A fallacy, superimposed on a model, built on an achievement

David Miller - 24.3.09

Amidst all the gloomy news about the economy it is worth recalling the considerable achievements of the last 25 years. In particular the reversal of the trend towards ever higher interest rates and inflation in the 1960s and 1970s.

Apart from a brief interlude around 1990 a quarter of a century of monetary stability and economic growth is an achievement which should not be dismissed lightly as it will eventually be the foundation for recovery.

Unfortunately this solid foundation was used as a platform for increasing risk and because we are dealing with a powerful long-term trend, the reversal that we are in the midst of at the moment is particularly painful. We all became complacent about risk and now find ourselves less able to cope with uncertainty than previous investor generations.

The most extraordinary thing about the current distress in financial markets was the speed with which apparently sound financial institutions imploded. Short sellers have nothing to do with this. A company does not become bankrupt just because its share price falls. The simple explanation is excessive leverage, but exactly how did our major banks come to gear up 50 times without scaring themselves or the regulators? This brings us to the model and fallacy.

The model worked on the assumption that risky assets, when packaged together would always be lower risk than the sum of the individual parts. As an aside, there is good historical evidence that this is indeed true. Next these lower risk or, as described “on the tin”, highly rated packages were sold to investors in an increasingly important and liquid market. The final element was that if you needed to borrow using these packages as collateral you could and at a low rate of interest.

There are two parts to the fallacy.

• Risky assets, for example mortgage loans, would behave in exactly the same way as in the past when bank lending officers had done their best to avoid making loans to higher risk borrowers If you wanted to sell ‘risk’ there would always be someone prepared to buy it. On reflection this is the equivalent of the ‘more fool’ theory which has been behind all stock market bubbles. How arrogant to assume that there would always be a supply of stupid investors.
  
  
• What we ended up with was a highly leveraged system based on a flawed model. A poisonous combination. Now that this model is unwinding the critical question for investors is how long it will take to get back to the firm foundations put in place over the last 25 years and what investment strategies should we pursue in the meantime?

Many investors remain in denial about the significance of the change to the environment in which we find ourselves. This seems strange given that the trinity of factors that supported markets - access to borrowing, low interest rates and a stable tax structure - is unlikely to reappear any time soon. Yet investors seem to remain committed to strategies which are based on return and correlation assumptions firmly based in the past. It is almost as if there is no-one left on the flight deck to switch off the auto pilot even when it is obvious that there is a fault.

The key change to markets has been the withdrawal of risk capital. Banks are no longer active traders, whilst hedge funds are collectively half the size of a year ago and even less influential allowing for the reduction in leverage. It is estimated that as a result the competition for inefficiently priced assets has fallen by 90%. A huge advantage for active investors. The downside is that markets are much more vulnerable to mood swings which is why we continue to see such high levels of volatility. As an example, British Government backed index linked stock prices fell by 15% between August and November last year  on the hint we might see deflation lasting for a number of years. When the real numbers failed to back this up, prices recovered by the same amount. Great for active investors but not so good for long term passive strategies.

Investment managers are driven not only by numbers but also by their experiences. Given the stability seen over the last 25 years very few have seen more chaotic times. Investment models are biased towards a return to stability, but so are investors and the companies that they invest in. All are struggling in this environment because the rules have changed and the necessary skills have been allowed to atrophy.

So far 2009 appears to have been a continuation of last year. Equities are down 16%, gilts are up and the dollar, which now seems to be directly correlated to pessimism about economic growth, has strengthened further.

Admist the gloom there are, however, signs of life. Good investment returns are starting to be generated by careful security selection and active management across a range of asset classes. Detailed research is paying dividends (no pun intended). Companies with sound balance sheets and free cash flow are outperforming those that struggled to survive a boom let alone a recession. Many hedge funds have restructured and have decoupled from equities.  Liquid strategies such as macro and systematic trading are doing well although illiquid, highly leveraged funds are still under huge redemption pressure.

After the rollercoaster ride last year commodities have split into three camps and prices are moving in an understandable way. Gold is perceived to be an attractive hedge against monetary instability and the return of inflation, industrial metals are sensitive to economic activity, whilst agricultural commodity prices have stabilised in anticipation of lower production levels. Farmers also rely on credit and are cutting back.

Private equity is in real trouble but banks are unwilling to call in their loans because they lack the management skills necessary to run the companies that they would acquire. However, expect the private equity industry to reinvent itself very quickly. Property remains under pressure because of falling demand.

A particularly interesting area is structure of products which introduced much need stability in the 2000-2003 bear market. The stars are aligned for a similarly favourable outcome, but this time more attention needs to be paid to counterparty risk. If you buy an insurance policy then the guarantor needs to be in business to pay in the event of a claim.

I try to ration myself to one reference a year to The Money Game by ‘Adam Smith’. He described the stock market as existing in three distinct phases. A normal stock market where rational investment decisions deliver good returns, a garbage market and finally, a kid’s garbage market. Keynes put it another way when he said that, “There is nothing so disastrous as a rational investment policy in an irrational world”.

The cycle is turning and we are now moving back to a more rational market. Only real investment managers need apply.

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Cheviot Asset Management Limited is authorised and regulated by the Financial Services Authority. The views expressed in this report accurately reflect the personal views of David Miller, Cheviot’s Head of Alternative Investments. This report is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that Cheviot considers reliable but Cheviot does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed. This report is not for distribution outside the European Economic Area.