At least we can stop dancing
Chuck Prince, the former CEO of Citigroup, famously said in 2007 “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. Shortly after this quip, he was unemployed and the bank was struggling for its survival in the midst of the global financial crisis.
One of the problems of benchmark investing is that you are constrained to a list of assets, often chosen many years ago and in a completely different environment to today. One of the consequences is that managers often “keep dancing”, taking the same risks as their peers because if they don’t their relative performance falls. This creates an environment where, when the music stops, investors lose money and the winner is the manager that loses the least. The point is a lot of money can be lost.
This bull market is old and most investors accept that the extraordinary liquidity created by 9 years of near zero interest rates combined with the huge increases in money in circulation from Quantitive Easing have driven valuations of many assets to extraordinary levels. We believe that investors should be more cautious and the big question is when all assets are expensive, how much cash should you hold for when they become cheaper?
Few investors could have failed to have heard of Bitcoin, which in our view, is a notable example of what can happen when investors forget about valuations. Bitcoin is a digital “currency” that has no intrinsic value, is backed by nothing, but can be used as a “medium of exchange” in a similar way one might attempt to use a Rolex watch (whose price is also readily verifiable) to pay for goods. Bitcoin started trading in July 2010, shortly after the credit crunch, and limited interest led to coins being valued at less than 10 cents. Interest in Bitcoin accelerated over the ensuing 6 years and at the end of 2016 these digital coins were trading at around $1,000. Over 2017, Bitcoin became a mania, frequently in the news and trading drove the prices to over $19,000! Alas the bubble burst in 2018 with prices falling to around $7,000 and we suspect further falls lie ahead. To our mind this is a classic example of what can happen when liquidity and excitement combine and it would be naïve to think that such behaviour is confined to digital currencies.
One of the best newsletters available is Warren Buffet’s annual shareholder letter which was released last month. On the subject of acquisitions, he makes the point that “finding companies at a sensible purchase price……proved a barrier to virtually all the deals we reviewed in 2017”. He also highlights that “prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers”. This has left Berkshire Hathaway with significant cash and we suspect that they will invest it, just as they did during the credit crunch, when prices are lower and the market is far needier for their money.
During January investors were jolted as volatility returned to the markets. To us, the fact it disappeared was the surprise and its return is a welcome sign that we are returning to more normal conditions. The consequences of this mini sell off saw the US equity market fall by circa 7%, 2 volatility funds lost 90%+ of their assets and the markets were making headlines in the newspapers.
These anecdotes explain why we are not that bullish as from our perspective valuations look expensive and although we accept that in the short term they could become even more expensive we believe that this is a risky point from which to chase them. Our second concern surrounds the less visible technical stresses within financial markets. Following the financial crisis, many investors are now governed by similar rules and so will be forced to behave in similar ways during the next downturn.
Volatility is an obscure financial metric but one that is widely used in the risk calculations of traders, investment banks, pension and insurance funds as well as being an input into many investment strategies. Artemis Capital Management estimate that there is ~$2+ trillion invested in strategies linked to the price of volatility and that most of it is effectively in the same direction – betting that volatility won’t rise. The problem is that other side of these trades often hedge their exposure through equities and so if volatility rises they need to sell shares. This creates a feedback loop as a spike in volatility results in a sharp sell-off in asset markets which itself often leads to a further rise in volatility. This is made worse by the rise of computer-driven trading strategies and passive investment both of which cannot apply judgement and have crowded out active managers who might have stepped in when valuations become compelling.
The last few days of January could be an appetizer of what might lie ahead and due to current valuations, there are few conventional assets in which to hide. In such an environment we are glad that we are not hemmed in by a benchmark and can take a break from “dancing”. Our sense is that cash, capital protection and more illiquid strategies (where the free money hasn’t distorted valuations) could become even more important.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. Investment markets and conditions can change rapidly, and as such the views and interpretations expressed should not be taken as statements of fact, nor should they be relied upon when making investment decisions. We undertake no obligation to update or revise any forward-looking statements and actual results could differ materially from those anticipated by any forward-looking statements.
Past performance is not a guide for future performance. The value of your investment can fall and you may not get back the amount invested.