to be caught up in momentum, even if it means that by leaving the party early we miss some short term upside. We must learn from the past to protect against future risks.
The role of human behaviour in markets
In our opinion, the significant decline in net worth of US households we saw between 2007 and 2009 happened because most investment strategies do not take risk off the table and go defensive when they should. Generally, this is because investors (both professional and non-professional) don’t like selling when prices are high, even though they should, essentially because we as humans always feel the asset will rise further. An analysis of human behaviour (behavioural economics) explains that this action is driven through fear of missing some upside, and subsequently, investors typically stay invested too long and then ride the momentum roller-coaster off the cliff. Once this happens, they have joined the group of “investor lemmings”, and by the time they realise it is too late, they are already falling faster in valuation terms than they originally thought.
Behavioural analysis also explains how, as the decline accelerates, no one wants to sell as clients hate realising losses and always believe that the market will recover, recouping the losses. For this reason, investors tend to hold and ignore the data, because history says it will be and that as long as they stay invested the losses will recover. In the end, at the very point of despair, when they know they should not sell, the investor does because they just cannot afford or stomach more losses and have no choice but to act. This is exactly what happened in 2009 and many sold exactly when they should not have at the start of 2009, just at the point when the opportunity was at the highest, purely because they did not get out when they should have and left the party early.
Investors typically display a number of biases
Another important insight from behavioural finance is that stocks can indeed be mispriced, that is, it’s not always true that a stock price is exactly equal to the true intrinsic value. That’s because investors display biases. For example, they believe that because a stock has done well in the past it will continue to do so in the future (the gambler’s fallacy). They will look at data that support what they want to believe and ignore other data (which is known as confirmation bias). They also sometimes have a tendency to blindly follow what other investors are doing (displaying herd behaviour). If they have been on a winning streak, they will come to believe they are infallible as investors (overconfidence). Investors tend to overreact to certain pieces of news and fail to place the information in a proper context (availability bias).
Most important is the concept of prospect theory, developed by Daniel Kahneman, whose book, “Thinking Fast and Slow,” popularised the idea that humans fear a loss much more than they get pleasure from a gain. That “loss aversion” went a long way to explain the panic selling we saw at the bottom in 2009. The opposite is true as well: Investors tend to hold on to losing stocks for far longer than is rational to avoid the pain of the loss.
As a result, it is not usual behaviour to accept the risk of missing some upside and locking in gains as actively as we have, as it is contrary to typical human behaviour. However, as we are conscious of human behaviour, we could also be wrong, and that also has to be considered. As I say when I am mentoring, arrogance is the first step to retirement because once you believe your infallible, then you should retire. It is therefore important to reflect and consider what happens if we are wrong and the decline, we anticipate does not happen.
Why does what happened in 2007 – 2009 not scare us?
From an OCM client perspective, we avoided the drop in 2008 and the issues as defined above for many of our clients by acting early, and similarly we have this time by acting at the start of December, noting if we had acted in September it would have been perfect in hindsight. When we look at the risks of being wrong, it highlights why we went defensive.
We went defensive In December to turn a potential threat of a significant downturn in the equity markets into a potentially golden opportunity to take advantage of the expected decline over the coming six months. In doing so, we have sold high and are awaiting an opportunity to reinvest at the point when markets look to be at their worst before buying low. In our opinion, at the start of December 2018 we saw in the coming six to nine months only 2% upside in our portfolios and 20% + downside, with additional downside risks created by currency risks due to Brexit.
A significant decline from where we are positioned today does not therefore scare us because if we actually see another global recession, the worse it becomes, the better it is for our clients, subject to there being a point that no asset is safe, but no one today is forecasting that scenario. As I have said though, to get this strategy right, we have to buy low and have the conviction on the other side of the trade and get back in.
What if we are wrong and what is the strategy?
Being wrong means that the market does not capitulate, we do not have a slowdown, and the risks we see today do not become a reality. The worst case scenario is the market rises for a long period of time and does not give us an opportunity to buy back in at a point similar to that which we got out at, within six months.
So far as at the end of December 2018 the decision looked perfect, with global markets capitulating through December with daily swings of 5%, putting us about 5% ahead of our peers. However, as we stood back and reflected at the end of February following a significant market rebound in January, it looked like a poor decision, with our peers being about 5% ahead.
Although we find ourselves in an uncomfortable position, and one that has seen us lose capital over the period for clients, we are moving at the extremity of expectations and we remain around 5% behind benchmarks year to date but with virtually no volatility in comparison. Since we went defensive in December, the portfolios are around 3% down against the benchmark. Compared to the benchmarks and indices, our OBI portfolios are very flat, with very little movement in comparison, which is very positive. Additionally, the way we are positioned allows us to gain when the markets fall, and as long as that continues and bond yields fall simultaneously (which is normal at this stage of the cycle), what may become a repeat of 2018 and 2001 (even if not as extreme) will be a positive from OCM clients. That means that everyone including my team, can sleep in confidence and comfort that our clients should not be experiencing the 20%+ decline in total asset values that US Households did in 2007 – 2009.
If the markets do capitulate and our thesis plays out in full, and we obtain a point of re-entry that is significantly lower than our exit, we will buy low. Granted, we will not get the bottom of the market, but when we see that the upside is 20% and downside 5%, we will decide to reinvest and I can tell you now, it will be stressful because if history repeats itself as it is today the portfolios will likely go down a bit before they go up.
If we manage that, I am personally going on holiday as the whole thing is stressful and exhausting, but that is exactly what it should be, and it is not easy. If it was everyone would do it.
All of the above detail does not detach from the fact that there are losses since we got out on the 5thDecember over the last 3 months, but the losses are small in relative terms, when compared to the losses we are trying to protect everyone from and that comes full circle to our behavioural analysis.
In summary, it is without a doubt that when faced with the pace of economic slowdown we are now seeing, it is rational to leave the party even if that means potentially leaving some fat on the table. The alternative is potential losses that will make you, me and everyone feel sick to the stomach and I would be negligent in my capacity as caretaker of your assets to ignore the economic data.
Please therefore be patient with us. We are doing what is in your best interests and if we are wrong then the markets (due to natural volatility) will give us a re-entry point which we hope means that no client is disadvantaged by our actions in real terms over the longer term. I would rather be safe and sorry and miss a few percent on the upside than be ignorant and lose 20% on the downside. I hope to that end you all agree with what we are doing and why.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline this half. Overall, global indices declined over the week on weaker economic data and continued political uncertainty. The exception to this were US markets, which declined for the majority of the week before a rally in tech stocks led a recovery on Monday. The Dow Jones index was weighed down by a decline in Boeing following the 737 max investigation. Markets are beginning to pause, with a number of key economists now questioning the sustainability of equity valuations given global economic conditions. Following a challenging week, the OBI portfolios performed consistently, gaining c. 0.2% while the benchmarks posted marginal declines.
Overall, while we know missing out on the gains from January is painful, we continue to see significant risks ahead in equity markets, with investor sentiment tilting towards the downside and risk off sentiment spreading as risks intensify. The economic data continues to support our expectation for a drop back in markets in H1, therefore we remain defensively positioned going forward. It takes time for the data to feed through structurally, therefore as we wait for the data to feed through into markets, we are expecting volatile market conditions to continue, however it is key to bear in mind that the scenario will take time to play out. We must view intra week market fluctuations in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1986, Microsoft had its initial public offering at a price of $21 per share. The stock is currently trading at around $114 per share.
Have a great week,
Gina & Jason