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I'll tip my hat to the new constitution
Take a bow for the new revolution
Smile and grin at the change all around
Pick up my guitar and play
Just like yesterday
Then I'll get on my knees and pray
We don't get fooled again
-Pete Townshend (The Who)
Bubbles always burst once there is widespread acceptance that they will not end any time soon. It is this very psychology that is largely responsible for both the repeated creation and inevitable bursting of asset bubbles.
In 1999, investors justified astronomical stock market returns and valuations by asserting that the economy had entered a new era of productivity growth. In 2006, many market participants embraced the notion that the strength of the U.S. housing market was merely a reflection of a strong U.S. economy.
Asset bubbles, the rallying cries of “this time it’s different”, subsequent collapses, and severe losses have characterized financial markets since time immemorial. Using history as a guide, most investors learn an enormous amount in a very short time, quite a bit in the medium-term, and absolutely nothing in the long-term. Despite differences in asset classes, narratives, and players, the ultimate playbook is always the same:
Today, pundits have found yet another reason for why “this time it’s different.” Investors are using the prospect of indefinite accommodative monetary conditions and zero real rates to rationalize extremely elevated valuations and forecast further appreciation in asset prices.
The Inevitability Of Cycles & The Paradox Of Risk
The repetition of cycles has, and always will define financial markets. Cycles are deeply rooted in human psychology and behavioural biases. For as long as markets exist, there will be periods of unsustainable optimism followed by times of irrational pessimism, and vice-versa. Cycles are inevitable, which dictates that mean reversion is the most powerful force in markets.
When investors are cautious, as is typically the case during and after bear markets, they demand generous risk premiums to compensate them for taking risk. In these environments, valuations are undemanding, prospective returns from bearing risk are high, and chances are good you that will be rewarded for taking risk.
Conversely, when investors are euphoric, as is typical near the tail end of long-running bull markets, they require little compensation for taking risk. In these circumstances, valuations are expensive, the prospective returns for bearing risk are low, and there is a high probability that you will be penalized for taking risk.
Given the tendency of markets to mean revert following periods of excessive optimism and pessimism, it would be rational for investors to become increasingly cautious as bull markets progress and to become more aggressive following periods of excessive pessimism when assets are cheap.
Paradoxically, people have historically done the exact opposite, taking their cues from the direction of markets rather than from risks and prospective returns. During the later stages of bull markets, when assets continue to appreciate and their valuations become increasingly unattractive, investors perversely view them with increasing favour. Conversely, during bear markets, as asset prices plummet and valuations become increasingly attractive, investors ironically view markets with heightened skepticism.
In short, investors tend to zig when they should be zagging, and vice-versa. They become aggressive when risk is high and opportunity is low and become defensive when risk is low and opportunity is high. They are most likely to extrapolate existing conditions into the future when mean reversion is most probable and least likely to do so when mean reversion is least likely. This irrational paradox is exquisitely summarized by Buffet’s contention that “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
Valuation Matters…But It’s A Horrible Timing Mechanism
According to a recent report by Goldman Sachs, the prolonged bull market across stocks, bonds, and credit has left average valuations at the highest level since 1900. The authors conclude that “all good things must come to an end” and that “there will be a bear market, eventually.”
Eventually…….and there’s the rub. Valuations are a necessary, but not sufficient condition for bear markets. Moreover, they are a horrible timing mechanism. During bull markets, assets can be overvalued, stay overvalued for an extended period, and become even more overvalued before ultimately crashing. Similarly, during bear markets, widespread fear can take asset prices far through their fair market values. This reality is eloquently summarized by Lord Keynes’ statement that “the market can stay irrational longer than you can stay solvent.”
Fortune (Sometimes) Favours Fools
Nobody who began investing in past twelve years has experienced a true bear market, let alone a really bad year, or seen dips that did not correct quickly. Many managers and investors have not had the opportunity to learn about the importance of risk management. They have not been tested in times of economic weakness, prolonged market declines, rising defaults, or scarce liquidity.
More specifically, markets have recently witnessed the emergence of a new breed of investors who have become a powerful force. As stock prices plummeted during the early stages of the pandemic, millions of small retail investors, equipped with stimulus checks and zero commission trading accounts, elected to catch the proverbial falling knife and buy stocks.
These traders were handsomely rewarded as markets staged an unprecedentedly fast recovery and hit new highs. Biased by their previous victory, these newcomers will likely pile in to try and catch the proverbial falling knife when markets next plummet. At this juncture, if markets do not cooperate and instead experience the type of protracted decline that has been more typical of bear markets past, these participants will only exacerbate the decline in markets as they are forced to sell.
When Did We Get So Paranoid? When The Markets Started Plotting Against Us
We believe that long-term investment success can be built much more reliably on the avoidance of significant losses than on the quest for outsized gains. A high batting average rather than a swing for the fences style offers the most dependable route to success.
We also believe that vigilance and flexibility are a constant requirement for achieving desirable long-term results. Conditions and investor sentiment can change abruptly, causing markets to swing from bullish to bearish with alarming speed. As such, we are always scared (P.S. you should think twice before giving your money to any manager who isn’t always scared).
Our Global Tactical Asset Allocation (GTAA) mandate is predicated on what can be referred to as unemotional fear (admittedly an oxymoron). The strategy uses big data analysis and machine learning to systematically shift its portfolio to participate in bull market gains and avoid large losses during bear markets. Since its inception in May of 2017, the fund has delivered strong risk-adjusted returns and protected our clients from large losses during the challenging fourth quarter of 2018 and in the tumultuous markets of early 2020.
For those who require income in today’s world of historically low bond yields, our algorithmically driven A.I.-based Enhanced Dividend strategy is an attractive proposition. Since its inception in October 2018, the fund has returned 21.1%, outperforming the TSX Dividend Aristocrats Index by 5.7%while achieving lower volatility and drawdowns.