Learning from hindsight

There have been many cycles in investment markets. Each has its individual features, but all have certain common characteristics. We cannot escape the rise and fall in asset values, but we can try to learn from it.

In my view, any planner who has been through one full cycle and who can recall the ‘flavour of the day’ at the peak and the trough, can be equipped for future cycles. The key is to remember the mood during the boom and during the bust. This can immunise one from being caught up in either need or fear in future cycles.

One factor peculiar to the latest cycle was the lesson that analysts need to focus not only on quality of assets but quality of debt. This knowledge should be tucked away for the next time credit spreads become wafer thin.

However, the most valuable lessons are learned by identifying those characteristics that are common to all bull cycles.

The cliché is that greed predominates. Greed is a judgemental word, so let’s substitute over-optimism or over-confidence.

Most booms begin on a firm foundation, which provides sound investment returns. If the previous decline has gone too far, particularly attractive value may be available. However, after some years of strong returns, momentum takes over. I don’t mean this simply in its technical sense, but also as a description of the behaviour of investors and some advisers. They develop a sense of inevitability about rising markets.

What behaviours were prevalent up to, say, six months ago and in earlier bull markets?

First and foremost is leverage. Margin lending increases, leverage within products escalates, people who have never owned a share before become convinced they must borrow and get into the stock market, and so on.

Taking property as an example, listed trust gearing rose in the boom of the late 1990s. Unlisted property trusts adopted the heavy internal gearing of the split trust structure. This reached its peak with BT’s Growth Units, which were designed to distribute nil income and all capital growth (or capital loss, as it proved).

During the subsequent property slump, listed trusts’ gearing fell. Then, in the recent up cycle, gearing was back in full force in listed and unlisted trusts.

This is merely one example. The key feature in most or all of the companies, trusts, hedge funds and collateralised debt obligations (CDOs) that have collapsed is heavy gearing.

I do not suggest that gearing is never appropriate. I simply note that leverage increases following strong returns and decreases following declines. It is one of the recurrent themes.

During the boom, there is an increased attraction for higher risk investments. This usually manifests in sector funds, most recently in regard to emerging market or China funds. The previous cycle saw a plague of technology or dotcom fund investing. There is nothing wrong with sector funds per se, I am merely noting the sudden upsurge in popularity.

The current cycle also saw a plethora of new products in the high yield space, including Basis Capital, Fortress, now infamous CDOs and so on. It is fair to say that few of these were understood by the market, but this did not hinder their popularity; they were new, ‘sophisticated’ and hot.

There is always some sector or theme that leads each boom.

Prior to 1987, the so-called entrepreneurs (some were later called inmates) were seen as the corporate heroes and geniuses of value creating — though this was subsequently revised to idiots who borrowed too much to pay too much for assets.

In the late 1990s, it was the dotcom mania, then argued to be different — later revised to insane — that was new, ‘sophisticated’ and hot. It is true that technology is a great and enduring force, but it did not remove market cycles or make it profitable to pay silly prices.

Until recently, some argued that the current cycle was different, driven by the great force of China, which would lift markets ever higher. Yet world markets fell; indeed, the Shanghai index losses have been about double those of our market — regrettably for those who had to have China funds at the peak.

Asset allocation (AA) always becomes more aggressive in bull markets. The dotcom era was an extreme. At a time when world stock markets became dominated by IT companies with little history and little future, the exposure to offshore shares in median balanced and growth super funds reached record levels. In parallel, industry inflow figures showed advisers giving far more support to international funds than at any time before or since. Frankly, it was an embarrassment for our industry.

During the euphoric phase, many clients and advisers scorn ‘boring’ stable fixed interest as a material component in portfolios.

Some advisers become concerned that they are doing clients a disservice by including assets that don’t ‘offer an adequate return’.

Advisers who have taken a more aggressive stance may even deride those who have preserved caution, suggesting that the cautious adviser has let their clients down.

Market participants feel absolutely unsurprised if a market rises by 5 per cent or 10 per cent in mere months. Many act as if it can be relied upon that prevailing conditions will continue for the foreseeable future. There is inadequate recall about how earlier bull periods ended (ie, in losses).

Many advisers would like to lighten growth assets before a downturn, but don’t want to be too early.

The one thing you can rely on at the peak (and all points in the cycle) is that the consensus will be that markets offer acceptable value. Only three things are certain: death, taxes and a financial industry bias to optimism in booms.

The above is neither an exhaustive nor scientific list of bull market characteristics. However, any adviser who circulated widely amongst industry colleagues last year would have seen most of these attitudes exhibited.

The other side of the coin is discovered during the down cycle.

If bear markets are extended (and I don’t think we are at this point currently), the prevailing characteristic becomes fear or, to be less emotional, excessive pessimism.

Advisers, like clients, discover their real tolerance for volatility. Before a slump, volatility is a theoretical concept and many advisers are confident that they are not worried by it and that their clients have been educated likewise. For some at least, the reality of significant portfolio losses is more confronting than historical graphs of markets oscillating around a long-term rising trend.

The initial phase may involve disbelief at how quickly it is happening. Many clients feel a conviction that someone should have told them this was coming.

Industry inflow figures may begin to indicate outflow from assets that were invested in with a purported long-term intention. These figures don’t reveal whether this is adviser or client initiated, but the point is that it occurs. Consistent with this thesis, after the US stock market had fallen by almost half from 2000 and therefore must have offered far better value, offshore funds became less popular.

Support drops for recent hot fund managers and long-term strong performers are rediscovered. There is even a trend towards those assets that were previously scorned (eg, cash, term deposits, bonds, and so on). Who can forget the rush to include fixed term options in public offer pension funds after the 1994 setback — all of which disappeared in the next up phase when cash ceased to be trendy?

If the slump extends, another form of amnesia develops, as if people cannot recall that all earlier down cycles have ultimately reversed, and that the strongest returns are achieved off the bottom.

I grant that all of these are simplifications and I stress that I am not passing judgement on any adviser or strategy nor laying blame. I am describing behaviours that tend to manifest. If advisers can recognise these, they can be better armed next time.

If we step back and view it objectively, we must acknowledge that the manic-depressive swings in market participants’ attitudes are dangerous.

The ideal investment strategy would be to become cautious when markets are high, reduce gearing, reduce exposure to growth assets and to increase holdings in cash, fixed term and so on — then become aggressive when prices are in a trough.

We must acknowledge that, like most ideals, this is not so easy to put into practice.

An alternative approach would be to take a long-term view of AA and to confine oneself to those products or direct assets with a strong track record and to hold this strategy through all points in the cycle. I believe this is less than ideal, but it would impose a discipline against the mood of the moment.

Then there is what really happens: aggression in AA peaks and gearing as markets peak. Investors therefore expose themselves to maximum losses before a fall.

Conversely, they trough at low points, thus investors are most ‘protected’ against volatility at the start of the next up phase.

We can’t change human behaviour en masse, but individual advisers can try to bring balance to their clients. Let’s assume that a planner wants to make some changes to AA over time. How might this be done?

No one can forecast turning points, so there is no use dreaming of perfect entry and exit timing. Therefore, the only options are too early or too late. I had one memorable occasion of being too late. In mid 1987 we had written to clients suggesting they lighten stock market exposure. One by one we worked through clients’ portfolios. My final client made an appointment to implement it, but the crash hit on the morning of the appointment. The stock market lost a quarter of its value. I still recall sitting there with him.

Moral — be too early!

Some advisers held cautious portfolios in the boom and are now increasing growth assets.

Others are comfortable with their holdings at the peak and are maintaining them. A third group now face a dilemma. They wish they had been more conservative, but don’t want to sell at a low point. I can’t offer any overly wise counsel in this situation.

But the lesson is clear, next time ensure profits are taken systematically (and don’t be put off by capital gains tax) to avoid repeating the current dilemma. I can offer a rough and ready principle for those who have nothing better: your satisfaction with the past should be broadly inverse to your expectations for the future.

After years of outstanding concerns, you will be pleased with your portfolios, and your clients will be pleased with you.

You should therefore start to wonder how much longer the good times can roll.

After a severe fall you won’t be enjoying yourself. It’s appropriate to feel increased confidence about long-term prospects for future returns.

For example, listed property has lost about a third at the time of writing. I make no call that property has hit a bottom, but I recognise an incontrovertible truth — property has to offer much better value with prices down by a third. You could include more in portfolios than would be appropriate at record highs.

In any case, AA through a cycle should not be heroic, simply incremental steps. For example, if property trusts fall another 15 per cent, you might further incrementally increase exposure. I grant there are more rigorous approaches. Nonetheless, following this approach towards both ends of the cycle, you risk being constantly too early. Congratulations.

Markets are manic-depressive, but advisers don’t have to be.

Robert Keavney CFP is the chief investment strategist at Centric Wealth Advisory.