KEVIN ARMSTONG’S STRATEGY THOUGHTS – July 2012
Should we Live in HOPE or Should we Sell The News?
INTRODUCTION
This month’s Strategy Thoughts is the first edition to be written since I resigned from ANZ. For the last four and a half years I have been writing Strategy Thoughts for the ANZ Private Bank and its clients throughout Australia, New Zealand and Asia and prior to that, right back to the 2002 cyclical bear market trough, I wrote Strategy Thoughts for the New Zealand Private Bank.
The original reason for writing a monthly paper on my views of investment markets was that it was a very healthy, and valuable, discipline to attempt to put my thoughts on what was important in markets and what was driving markets each month ahead of my chairing the bank’s Regional Investment Committee. The discipline continues to be of value and so I will continue to write.
The basis of the views expressed in Strategy Thoughts were never economic in nature and valuation has never been used to justify a view except over the very long (secular) term, this will continue to be the case. I firmly believe that investment markets are an accurate depiction, in real time, of investor expectations and so movements in broad markets are a reflection of broad social mood. Expectations, or levels of social mood, are also captured in broad economic numbers but only after a long lag that may be six months or more. This makes forecasting markets by forecasting the movements in the economy a real challenge, an accurate forecast of where the economy will be in six to twelve months likely explains why markets are where they are now. Swings in social mood or expectations, driven by the numerous behavioural biases that drive humanity, from pessimism to euphoria and back, over periods of six months to a few years are the primary drivers of cyclical moves in markets over similar periods; valuation tells an investor nothing over such time frames. Valuation is important as an indicator of where a market will likely go over the very long (secular) term. All markets display secular bull and bear markets that may last three decades or more and the inflection point from secular bull to secular bear is always accompanied by historic extremes in valuation. Over the very long term, long term measures of valuation are an exceptional indicator of long term prospective returns.
In this month’s Strategy Thoughts I will review the rally that has been seen in most ‘risk’ markets throughout June and attempt to put them in some broader perspective, highlight the HOPE that seems to dominate the investment media currently, explore the corporate ‘malfeasance’ that is once again raising its head, this time at Barclays, and finally provide some timely, albeit a little light hearted, secular observations.
Has anything changed?
Over the last month equity markets have rallied and if the media were to be believed (not a good idea usually although they should be studied closely) the rally has been of historically rewarding proportions;
Stocks end first half of 2012 with a bang — CNN Money June 29, 2012
Global stocks, euro, oil rally after euro zone deal Fri Jun 29, 2012
(Reuters) – The euro jumped nearly 2 percent, oil prices surged and world stocks rallied on Friday after euro zone leaders agreed on measures to cut soaring borrowing costs in Italy and Spain, in addition to directly recapitalizing regional banks.
Stocks Log Best Day of 2012, Dow Back in the Black –6 Jun 2012 CNBC
Hope Turns Into Biggest Stock Rally of 2012 — WSJ.com 6th June 2012
Much of the excitement and ‘hope’ on the part of the media and investors has been based upon Europe somehow averting a cataclysm. It is possible that this may indeed happen, however, if one was already a European investor it is quite likely that you would think that whatever ‘they’; governments, central banks, the ‘troika’ or whoever, are going to do, well it’s too late. Investors have already been well and truly beaten up.
The broad Euro Stoxx 50 index of European markets peaked in the second half of 2007, it then fell more than 60% to its low point in early 2009. Along with most other markets it then enjoyed a rewarding cyclical rise of more than 70% but this rally lasted less than a year, the market then entered what for investors must have been a very frustrating trading range moving broadly sideways until the second half of last year. From there it fell by more than 30% into the last quarter of last year. It then recouped about half of what it had lost in the 2011 sell off before rolling over again through April and May of this year. At its recent low point the Euro Stoxx 50 stood at 2050, only 16% above the low point recorded in 2009, but more importantly still down about 35% from where it was in early 2011 and early 2010 and still 55% below where it stood almost five years ago.
For some of the more troubled markets of Europe these numbers make even bleaker reading, but even for the supposed bastion of economic strength in Europe, Germany, the investment experience has been far from a happy one. At the low point at the beginning of June the DAX was down 18% from March of this year, still down 22% since May of last year and 28% from the high points recorded in both July 2007 and March 2000. With this backdrop it is worth reviewing just what the ‘bang up, surging, best days since…..’ rally of the last few weeks has delivered.
Over the last four weeks the DAX has rallied less than 10% and recouped only 45% of the fall, from the March highs, it suffered through to the June lows. The French market has recovered a similar percentage of the fall from the March 2012 highs over the last few weeks but still languishes 48% below where it was in 2007 and nearly 55% below where it was in 2000, even after the recent strength. Finally the Euro Stoxx 50 index has, over the last four weeks, also only recovered about 43% of the decline it suffered from March and is also still well below other recent peaks.
The final headline above perhaps best captures the vulnerability of the recent European solution induced rally and it can be summed up in one word ‘HOPE’. Hope is an understandable, and in many walks of life valuable, human emotion or response, unfortunately it does not tend to serve investors well. There is a reason why it is said that a bear market ‘slides down the slope of hope’.
THE SLOPE OF HOPE LIVES ON!!
The current slide down the ‘slope of hope’ of a cyclical bear market began for most markets in the first half of last year. Certainly that was when most European markets reached their cyclical bull market highs, although for some, as discussed above, those highs were only marginally higher than was recorded a year earlier in early 2010. The reason the adage about the ‘slope of hope’ came about is that it was observed that throughout a cyclical bear market there are always many bear market rallies, and each of those rallies comes about because of hope; hope that the latest government plan, or the central bank’s action, or some other event will reverse the inconvenient decline that is upsetting the majority of investors plans. After the announcement, whatever it may be, the market rallies, and the rise can be self fulfilling for a while as the hope spreads, but eventually the rally falters, it fails to surpass the previous high and as the market rolls over the larger decline continues. There can be many such rallies during the full slide down the ‘slope’ but it is only when all hope has been dashed, as a result of disappointment after disappointment, that the conditions for a new bull market can be found. When expectations, having been repeatedly dashed, are so low, then, virtually any news is good news, no matter how bad it may be in an absolute sense. Cyclical bear markets always bottom amid miserable news, just not as bad as by then investors expect. They do not bottom because of a positive announcement about a solution, to whatever the problem supposedly was, having been found. The initial rise off that bottom of the slope of hope is always greeted with great suspicion and never expected to endure.
From late 2007 through to early 2009 a real time learning opportunity was provided, by most equity markets in the world, as to what a slide down a slope of hope is like. There were numerous rallies on the back of this program or that acronym that were set to ‘fix’ the problem, none of them did. It was only when no solution appeared possible, when Great Depression II had supposedly already begun, in March of 2009, that the conditions of devastated expectations were in place so that no matter how bad the news was it wouldn’t be as dire as the vast majority were by then conditioned to expect. From there the new cyclical bull market began.
In many ways the current decline on the back of Europe’s problems is analogous to that which the world suffered through the Global Financial Crisis, except that the current decline is even more protracted. Perhaps that is why ‘hope’ has been so persistent. After every one of the eighteen, or is it nineteen now, Euro Summits a plan has come out that delivers hope, and a rally. This was seen at the end of last week and it was seen just two weeks earlier, as Barron’s reported;
Hope Lifts Stocks, Trims Bonds Barron’s 11 June 2012
Hopes that central banks will expand liquidity to counter economic weakness and Europe’s debt crisis produced the best week of the year for U.S. equities, which reduced demand for the safe haven of government bonds whose yields had plunged to historic lows.
The media commentary ahead of the much anticipated Greek vote was all focussed upon the HOPE, in fact it seemed in some quarters to be a certainty, that central banks would do whatever was necessary if markets reacted badly. This seemed to add some comfort and prompted a rally in the US market immediately ahead of the weekend vote. The following headline from the New York Times on the 15th June captured the spirit of this view;
Central Banks Stand at Ready to Fortify Euro
There were other more extravagant pronouncements like that from Reuters that homed in on the fact that central bankers were ‘checking their ammo’ ahead of the weekend. But the result on that occasion once again was hope. As I wrote earlier the desire to seek comfort in hope is understandable, but unfortunately for investors as long as hope survives, and can repeatedly be rekindled, the bottom has not yet been reached. It really does NOT feel like the conditions for a meaningful market recovery, a new cyclical bull market rather than just another bear market rally, are even close to being in place given the prevalence of the current hope.
THE OTHER GREAT HOPE! CENTRAL BANKS
Whilst it may be understandable that we humans cling to and seek hope, it is remarkable that we just don’t seem to learn, even from the relatively recent past. There remains an abiding hope that central bankers will fix whatever the problem is, that they will do ‘whatever it takes’. These are sentiments that are often reported and in some quarters relied upon, what is most surprising to me is that that the same phrases continue to get trotted out and that the faith in the ‘almighty’ central banker is so strong.
Throughout 2008 central banks threw everything they could at the situation, and they may claim victory after the event because ‘Armageddon’ or ‘the end of the world’ was avoided, however, investors should take no comfort from the idea that central bankers can stop markets plunging. After all, from 2007 to 2009 markets the world over fell between fifty and eighty or more percent!
The current HOPE, and the hope that was so present until the very end of the decline in markets associated with the GFC four years ago, that central bankers would conjure up a solution is very reminiscent of the hope that was placed in the so called ‘Plunge Protection Team’ that was formed in the wake of the 1987 crash by Ronald Reagan or as Time Magazine in February 1999 put it ‘The Committee to Save the World’ with a cover photo of Larry Summers, Alan Greenspan and Robert Rubin.
These titans of finance, economics and business were supposed to stop any sort of financial meltdown, three years later world markets had suffered their worst collapse in more than a quarter of a century, the tech bubble had burst and the NASDAQ had fallen 80%. Undoubtedly a ‘plunge’ had occurred but there did not seem to be too much protection. Yet still the media talks about the almost mythical powers of this group to prevent a severe market decline, particularly as ‘they’ also have the supposed ‘Bernanke put’ and everything at his disposal to rely upon as well.
Prior to the Dotcom bust in the early 2000’s and then the GFC there was a general belief that Wall Street couldn’t have a severe decline because ‘The Federal Reserve wouldn’t let it’. The naiveté of this attitude is obvious now after two of the worst declines in history, yet still so many cling to this hope. However, the naiveté should have also been obvious in the late nineties. A decade earlier there was a similar widespread belief, and hope, that the Japanese market could never suffer a severe decline, because the almighty Ministry of Finance wouldn’t let it happen. It is hard to believe that after witnessing in real time the devastation of the Japanese market from 1989 to now, and the two massive bear markets of the last twelve years, investors still do believe and hope that somehow someone is going to prevent a severe fall. As long as that hope persists, and makes headlines, a bottom has not been seen, irrespective of valuations or economics!
New bull markets are never recognised and understood until they have been in place for some time and delivered a lot of whatever gains they are ultimately going to produce. If a rally is broadly understood and recognised, and the majority know exactly why the market is rising, such as the current rally on the back of the Euro fixes, then it is almost certainly merely a bear market rally on the way down the ‘slope of hope’.
IT HAS PASSED!
In March of last year I titled Strategy Thoughts ‘It hasn’t passed yet!’ I chose that title because the month before I had referred to the old adage, that all investors should always remember, ‘This Too Shall Pass’. At the time I was alerting investors to the danger of getting excited or even comfortable with the then growing enthusiasm that was apparent amongst investors, market commentators, economists and strategists, I wrote;
“At such times it is easy to get swept up in the bullish excitement. Unfortunately for investors amongst the most important lessons we ever need to learn is that getting swept up in a crowd, whilst it may feel great, is not the path to investment success. “This time’ is never really different and because as human beings we are hard wired with behavioural biases we never remember the ‘lessons’ we have ‘learnt’ in the past, often as a result of painful experience, just when we need to. That is why it is so important for investors to remember that whatever is occurring in markets, no matter how good, or how bad, it will pass.”
I went on to describe the previous occasion that remembering ‘this too shall pass’ was vital; late 2008;
“Two and a half years ago I employed this title to highlight that the then overwhelmingly depressing gloom that prevailed would pass, and it did. Last month I used it to remind the growing number of newly confident bulls that the current enthusiasm and optimism would also pass, eventually. So far it hasn’t, which is good, as I also implied that even as the longer or intermediate term risks grew, the short term probably would be characterised by an increasing level of confidence and the kind of environment that could ultimately cause one to forget that ‘it will pass’.”
I now believe, as I described above, that the cyclical bull market peak did in fact occur last year or even the year before for some markets and so ‘it’ has passed, however, we continue to see the collective amnesia amongst investors that is always found at turning points. It is hard to battle the behavioural biases that so frequently conspire against us in investment markets and it is hard to remember the ‘lesson’ we find so easy to forget , yet it is essential if we are to succeed.
Not getting swept up in the frequent bouts of ‘hope ‘is one lesson that needs to be remembered, as is not taking comfort from economic forecasts and there is also a lesson that should be learnt from the current banking revelations emanating from Barclays.
ECONOMIST FORECASTS!
Over the years I have frequently highlighted the futility of relying upon an economic forecast to build an investment view, the reasons for this are many but one only has to think back to the disaster that was the GFC and the collective failure of the economics ‘industry’ to alert us to that disaster, until it was actually over by which time we were repeatedly being told that it would get worse, to recognise that the ‘industry’ does have shortcomings when it comes to investing. Nonetheless, it seems that many still seek the comfort of an economic rationalisation for what markets will do in the future and are captivated, and comforted, by the seeming exactitude of the forecasts, often to several decimal places. All this despite enduring repeated frustrations as the exactitude and the comfort proves totally misplaced; it is indeed hard to learn from the past. As George Bernard Shaw wrote;
“We learn from history that we learn nothing from history.”
I was reminded of the beguiling exactitude, if not accuracy, of economic forecasts earlier last month when reading a Bloomberg article on the movement of the Euro;
Euro Strength Seen By Stiglitz Removing Greek Debt — June 12, 2012
The article summarised the forecasts of economists / strategists for the movements of the Euro US dollar exchange rate over the next few years;
“The median estimate of 57 strategists surveyed by Bloomberg is for the euro to trade at $1.26 by the end of the year, dip to $1.25 in 2013, and then strengthen each year until it reaches $1.30 in 2016.”
This truly is a remarkable forecast. Over the last five years the Euro has risen from $1.33 to $1.60, then fallen to $1.25 before rising above $1.50. It then fell below $1.20, reversed and rallied to almost $1.50 and then once again fell below $1.25. The average move in the Euro US dollar exchange rate over just the last five years has been more than twenty percent and each move lasted about a year or less. According to the median forecast from the 57 strategists surveyed by Bloomberg all this volatility is now a thing of the past. Over the balance of this year the Euro will move sideways before falling ONE CENT over the next twelve months and then rising at a rate of a little over a cent a year for the next three years. Well it might happen, but it has to be an incredible long shot. Movements of that magnitude are seen in one week and occasionally over even shorter periods. Such a forecast may appear considered, exact and even sensible, but one with such a low probability of occurring should not be the basis of any investment decisions.
Currently the conventional wisdom amongst forecasters continues to be an outlook that is both benign and hopeful, as it has been for many months now. This benign outlook is based upon the hope that China doesn’t have a hard landing, that Europe continues to muddle through and that the US recovery continues, albeit at a tepid pace. If there is a surprise or disappointment, and it is surprises and disappointments that drive markets, the expected or hoped for is already priced in, then I continue to fear that the hope is misplaced and the outcome will be less benign.
WHEN DOES CHANGE OCCUR?…… ALWAYS TOO LATE AND ALWAYS AFTER THE BOTTOM!
One of the hopes that many continue to cling to is that regulations will prevent anything too disastrous happening. Unfortunately history shows that regulators are always outstanding in preventing the last disaster, obviously too late, and then when no disasters happen for an extended period repealing the very rules that prevented disasters, just in time for the next disaster. It is also the case that in addition to regulatory changes, after a financial disaster blame has to be assigned. Most recently this was seen in with the outbreak of so called ‘corporate malfeasance’ in the wake of the dotcom bubble bursting. In every case the malfeasance was taking place while markets were soaring, however, while there are no problems to address no questions get asked and those that do get asked tend to be easily dismissed.
Once markets turn ugly then questions have to be asked and eventually someone has to take the blame. Enron went from being America’s most innovative company six years in a row, as named by Fortune magazine, to filing for bankruptcy in just a matter of months, but the music didn’t stop for Enron until almost two years after the peak in the stock market. By the time Ken Lay, the CEO, was indicted by a grand jury in 2004 the bear market was over and a new bull market had begun. The same was true for Bernie Ebbers of WorldCom.
It was a similar story after the Great Crash in 1929. In the same edition of Strategy Thoughts mentioned earlier, from March 2011, I recommended a remarkable book, “The Hellhound of Wall Street. How Ferdinand Pecora’s investigation of the Great Crash changed American finance”. After such a devastating financial disaster it is understandable that a major investigation would take place, but it didn’t occur until 1933, a year after the Dow bottomed out having fallen 89%. And it wasn’t until five years later that Richard Whitney, the president of the New York Stock Exchange, was sent to jail. Whitney didn’t cause the crash, just as Ebbers, Lay and others did not cause the dotcom collapse, and subprime mortgages did not cause the GFC. All of them were symptoms of the preceding booms that were exposed by the eventual bust and ultimately targeted to take the blame for all the lost fortunes.
None of this is intended to excuse their behaviour, rather it is to highlight the progression of booms and busts that never seems to change because the majority never learn from the past, until it is too late, and then they forget when the next boom arrives.
In the wake of the GFC some regulations were passed, and eventually some very similar to those that had been repealed ahead of it may be reinvented, but it is not clear that much blame, rightly or wrongly, has been assigned. It is likely that one of the signs that the current bear market is over will manifest itself in a far more punitive and aggressive search for ‘someone’ to blame.
Bloomberg this week may have begun that process with their commentary on the Barclays scandal, under the headline;
There’s Something Rotten in Banking Bloomberg 3rd July 2011
Bloomberg went on to explore what could and eventually probably will happen;
Chief Executive Officer Robert Diamond, who has agreed to forfeit his bonus, shows no sign of following the chairman out the door. He should. In an apology to employees, Diamond wrote that some of the misconduct occurred on his watch, when he was head of Barclays Capital, the investment banking unit. Diamond was already in the doghouse with investors. In April, 27 percent of shareholders, upset that Barclays had missed profit targets, voted down his $19.5 million pay package.
Heads should roll at other banks, too. Regulators and criminal prosecutors, including the U.S. Justice Department, are investigating at least a dozen other firms to determine whether they colluded to rig the rate. Among them: Citigroup Inc., Deutsche Bank AG, HSBC Holdings Plc and UBS AG.
BANK BASHING
We don’t countenance bank bashing. Nor have we ever called on regulators to bust up big banks. But it’s difficult to defend an industry that defrauds the market with fake interest rate figures, thereby stealing from other banks and customers.
Sadly, the Libor case reveals something rotten in today’s banking culture. We hope the investigations expose the bad actors, lead to jail terms for those who knowingly manipulated the market, and force out the senior managers and board directors who participated in, or overlooked, such conduct.
Since this article appeared Diamond has resigned but there is likely far more to come, as the article pointed out, but the blame game will probably not get into full force until after the next bull market has begun.
CONCLUSIONS
My long term perspective continues to be that the major stock markets of the world, particularly those of Europe and the US, are continuing to unwind the extreme excesses that were seen in the late nineties, excesses of both valuation and expectation. Such secular unwindings tend to take a very long time and are eventually characterised by extremely low valuation and extremely low expectations. It is unlikely that such a point has been reached yet. As result cyclical bull and bear markets, driven by a succession of surprises and disappointments as have been seen over the last dozen years, should be expected going forward. Buying and holding will still likely continue to result in severe frustration, just as it has done since 2000, as will relying on economists or valuation measures no matter how comforting or hopeful they may seem.
The current cyclical decline, which has been seen in commodities as well as stock markets, probably has further to run. It will end with very depressed expectations, no sign of ‘hope’ from yet another summit, economists slashing forecasts for growth and a global recession probably imminent. By the time these things occur it will probably be the case that the recession (it will eventually be determined) had already started and with rampant gloom and dire forecasts abounding. By then another great opportunity, like those seen in late 2002 or early 2009, will be at hand. For most markets this will be another cyclical opportunity, however, it is possible that some of the most depressed markets may also be on the brink of a new secular bull market.
In the meantime it will be prudent to avoid the excitement and attraction of the ‘hope’ that has accompanied this recent rally, and to maintain a very cautious investment outlook with a particular focus on high quality fixed income, don’t chase yield, and the still relatively depressed US dollar.
The old investment adage is ‘buy the rumour sell the news’. Any superficially good news that seems to satisfy the hopeful should probably be sold into.
Kevin Armstrong
POSTCRIPT
4th July 2012
Final thought, another secular perspective: The Late Seventies Revisited?
Travelling in the US and UK a few weeks ago I was struck by the excitement associated with the re-launch and continuation of the hit seventies and eighties TV show ‘Dallas’. The new show premiered a couple of weeks ago and was apparently well received, as a result a second series has already been scheduled for 2013. You may well wonder what on earth Dallas could have to do with markets, well a recurring theme of this month’s Strategy thoughts has been the fact that humans don’t learn from the past. Because of this history does have a tendency to at least rhyme or echo, and there is an uncanny rhyme in the timing of Dallas’ re-launch.
The original show debuted on April 2nd 1978, just over twelve years into the miserable secular bear market that began at the beginning of 1966 when the Dow touched 1,000 for the first time and it was three and a half years after the 1974 trough, the deepest of that secular bear. It is now a little over three years after the deepest selloff in the current secular bear market and it is also just over twelve years since the start of the current secular bear market in early 2000.
History never does repeat exactly, and who knows whether Dallas this time around will be anything like the cult show it was more than thirty years ago, but it may be worth noting that the seventies secular bear market still had four years to run when Dallas began although the subsequent cyclical bull and bear markets were less severe than those earlier in that secular bear market.
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The views expressed in this document accurately reflect the author’s personal views, including those about any and all of the securities and issuers referred to herein. The author however makes no representation as to its accuracy or completeness and the information should not be relied upon as such. All opinions, estimates and forecasts herein reflect the author’s judgements on the date of this document and are subject to change without notice.
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