I have become increasingly respectful of the power of the narrative to drive stock market action. However, that goes against everything I have learned over decades of investment training and experience … or does it?
Value Investing
I was originally trained as an investor by my grandfather. I fine-tuned my investment management style over the next 30 years based on value principles found in textbooks and espoused by greats like Warren Buffet.
Here’s the theory. If you buy well managed companies at stock prices that are inexpensive relative to the company’s expected long-run stream of cash flows, your investments will do well. This means doing tons of research and analysis and ignoring short-term stock price movements. Value-based investing worked well through the 70’s, 80’s and 90’s. It only began to come in conflict with reality in the bubble years prior to the millenium.
In 1998-2000 valuations were extremely rich but that didn’t seem to matter … until it did in late 2000. We’re at that “extremely rich” point again today, only more so.
Asset Classes vs Individual Stocks
I became a professional investment manager in 2002. By then, It didn’t seem to matter that one particular company was well managed or a good value. Every company’s stock price movement closely follows market pricing for its asset class. When US large-cap stocks are doing well, all company stocks in the category do well. When the asset class is under pressure, “good” companies as well as “bad” have their heads handed to them.
By my analysis, the value gained by doing company-by-company research does not cover the cost of that research, even at the institutional level. It is more cost effective to apply basic value-based theory across asset classes rather than individual companies.
The rising tide floats all boats. The sinking ship takes down all souls, not just the captain.
Diversification – More Asset Classes
If company research isn’t worth the cost, what is? I believe the value I create as a money manager is in risk management – specifically downside risk management. I first design and manage a portfolio to minimize the magnitude of drawdowns. The second part of the job is managing client behavior after any drawdown is experienced.
After the Great Recession market correction I added more non-traditional asset classes to better diversify risk. Instead of tracking three (cash, bonds, stocks), my research tracks 14. Many of the non-traditional asset classes we track do not correlate with the stock market, especially in turbulent markets.
Diversification works over the long haul (a full business cycle – 12-25 years). Alternative assets are great for managing the downside portion of that cycle, but they also dampen the upside during bull-markets. In a bull market, a well diversified portfolio will underperform the market (what’s reported on the news every day). That’s not good for (my) business as clients tend to jump ship to more traditional asset managers that simply follow the crowd and deliver results that more closely match the headline.
I have often said that “good” money management is impossible to distinguish from “bad” during bull markets. The rising tide floats all boats. It is only in tough times that the value of a good manager comes to light. Unfortunately for me and the growth of my business, we’ve been in a record rising tide for many years. Most of that rising tide can’t be explained by traditional valuation metrics. It has been the result of unprecedented liquidity provided by central banks around the world (quantitative easing).
All that diversification has done for clients has left them watching the market experience double-digit growth while they have not (to put it kindly).
Historical Reference
My approach has further been influenced by historical research, especially work done by John Hussman, a PhD and 30-year professional money manager. I recommend reading his monthly update. Despite accurately identifying tops and bottoms for the better part of 20 years, however, Hussman has struggled the past few years. All the metrics he follows have suggested (from a historical perspective of more than 100 years of data) that valuations are as rich as they have ever been – even going back to 1929 – and yet the market continues to trudge higher.
Hedging downside risk, no matter how you do it (diversification, options, tactical shifts), comes with a cost. That cost is dependent on the size of the hedge and is realized by the investor in the form of a drag on upside performance. This is why hedge funds have done so poorly the past several years. Investors have been needlessly paying to manage risk that hasn’t reared its ugly head. The risk is still there. It just hasn’t affected the results that matter – the value of your portfolio when you check your statement each month).
Historical references be damned. We live in a new paradigm, right? No, not really. There are no new paradigms. What’s really going on?
It’s The Narrative Stupid
This isn’t rocket science. In fact, it’s quite simple. What really matters is what the market believes is what matters – that’s the Narrative.
Valuations do still matter in the long run, but the narrative matters more right now, especially with a super-short news cycle and our hyper-connected world. If everybody believes that central banks have our backs, the market is going to keep going up. There will be more buyers than sellers and prices will continue to rise. However, if that narrative changes for some reason and more people believe something less accomodative, there will be more sellers than buyers and we’ll see another correction. At that point valuations WILL matter as will having hedges in place.
When the ship is sinking, souls with a lifeboat will fair far better than those that don’t. Risk management will improve results considerably.
John Hussman frames it this way. “When investors have the bit in their teeth, they tend to be quite indiscriminate about what they are buying.” When fear gets into the psyche of the average investor – watch out below. Being able to more accurately identify when investors have “the bit in their teeth” and when they don’t is the key. My research finds that investor sentiment shows up for each asset class within recent market data. Our tactical strategy responds to market action over the past several months. But we are still looking for other ways to more accurately identify when the narrative is switching.
Is that narrative switch going on right now? I’m not saying that it is, but I would say that other research (maybe for a future post) indicates we are much closer to a narrative shift than we’ve been in years.
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