Commentary | Jun 04, 2020

Looking in the Rear-View Mirror to Avoid Hitting Something That Lies Ahead

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Looking in the Rear-View Mirror to Avoid Hitting Something That Lies Ahead

The vast majority of today’s portfolios represent a Pavlovian response to the obliging nature of markets over the past several decades. The unprecedented increase in the value of risk assets coupled with low volatility have lulled investors into a false sense of security accompanied by an “if it ain’t broke, don’t fix it” approach to portfolio construction and risk management.

Most portfolios are dependent on the next few decades mimicking the last few. Specifically, they are over-allocated towards assets that have performed well during the secular (yet unusual) goldilocks environment of the past 40 years. As is typical of human behaviour, investors are looking in a 40-year rear-view mirror to avoid hitting something that may be in front of them.

What is Normal?

The past four decades have been unusually kind to investors. Strong tailwinds of favourable demographics, low inflation, falling rates and globalization have fueled an unprecedented rise in stocks, bonds, real estate, and almost every other major asset class. While it would be nice if these conditions were the norm, the fact is that they are unique from a long-term historical perspective.

An astounding 91% of the total price appreciation of a classic 60/40 equity/bond portfolio over the past 90 years is attributable to 22 years between 1984 and 2007. This period was also an atypically strong period for real estate, representing 72% of total appreciation over the past 90 years.

Notwithstanding some painful bumps along the way, including the tech wreck of 2000-2002 and the global financial crisis of 2008, the investing experience of most people today has been a proverbial walk in the park. An entire generation of investors has never experienced anything like the 86% peak-trough decline in equities of the 1930s which resulted in two decades of lost performance. Nor has it faced anything remotely like the 25% decline in U.S. Treasury Bonds during the stagflation-plagued 1970s.

What If?

Nobody (including us) can know for sure what the future holds. However, there are strong reasons to suspect that the road ahead will be drastically different than the unusually smooth path we have been on for the past several decades. Historically high asset valuations, record corporate and sovereign debt levels, $17 trillion in negative yielding debt, the lowest capital gains taxes in U.S. history, historically high income disparity across the developed world, and a global rise in populism and protectionism all suggest that, as Dorothy stated in The Wizard of Oz, “We’re not in Kansas anymore.”

If the next few decades resemble their recent predecessors, then the same portfolios that have prospered should continue to do so. However, should economic conditions change, they will likely deliver disappointing results. The relatively rapid bear market recoveries that have characterized the past few decades have emboldened advocates of buy and hold strategies who have sat tight through challenging periods, recovered losses and realized new highs within only a few short years.

Current global debt levels are at all-time highs. Any difficulties in servicing this debt could result in deflationary deleveraging accompanied by widespread debt defaults and a collapse in growth-sensitive assets such as stocks. Global markets experienced this scenario both during the Great Depression and to lesser extents during the dotcom crash of 2000-2002 and the global financial crisis of 2008. The Japanese stock market has yet to recover its 1980s peak following the bursting of an asset bubble.

At the other end of the spectrum, the massive amount of monetary stimulus that is being injected by central banks into the global economy could spur inflation, thereby creating a less favourable backdrop for stocks and wreaking havoc on bond values. In the 1970s, the word “bond” became a bad word. Not only did bond owners suffer negative real incomes, but also suffered punishing capital losses.  The current era of financial repression may well lead once again to the euthanasia of the bondholding class.

Failing to Prepare = Preparing to Fail

At Outcome Metric Asset Management (OMAM), we have never taken stability for granted, and have always been skeptical of the static, buy and hold – everything will be alright in the long-run – approach to investing that has been widely adopted for as long as memory serves. While this has proven a satisfactory (if far from optimal) approach during what has been an unusually favourable environment, there are many reasons to suspect that it will not yield desirable results going forward.

Risky assets do not become undervalued during times of crisis because investors are irrational, but rather because they lack the money, liquidity, financing or risk-tolerance to hold or buy them. We are dedicated to (and somewhat obsessed with) using the power of data analysis combined with machine learning to manage risk and dampen volatility.

This focus enables us to avoid large losses during times of market turmoil and re-allocate capital to appreciating assets. These characteristics have and will continue to allow our clients to compound their money more effectively and achieve superior results over the long-term.