18/9/2023. Cartoon courtesy of Glasbergen Cartoon Service.
Because We Really Don't Know
It's more important for a financial advisor to be 'right' about a potential market downturn, than it is about a continued bull run, for two reasons.
- Firstly, research shows that investors feel the emotional pain of loss more intensely, compared to the pleasure of gain. In behavioural economics, this is a cognitive bias known as loss aversion.
- Secondly, the loss vs gain asymmetry is not just emotional, but is numerical. If we suffer a 30% loss, we need a 43% gain just to get back to where we started. A 40% loss needs a 67% gain to recover.
There are some emotional reasons too.
- If you've ever had a car accident, I guarantee that for months afterwards you'll have driven more cautiously (regardless of where the fault lay). Youngsters who've never had a bump are more carefree drivers. Investing is the same. Experienced advisors have accumulated memory of major downturns and are more likely to exercise caution.
- The other emotional reason is simple respect. We know how hard our clients have had to work for their money. It's not ours to put at risk.
With the above in mind, it's quite possible that my general opinion on the nearer-term economy and markets is more negative that it needs to be, but there's no harm to review some key points.
Backdrop To The Economy
- Notwithstanding the tech surge this year (driven by a small number of stocks including Nvidia), the underlying economic backdrop has some concerning aspects.
- Yield curve inversion (meaning that shorter term government bonds pay higher yield that longer term, which is the reverse of the situation in normal conditions) has for decades been a perfect predictor of a coming recession. As it is right now.
- Meanwhile, another accurate predictor, the Conference Board US LEI has been flashing a warning for several months, and the Euro Area LEI has turned negative again also.
- We are reminded that the blunt instrument of using interest rate rises to dampen inflation may need (perhaps by definition) to trash the economy to obtain it's goal.
- Interest rate rises hurt both businesses and families. Firms' cost of capital increases, reducing margins and profitability unless cost is passed on to customers. Bank lending continues to tighten, hampering growth. The risk of default especially amongst small and mid-size companies continues to rise.
- Meanwhile for homeowners increases in mortgage rates drive higher the cost of living, and dampen the housing market, as we have seen in numerous countries.
- Consumer debt has surged, and US credit card debt has risen over $1 trillion for the first time in history. Delinquencies for repayments on credit cards and auto loans are rising. This is worrying as approximately 70% of US GDP is driven by consumer spending.
- The flipside argument is that households borrow more when they feel more confident about their jobs and personal finances. Whether the rise in debt is because families choose to, versus need to, remains to be seen.
- Whilst banks such as Deutsche Bank believe a US recession is more likely than not, some major institutions such as Goldman Sachs believe that the current measures are working in the fight against inflation, and are increasingly optimistic about a 'soft landing' – avoiding a recession.
- Meanwhile fixed income behemoth PIMCO says that many are underestimating the chance of a US recession and that the global recession risk is a 'coin toss'.
Investment Strategy Considerations
- We can't predict the future nor reliably time markets, but we can ensure that our broad asset allocation is aligned with our investor risk profile.
- We can also review strategy and focus on some investment principles that decades of evidence tell us are important.
- In the same way that most active single-asset (eg 'US large cap', 'global small cap', etc) fund managers don't outperform their benchmark in the long run, multi-asset managers (whether it's your advisor, a fund, a model portfolio service, or a discretionary manager) also face a difficult challenge - portfolios are actively managed by default (except for a very few).
- Even the largest and most famous multi-asset portfolio managers don't reliably outperform a relevant benchmark. The idea that active portfolio managers can reliably add value in volatile markets is questionable.
- Research shows that a good choice of core holdings is key. The reason is that portfolio returns are dominated by overall market movement, not by the detailed asset allocation nor by skill of an active manager. On average, eighty percent of portfolio returns are attributable to market movement.
- A rising tide raises all boats. Capturing long term overall market growth is best achieved by a portfolio core that tracks broad market indices, for example a global developed market equity index, and a global quality bond index. The split between equities and bonds reflects our investor risk profile.
- If we want to play hunches, such as a bet on tech or pharma, or a bet on a region such as asia-pacific, or an allocation to our favourite active manager, we can do so with satellite holdings. But we must understand they are bets. And, especially in a context of economic uncertainty and asset volatility, we should moderate and not place big bets on such uncertain outcomes. (And see above about not taking risks with client's money.)
- Let the portfolio core do the heavy lifting. Of course, there are certain 'factors', such as small cap or value stocks, that research shows benefit long-term investors. But that often means very long-term investors.
Questions To Ask Ourselves
- Am I holding the right core assets? Do they make up enough of my overall portfolio?
- Is every asset I hold still playing the role expected when I bought it? Should I accentuate less on side-bets and more on broad market indices?
- Is my equity/bonds+cash split a good reflection of my current risk profile? Bearing in mind the good interest rates currently available, should I tilt more towards cash?
These are some of the points for consideration, and discussion with your advisor. I hope they're useful.
As a final thought, remember that advisors sell advice. Fund managers sell funds. Who has the greater incentive to be optimistic?
Have a great week ahead.