A Broken Clock That’s Right Only Once

Dalio
Ray Dalio: ‘We’re disappointed because we should have made money rather than lost money in this move the way we did in 2008’ © Reuters

In 2009 I was working for a large mutual fund company in Western Canada. It was the peak of the financial crisis and I was given the opportunity to take a promotion but had to move to Alberta. I was eager to move up (I was only 28) and jumped at the chance though I had no great desire to live in Edmonton. It was a difficult time. It was lonely in Alberta, and people weren’t eager to speak to a wet behind the ear’s wholesaler right after the biggest rout in modern financial history.

One particularly vivid memory for me was back in 2009, walking into an office at the tail end of conference call being given by Christine Hughes, a portfolio manager of some note during the crisis. Hughes was at the top of her game. She had outperformed much of the market by holding 50% cash weighting and had correctly predicted the financial crash. In later appearances she would complain that the company she worked for had prevented her from holding more and would have had been allowed to. But at this moment, in 2009, it was late summer, and markets had been rebounding for several months, having hit bottom in early March. Hughes was adamant that “the other shoe was going to drop” and that’s when things would really go wrong.

For much of my time in 2009 Hughes, and her fund, was the story that challenged me. Having made the correct call in 2008, advisors were eager to listen to what she had to say and believed that her correct prediction in 2008 meant she knew what was coming next. Many people followed Hughes and her advice, which led primarily nowhere.

Hughes’ time subsequent to 2008 was not nearly as exciting or as successful as you might have guessed. She left AGF, where she had made it big, and went on to another firm before finally starting her own company, Otterwood Capital. The last time I saw Hughes it was in 2013 and she was giving a presentation about how close we were to a near and total collapse of the global financial system. Her message hadn’t changed in the preceding four years, and to my knowledge never did.

Hughes may not have prospered as much as she hoped following her winning year, but others who made similar predictions did. One such person is Ray Dalio, the founder and manager of Bridgewater Associates. Dalio is a different creature, one with a long history on Wall Street who had built a successful business long before 2008. But 2008 was a moment that launched Dalio into the stratosphere with his “Alpha Fund” largely sidestepping the worst of that market and by 2009 his hedge fund was named the largest in the US. Since then Dalio has grown a dedicated following beyond his institutional investors, with a well watched YouTube video (How the Economic Machine Works – 13 million views) and a series of books including one on his leadership principles and a study on navigating debt crises (I, of course, own a copy!). Yet when the corona virus rolled through Dalio’s funds faired no better than many other products (I’m sorry, this is behind a paywall, but I recommend everyone have a subscription to the Financial Times). Once again past success was no indication of future returns.

I’m not trying to compare myself to a hedge fund manager like Dalio, a person undoubtably smarter than myself. However its important to remember that being right in one instance, even extreme and unpredictable events, seems to offer little insight into when they will be right again.

If you’ve read many of these posts you may know that I am a fan of Nassim Taleb, the author of The Black Swan and Antifragile. Early in the book Black Swan, Taleb makes the case that “Black Swan logic makes what you don’t know far more relevant than what you do know. Consider that many Black Swans can be caused and exacerbated by their being unexpected.” This is an important idea that I think can be extended to our portfolio mangers that gained notoriety for getting something right and then getting much else wrong.

A complaint I have long held about experts within the financial industry is both their desire to position themselves as outsiders while being likely to share many of the same views. Having a real contrarian opinion is more dangerous than being part of the herd, after all if things go wrong for you as a contrarian, they are likely to be going right for the herd. On the other hand, if things go wrong for the herd, the herd can use its size as a defense: “We were all wrong together.”

Some of this group think can be applied to the failure of governments to get a jump on the coronavirus situation. Far from not listening to experts, governments took the safest bet which was also the most conservative view, that the virus posed a low risk to the population of countries outside China. People who thought the virus was a large risk were taking a more extreme view; that the virus posed a serious risk and required extreme measures such as travel restrictions, aggressive testing, encouraging people to wear face masks and socially distance. As a politician which choice would you make?

The point for investors should be to treat the advice of financial experts who rise to prominence during outlier events as no more special than those that got big financial events wrong. This is not because their advice isn’t good, just that the thing they got right may not indicate wide ranging knowledge, but a moment when they understood something very well that other people did not. Investors should avoid personality cults and maintain a principle of uncertainty and scepticism to prophets of profit. The rise of COVID-19 and the global pandemic response, including the rapid change in the market, will produce a number of books and talking heads who will parlay their status as hedgehogs into that of a foxes! (If you don’t know what I’m referring to, please read this from 2016).

Dalio remains a very successful manager, but his correct reading of 2008 did not prepare him for 2020. In his own words: “We did not know how to navigate the virus and chose not to because we didn’t think we had an edge in trading it. So, we stayed in our positions and in retrospect we should have cut all risk.” Christine Hughes on the other hand seems to have disappeared, her fund gone and she in an early retirement. I know of no financial advisers eager to hear her views.

Information in this commentary is for informational purposes only and not meant to be personalized investment advice. The content has been prepared by Adrian Walker from sources believed to be accurate. The opinions expressed are of the author and do not necessarily represent those of ACPI.

The Deceptive Nature of Indices

Index

An essential part of the business of investing involves figuring out how well you are doing. In some respects, the best benchmark for how well you are doing should be personalized to you. How conservative are you? What kind of income needs do you have? How old are you? While the case remains strong for everyone to have a personal benchmark to compare against their investment portfolios, in practice many people simply default to market indexes.

I’ve talked a little about market indexes before. They are poorly understood products, designed to give an impression about the overall health and direction of the economy and can serve as a guide to investment decisions. Large benchmarks, like the S&P 500, the TSX, or the FTSE 100, can tell us a great deal about the sentiment of investors (large and small) and what the expected direction of an economy may be.

But because these tools are usually poorly understood, they can contribute to as much confusion as they do clarity. For instance, the Dow Jones uses a highly confusing set of maths to determine performance. Last year General Electric lost about 50% of its market capitalization, while at the same time Boeing increased its market capitalization by 50%, but their impact on the Dow Jones was dramatically different. Boeing had an outsized positive contribution while General Electric had a much smaller negative impact.

The S&P 500 currently is one of the best preforming markets in 2018. Compared to most global indexes, the S&P 500 is ahead of Germany’s DAX, Britain’s FTSE 100 and FTSE 250, Japan’s Nikkei and Canada’s TSX. Yet if you are looking at your US focused investments, you might be surprised to see your own mutual funds lagging the index this year. If you were to ask an ETF provider or discount financial advisor why that is they would likely default to the answer “fees”, but they’d be wrong.

YTD FTSE S&P500 TSX
While the S&P 500 isn’t exactly “running away” it is doing considerably better than the TSX and the UK’s FTSE 100

This year is an excellent example of the old joke about Bill Gates walking into a bar and making each patron, on average, a millionaire. While the overall index has been performing quite well, the deeper story is about how a handful of companies are actually driving those returns, while the broader market has begun to languish. Of the 11 sectors in the S&P 500, only two are up, technology and consumer discretionary, while a further 6 were down for the year. In fact the companies driving most of the gains are: Facebook, Amazon, Apple, Alphabet (Google), Netflix and Microsoft. The 80 stocks in the consumer discretionary space not in that list have done almost nothing at all.

What does this portend for the future? There is a lot to be concerned about. The narrowing of market returns is not a good sign (although there have been some good results in terms of earnings), and it tends to warp investment goals. Investors demand that mutual fund returns keep up with their index, often forcing portfolio managers to buy more of a stock that they may not wish to have. In the world of Exchange Traded Funds (or ETFs), they participate in a positive feedback loop, pulling in money and buying more of the same stocks that are already driving the performance.

In all, indexes remain a useful tool to gage relative performance, but like with all things a little knowledge can be deceptive. The S&P 500 remains a strong performing index this year, but its health isn’t good. Healthy markets need broad based growth, and investors would be wise to know the details behind the stories of market growth before they excitedly commit money to superficially good performance.  

Did that make you worried? Don’t be scared, call us to set up a review of your portfolio to better understand the risks!

Vexed by the VIX

This past week a number of articles spilled forth regarding the VIX index being at record lows. If you aren’t familiar with the VIX, that’s quite okay; the VIX is an index that tracks the nervousness of investors. The lower the VIX is the more confident investors are. The higher the VIX, the greater the concern.

At first glance the VIX seems to clearly tell us…something. At least it seems like it should. The index is really a measure of volatility using an aggregate of prices of options traded on the S&P 500, estimating how volatile those options will be between the current date and when they mature. The mechanics aren’t so important for our purposes, just that this index has become the benchmark for the assumed fear or comfort investors have with the market.

So what does it mean when the VIX is supposedly at its lowest point in nearly a quarter of a century?

Historic VIX
This is the historic performance of the VIX. Data provided by CBOE.

Because we live in the 21st century, and not some other more primitive time, we have the best technology and research to look to when it comes to discerning the meaning of such emotionally driven statistics. Its here that the the area of study of behavioural economics and investing supposedly cross paths and that we might be able to yield some useful insight from the VIX.

Motorola RAZR V3_1
What is this, 2007? Might as well be the stone age!

Or not.

The holy grail of investing would presumably be something that allowed you to accurately predict changes in the market based on investor sentiment. Though over time stock markets are meant to be an accurate reflection of the health and wealth of an economy, in the short term the market more closely tracks a series of more micro events. Investor sentiment, political news, potential scandals as well as outside influences like high frequency trading and professional traders pushing stocks up and down all make up daily activity.

The VIX seems like an ideally suited index to then tell us something about the market, and yet it probably isn’t. The problem with research into behavioural economics (and its other partner, big data) is that it is great at telling us about things that have already happened. The goal, that we could use this information to change or alter human behaviour, is still a long way off (if it exists at all). Similarly the VIX is basically great at telling us stuff that we already know. When markets are bad the VIX is high. When markets are good its generally low.

Skiing in pants
Bad forecasting can lead to terrible outcomes.

Thus, the VIX represents a terrible forecasting device but an excellent reminder about investor complacency. When markets are “good” (read: going up) there is a tendency for investors to ask for more exposure to those markets to maximize returns. If you feel uncertain about the future, investors and financial advisors are less likely to “drift” in terms of their investing style, but if people feel very good about the future their far more likely to take their foot off the breaks.

Screen Shot 2017-05-18 at 2.00.19 PM
Yesterday’s selloff followed news that Trump’s Russia problem wasn’t going to go away, but remain a permanent feature of his administration.

Real market panics and crashes tend to be triggered by actual structural problems. 2008 wasn’t the result of too much confidence about the future from investors, but because the market itself was sitting on a bubble. That the VIX was low only tells us what we already knew, that we weren’t expecting a financial crisis.

Trump-Jail
We can hope.

With markets down sharply yesterday its tempting to see that this level of investor complacency/confidence harbingered the most recent sell off. But that’s not the case. Trump is, and remains, a kind of nuclear bomb of unpredictability that must be factored into anyone’s expectations about the markets. But what we should do is consider the VIX a mirror to judge our willingness and preparedness to deal with unexpected events and market downturns. If you’ve started to assume that you can afford growing concentration in your portfolio of high performing equity or that you don’t need as many conservative positions, you should take a long hard look at why you feel that way. Maybe its just because you feel a little too confident.

Like everyone else.

 

Canada’s Economy Still Ticking Along, But Don’t be Fooled

Money CanThis year the Canadian markets have been doing exceptionally well. Where as last year the S&P/TSX had been struggling to get above 2% at this time, this year the markets have soared ahead of most of their global counterparts. In fact the Canadian market triumph is only half of this story, matched equally by the disappointing performance of almost every significant global market. Concerns over China have hurt Emerging Markets. The Ukrainian crisis has hindered Europe, and a difficult winter combined with weaker economic data has put the brakes on the US as well.

YTD TSX Performance

But this sudden return to form should not fool Canadians. It is a common trope of investing that people over estimate the value of their local economies, and a home bias can prove to be dangerous to a portfolio. Taking a peak under the hood of Canada’s market performance and we see it is largely from the volatile sectors of the economy. In the current year the costs of Oil, Natural Gas and Gold are all up. Utilities have also driven some of the returns, but with the Materials and Energy sector being a full third of the TSX its easy to see what’s really driving market performance. Combined with a declining dollar and improving global economy and Canada looks like an ideal place to invest.

TSX Market Sectors

But the underlying truth of the Canadian market is that it remains unhealthy. Manufacturing is down, although recovering slowly. Jobs growth exists, but its highly anemic. The core dangers to the vast number of Canadians continue to be high debt, expensive real-estate and cheap credit. In short, Canada is beginning to look more like pre-2008 United States rather than the picture of financial health we continue to project. Cheap borrowing rates are keeping the economy afloat, and it isn’t at all clear what the government can do to slow it down without upsetting the apple cart.

For Canadian investors the pull will be to increase exposure to the Canadian market, but they should be wary that even when news reports seem favourable about how well the Canadian economy might do, they are not making a comment about how healthy the economy really is. Instead they are making a prediction about what might happen if trends continue in a certain direction. There are many threats to Canada, both global and domestic, and it should weigh heavily on the minds of investors when they choose where to invest.