2021 Q2 Market Commentary
Chris Brown
Chief Investment Officer
The psychology of money
This quarterly update is often guilty of writing about numbers and data and mathematical returns and making it sound like markets are a giant machine where if X happens then, pull the handle, and Y will pop out as your portfolio return. This is probably true enough over the longer term (say 5+ years) but some of you might be reading this because you are interested in what is going to happen over the next year or two. Here, the machine is not much help. Instead, surprises and, more importantly, how investors react to them will have a much bigger impact. Greed can turn to fear and fear back to greed in a few days. Predicting next quarter’s returns is as hard as predicting the weather on the 30th September this year. I can’t (and nor can anyone else).
And what is true for markets in general is also true for you. Another reason for trying to be a fact based quarterly update is that everyone’s personal history is different and unique. This personal history – including how you were brought up, the values your parents gave you (directly or indirectly), the way you make your living and the bumps you have experienced along the way – shape the issues you personally are most concerned with and the risks you can live with and those you can’t. We are all at different stages of our financial and life journeys. And things like ego, concern for our social standing and marketing all player a bigger role than we would like to admit when making plenty of our decisions, including of course financial ones. It is this behavioural side of investing that we rarely discuss that can be the most important component of the decisions we make. It is also the most important short-term driver of markets.
Markets are never “just right”
I write this because today it is clear that the big machine with the handle is not in charge of what is happening in markets today. Greed is in charge and all the emotion and excitement that come along with it are on display front and centre in markets. There are more than 4,000 crypto currencies out there apart from the big two of Bitcoin and Ethereum. Tesla is worth more than VW, Toyota, Mercedes, General Motors and BMW combined (see Chart 1). AMC, a loss making US cinema chain beloved of Reddit reading retail investors is now worth $28bn and is up over 2,500% year to date.
It is of course tempting to say, well, markets are overheated right now so let’s get cautious and wait for the craziness to blow over and buy back at lower prices. But if you look at our current positioning we are currently overweight risky equities and underweight safer bonds. Why?
Our reasoning is that emotion is always in charge in the short term. If you are waiting for a time when markets are more or less at fair value and everyone has a reasonably balanced view of the future you could be waiting a very long time. I have been the Chief Investment Officer at IPS for 12 years now and I don’t remember writing those words once in any of these updates. Unfortunately, unpredictable is normal.
As an example, what is Tesla worth today? Its valuation will be determined by the price people are prepared to pay for a very small number of its total share count at 4pm New York time. The formula for this price is a number today multiplied by a story about tomorrow. This story can change at any time depending on how investors feel, how persuasive the story teller happens to be and what they want to believe at that time.
The important thing to understand is that these stories change all the time. They can’t be predicted any more than you can predict what mood you will be in 3 years from now. Over the longer term Tesla will either succeed and prove the doubters wrong (like Apple) or slowly fizzle. In the short term, anything can happen.
In return for putting up with all this you can expect to earn a 7% or so annualised return on your equity investments which is enough to double your money every 10 years. But you will also of course have to put up with gut-wrenching periods like 2008 and even parts of last year when it looked like the financial world might end and you’d never make all your money back. Everything has a price and these emotional ups and downs are the price you pay for a 7% return. But a reasonable question is: what if you don’t want to pay this price?
One book we would recommend to all our clients is the Psychology of Money by Morgan Housel. In it he gives the analogy of buying a car. You really have three options when buying a car: (i) pay the £30,000 (say) price, (ii) buy a second hand one a bit cheaper or (iii) steal it. I like to think most of our clients wouldn’t steal a car But, similarly, we don’t recommend trying to steal market returns. The main way to do this is sell, go to cash, wait for the market to drop and buy back. Like stealing a car you might get away with it! But you have two things going against you. First this is a shorter-term strategy and, as we have discussed, in the short term it is emotions that drive markets and emotions are hard to impossible to predict. Secondly, there is not much evidence that this sort of approach has worked in the past for anyone else (even the brightest and the best). Plenty of studies have shown that the returns of people who try and time the market (including professionals) are well below those who just put up with the various ups and downs as a cost of doing business. Everything comes with a price and in equity markets the price is putting up with volatility and (occasional) sharp losses. To get your full return you have to pay this price.
But what about the second hand car option? This is where you still want a car but the price is too steep. You are happy to get a bit less and pay less. The analogy to this in our business is reducing the risk on your portfolio to a level you are comfortable with. Lower risk also means lower returns but why spend any more on a car than you need to? Or, in investment terms, why take any more risk than you need to meet your own financial objectives. We run plenty of risk-controlled portfolios at IPS and you should always be in the one that is right for you. This is always a conversation we are happy to have with our clients so please get in touch if you want to talk through your options with us.
Our alternative assets remain attractive
That said, sometimes there are just better options out there that mean we can reduce our exposure to the ups and downs of equity markets and still generate the returns you are looking for. The good news is that we have – and have always had – a multi-asset approach and so we have a meaningful allocation to alternative, cashflow based investments. The key here is the underlying asset generates a steady, ideally inflation protected return that is close to a 7% or so target but where the cashflows are less exposed to the ups and downs of the business cycle and investor sentiment. These assets are listed trust vehicles so we can meet your liquidity requirements and keep the ability to change our mind and exit when and where we want to. We have talked in the past about some of the underlying investments we own which include solar and wind farms, infrastructure assets, insurance linked securities and social housing. As a group, these have had a very strong start to the year and have generated more than their fair share of this year’s performance. Longer term they have also done their job which is to generate inflation beating returns and bring some genuine diversification to the portfolio. Whatever the weather, these sorts of alternatives will continue to be a focus and an overweight for us for the rest of 2021.
The story for fixed income remains more challenging. In the UK, short term interest rates are anchored at 0% and even longer term bond yields are barely over 1%. You can get a higher return lending to companies rather than governments of course but the safe end of this market (called investment grade in the jargon) still only has a yield of 1.6% per annum.
This is in the context of the UK (CPI) inflation rate which is currently at 2.1% and rising. To beat inflation you have to lend to riskier companies or take on some liquidity risk (and so risk not being able to sell when we want to). There are some opportunities here which we are of course invested in but the bigger picture is if, ultimately, the aim is to make inflation beating returns there is no alternative than to have a meaningful allocation to equities and alternatives (and pay the emotional price that necessarily incurs). We remain underweight fixed income.
One piece of comfort we take here is that we have seen some examples of true market excess build up, spill over and then collapse without having any real impact on broader markets. Bitcoin has halved from its peak earlier this year (see Chart 2). Gamestop (another stock popular with the Reddit crowd) rose 1,625% in January, fell almost 90% in February and then rose 420% to today’s share price of $210 (see Chart 3). The fact that these sorts of moves can happen without creating bigger market dislocations shows that for now a lot of the excess looks to be confined to niche parts or retail driven markets. Crazy is normal and we should be ready for more of it but, for now, you should know the bubbles that are forming and popping are not particularly affecting your investments.
Is higher inflation here to stay?
Putting this all together then we are overweight equities, overweight cashflow driven alternatives and underweight fixed income. One extra benefit of this strategy is that it looks to be well-positioned if inflation risks rise. In the short term we think inflation will inevitably increase as bottlenecks appear in supply and demand. The pandemic closed factories and shut down industries such as hospitality and hotels. As demand comes back strongly many businesses are just not geared to meet this new surge of demand. As an example you can look at the lumber market (which is wood used mainly in US housing building). As house prices have been (surprisingly strong) so has demand for lumber (even as the pandemic reduced supply). This meant lumber prices doubled in the first few months of 2021. However, the best cure for high prices is high prices. Eventually supply increases to capture the increased profits on offer and demand balks at the higher prices being asked. The lumber price is today back below where it started the year. We think most of the inflation we are seeing today is of this nature. The risk for markets is not that inflation will rise this year (it will) but that it remains sustained and above target over the next few years. This of course may yet happen but today’s bottleneck driven inflation spikes tell us very little about the longer term picture. For now, we – and indeed broader markets – think these risks remain low. But you should know that if we are wrong then we think our current portfolio is well positioned to survive. We are underweight fixed income which is most exposed to higher sustained inflation and our equity and alternative investments are both in “real” assets that should see sales and revenues rise along with inflation.
As ever, we thank you for your continued support of IPS and, if there is anything in this update you want to discuss in more detail, please feel free to get in touch.