Postmodern portfolio theory
Posted on 28 March 2014
"I’ve learned from my mistakes, and I’m sure I could repeat them exactly" – Peter Cook
The decade or so to 2007/8 saw a richness of embarrassments for deregulated markets. One of its legacies is a tendency now to see a bubble and its bursting around every corner. But bears are just as likely as bulls to be greedy and complacent. We should consider the possibility that a dramatic collapse, as opposed to a setback, in stocks and/or bonds may not be at hand.
Unthinking inflows of cheap liquidity to emerging markets sharply reversed when the US Federal Reserve (Fed) started to normalise interest rates from 1994: the Asian crisis that erupted in 1997 was the first big embarrassment, followed quickly in 1998 by Russia’s local currency default and the LTCM fiasco. The Fed’s attempts to mute the impact of the latter, and of looming Y2K concerns, helped create the dotcom and wider TMT craziness that pushed stock valuations in 2000 to still comfortably-unchallenged highs. The subsequent stock market implosion and hunt for safety led to the expensive and complex credit markets of the mid-noughties, and to a mistaken faith in a ‘supercycle’ for emerging markets and commodities.
Is this where we came in? We’ve noted that there are some striking resonances with 1994, monetary normalisation and emerging market underperformance being the most obvious examples. And the rebound from the financial crisis has now run some way, and extended to even the most depressed assets. In Dublin this week there was much talk of rising house prices. I have long argued – coincidentally, since 1994, when I wrote the Celtic Tiger report – that the Irish economy is not driven mostly by real estate but by flexible labour markets and inward investment. Another, more modest, period of outperformance has seemed quite likely. But a surge in house prices there must be mixed news – as it should be here in the UK too.
Despite the historical echoes – and the obvious risks posed by the Ukraine and China’s shadow banking sector – we think the richness of embarrassments has at least paused for a while. The US’ twin deficits have faded, and its private sector is in rude financial health. Operating margins are high, but predictably so, and, without a recession, are unlikely to fall sharply. Those margins coincide with falling leverage at many non-financial companies. Bank balance sheets have improved, and are more closely scrutinised, on both sides of the Atlantic. The single currency‘s architecture is being more convincingly built (if slowly). And despite some obvious parallels with the ‘noughties – the return of covenant-lite borrowing, for example – today’s expensive credit is less likely to be owned by investors who themselves are recklessly geared.
For sure, many bonds look expensive, but almost all will be redeemed at par: there is no “bubble” in Treasuries, gilts or bunds. We’ve noted often how stocks still look reasonable value, with many of the exotic valuation metrics favoured by some pundits (and gullible fund managers) based on some decidedly dodgy statistical and epistemological foundations.
Superimposed on these (I hope) objective points there is a more personal consideration. The more I do this job – and I have always counted myself lucky to have it – the more I am struck by not just the what but also the how of financial advice. How do we evaluate data and ‘research’, unravel the unspoken biases in the public debate, and place events in their appropriate context? The financial noise so often obscures the signal. Even professional investors pay attention to data and analyses that they really shouldn’t bother with. When all is said and done, economies grow because people get better at what they do and invent new stuff. You need good reasons for investing strongly in the other direction.