Bear necessities

“At first sign of crisis, the ignorant don’t panic because they don’t know what’s going on. Then later they panic precisely because they don’t know what’s going on.”
– Jarod Kintz.

In a crisis, it helps to have good counsel. Investment strategist Mike Tyson is pretty good at summing up the problem:

“Everyone has a plan ‘til they get punched in the mouth.”

Or as the military strategist Helmuth von Moltke the Elder put it, somewhat more formally:

“No battle plan ever survives contact with the enemy.”

The enemy has been quick to show himself this year, in the form of a bear market, at least for stocks. This bear has so far been quick, and indiscriminate: the US; Europe; China; stock markets have fallen sharply, internationally. Investors, being human, have scrabbled in search of an explanatory narrative.

Some have blamed the Fed’s baby steps towards normalising interest rates (if a rise from 0% to 0.25% can cause this much investor concern, get a load of history). Some blame the collapse in the oil price. Last week we watched David Cronenberg’s 2012 thriller ‘Cosmopolis’, which has Robert Pattinson playing a 28-year-old hedge fund billionaire driving around town and losing his entire fortune in a single day due to the unexpected rise of the yuan. Other than getting the direction of the renminbi wrong, it could have been shot yesterday. (The film, like the financial markets of 2016, is largely unfathomable.)

But as CLSA’s Christopher Wood points out, perceptions of emerging markets, including China’s, are becoming increasingly divorced from reality. The oil collapse, for one, is a huge red herring. Asia in aggregate

“is a massive beneficiary of lower oil prices.. [and] Asia now represents 72% of the MSCI Global Emerging Markets Index.”

So the narrative on oil is probably wrong, at least as regards most Asian economies, including Japan’s.

Fears that the Chinese authorities have lost control of their own markets, or have botched their own narrative regarding a measured devaluation of the renminbi against a trade-weighted basket of currencies, probably have more substance. CLSA suggest that the intent of the Chinese authorities may well be to devalue the renminbi against the US dollar while maintaining stability against a currency basket (à la Singapore). But the lack of policy guidance from the Chinese – by comparison “with the overdose of communication from G7 central bankers” is clearly unhelpful.

But it has certainly been a good week for bears. RBS told us to “Sell everything except high quality bonds”. This is somewhat problematic if there aren’t actually any high quality bonds to buy, hold or sell. But then nobody should expect nuance, foresight or intelligence from the bank whose management helped bring us Financial Crisis #1. And as The Spectator pointed out, the author of RBS’ ‘Sell everything’ note has been predicting disaster for the past five years.

Tuesday brought us SocGen’s Global Strategy Conference. Quantitative strategist Andrew Lapthorne’s advice was more measured: do nothing, on the basis that almost half of your real return from equities comes from compounding dividend income. Clearly, if you don’t hold equities, you don’t get that income. Or any compounding.

SocGen’s guest speaker Russell Napier pointed out that growth in emerging market foreign exchange reserves from 2008 to 2014 amounted to the most rapid increase in emerging market money supply in history. As this process goes into reverse, EM growth will clearly suffer.

And since many emerging market countries have over-borrowed in foreign currencies, the fighting in the global currency wars is set to get more intense this year. Many EM countries now look, in Napier’s words, “like Northern Rock on speed” – with too much local currency and foreign currency denominated debt issued to foreigners – mainly to European banks. As Napier warns, 2016 has also ushered in BRRD in the euro zone: new rules requiring bond and deposit holders to be bailed in when banks blow up. The EU (and many of its bank depositors) will come to regret not restructuring their banking system during the seven years post-Lehman when they had the opportunity.

The search for an easy narrative to explain the bear market is probably a waste of time. The financial market is a complex adaptive system and investors are prone to irrational behaviour and mood swings.

They are also prone to overpay. The great ‘value’ investor Benjamin Graham reminded us that

“Operations for profit should be based not on optimism but on arithmetic.”

The optimists have had things their own way in an almost unbroken line since March 2009. January 2016 so far would suggest that the pragmatists are now in charge.

So the pragmatic response to this month’s volatility – if any is indeed required at all – is as follows:

1) Diversify by asset type.

2) Limit or eliminate exposure to EM debt. Raise cash rather than cling to a benchmark with no conviction (and no obvious value).

3) Concentrate any debt exposure to bonds issued by creditors, not debtors.

4) Limit equity exposure to high quality and inexpensive markets offering a ‘margin of safety’. (Most of the US market does not qualify in this regard.) Russell Napier recommends Japanese equities, currency hedged, and so do we. And in a bear market, you don’t want to own expensive growth, you want to own defensive value.

5) Complement traditional investments with alternatives – we would advocate systematic trend-following funds (which can profit in bear markets just as they did in 2008), and gold – the one form of currency that comes with no counterparty risk because it is the one asset that is no-one’s liability.

6) Limit your exposure to financial media, and especially to economists employed by commercial banks.

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