Stormy Seas Ahead

In our last quarterly we introduced the concept of thinking in ‘Oceans, not Seas’, which was to focus on the long-term opportunities, not the short-term tides.

Keeping with this nautical theme, every sailor knows that bad weather and storms are an inevitable part of any long sea voyage. The same is true with long term investing: whilst the market is usually upward most of the time, it has its own headwinds and storms from time to time.

However, to borrow from the language of Silicon Valley, this is ‘not a bug but a feature.’ One of the reasons that equities produce higher long-term gains is because they are prone to bouts of significant volatility and uncertainty of return. To put it another way, there is no such thing as a free lunch: the superior return is due to the premium investors need to compensate them for these periods, but you only really benefit from it by being prepared to weather the occasional storms.

Unfortunately, many investors fail to stay the course and—overcome by financial sea sickness—often tend to panic at the height of the storm and leave. They then compound the error by spending too long on the shore, waiting to get back into the market; thereby missing the huge premiums and therefore returns that usually mark the start of a new bull market. Given that there are no reliable or proven ways to time the market, most investors are better off picking a sensible strategy and staying invested in some form.

As some of you are aware, we are fond of quoting famous investor Peter Lynch’s dictum that, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves”. As you can see from the table below, this appears to hold true. What is even more remarkable is this data assumes you had invested just before the start of one of the biggest stock market downturns in history: the dotcom crash. It also includes another one of the biggest, which was the 2008 Global Financial Crisis. Despite this, you were still rewarded for your patience.

TABLE

Value of $10,000 invested 3/1/2000 and 3/1/2020

What do Storms look like?

Storms in the financial market are often called bear markets. The origin for this term remains unclear though several theories abound. Broadly, a bear market is one in which the primary trend for many financial assets is falling prices. Some commentators go further and put precise levels to the size of this decline. Personally, I have always liked the description by great market theorist, Brian Marber, that “a bear market is the period between two bull markets”.

A key consideration is that not all bear markets are the same. 1930s market theorist Robert Rhea described bear markets as occurring in three forms: Daddy Bears, Mummy Bears and Baby Bears to describe their magnitude and causes. The investment bank Goldman Sachs also uses the three type classification but with more technical definitions. Whilst we think it’s actually more complicated than this, this approach does add some more clarity:

Event driven – these are Rhea’s Baby Bears; they are relatively short-lived down markets often caused by a single event. We have just had an excellent example of this with the Covid related sell-off in 2020.

Cyclical bears – these are Rhea’s Mummy Bears and by far the most common type of down markets. They have a variety of causes but tend to last a bit longer. These usually turn-up every 4/5 years and—since the market has been demonstrated to go up over time—it’s usually during a much longer period.

Structural bears – these markets are relatively rare. They are much longer in duration and scope and have a profound effect on overall market psychology. The repair of both investor and other various balance sheets can take some time. Volatility remains high but they are often excellent long-term buying opportunities. They are Rhea’s Daddy Bears.

TABLE

A history of S&P 500 Bear markets

To further complicate things, some of the most powerful rallies can occur in the middle of bigger bear markets. Often the bigger the bear market, the bigger the rallies which lure in the unwary. This is one of the reasons why ‘buying the dip’ can be so destructive and market timing so difficult. This process is where we believe the market is now.

With the Federal Reserve determined to squeeze the US economy and with the dollar so strong, we struggle to see how some of the US megacap stocks that have performed well in the past cycle are going to maintain their margins and revenues over the coming quarters. Many are amazing companies, but the market was demanding amazing prices for them too. Additionally – as the UK pension funds are discovering—in a panic, investors can only sell what the market is prepared to buy and not what they would like to. Hence, with market liquidity disappearing it is possible—if not probable—that these companies increasingly see investors selling despite their quality. As the expression goes, ‘markets are made on the margin’.

CHART

Bear markets rallies in the S&P 500 during the Dotcom bust.

Weathering the storm

As you are aware, we have greatly benefited from being defensive since the beginning of the year. If this was a ‘Mummy Bear market’, we could reasonably expect it to be close to the end based on the simple metrics of standard duration and drop in the value of the broad equity index.

For reasons we explain below we think this might be a bigger ‘Daddy Bear’:

• As the Federal Reserve is determined to squash inflation, this means they are likely to push rates higher and hold for longer than the market expects.
• Bigger bear markets are often driven by a bursting of a financial bubble. This is often due to rising rates and/or credit spreads. Basically, exactly what is happening now.
• There is likely to be a recession which often causes more, longer term, problems—indeed the Federal Reserve has said it all but wants one.
• Valuations are elevated by historical standards, so they have further to fall to return to historical norms. With the Federal Reserve pushing up the cost of money globally, other assets will be forced to reprice.
• The ultra-easy monetary policies and low rates have caused many investors to take more risk than they are comfortable with or even understand. These excesses can take time to work their way through the system.

CHART

Using longer term metrics the S&P still looks expensive, even more so when rising rates are considered.

So many of the key conditions are now being met. A key question is: if we might be seeing a bigger downturn, then how long for?

A simple, but not easy, concept to focus on is monetary policy itself. It acts with long & variable lags. One of the reasons for the inflation today is the massive loose conditions seen in 2020 and 2021. Given the rapid rate of financial tightening by the Federal Reserve, the real economy is likely to be struggling next year as the financial conditions of today manifest themselves in the real economy in 2023 and probably into 2024. This timeframe would also fit with the more standard pattern of bear markets.

Counterintuitively, given the tightening in the United States, places like Europe or parts of Asia might be in relatively better condition due to their relatively laxer financial conditions and therefore offer investment opportunities sooner. Indeed, after the LDI debacle in the UK, local assets are already starting to look attractive due to the forced liquidations.

As this process unfolds, it’s important to remember that most market commentators—economists, think tanks, international organisations, journalists and politicians—have never managed a portfolio. Some, such as The Economist, have an excellent track record in being precisely wrong. So the headlines will likely be at their worst when the opportunities will be at their most attractive. The market is forward looking, they are backward.

Indeed, if they were a bit more forward looking, they might want to reflect on the impact that lurid headlines and panic-mongering is likely to have on consumer sentiment given their advertising-driven business models.

SUMMARY

Stay calm—we are in the business of taking risks

A common mistake in risk management is over-diversification, or ‘deworsification’ in market parlance. Many of our competitors relied on spreading client portfolios across a range of third-party funds that covered different assets, geographies and risk profiles. This was all governed by some basic statistics that relied on deeply flawed assumptions about correlation.

As they are now discovering, they had no idea how their client portfolios were going to perform in certain types of bear market; nor do they have the internal capacity to change course either. So they now have thousands of underlying securities in a variety of different jurisdictions all overseen by dozens of different fund managers doing their own thing. If you think that is likely to lead to a good outcome, I have a picture of a digitised monkey to sell you.

CHART

Monkey business—after a sharp rise the ‘value’ of NFTs has collapsed over the past year

By contrast, we are very much focused on the fact we are in the business of taking calculated risks. We spend a lot of time considering what market regimes we are in and what is more or less likely to do well; crucially, how the portfolio is likely to perform as a whole. Given our market outlook the key question is: what are we are doing about the stormy waters ahead?

The first principle any sailor knows in a storm is to keep calm. We know that it is likely that rough waters are ahead and things will get choppy. But we also know valuations are likely to get really attractive. Patience and a key focus on the ‘Oceans’ view means that an amazing opportunity to redeploy your capital will likely soon start to appear on the horizon.

The next is to batten down the hatches and reduce sail—we have done a lot of this to your portfolio in two ways:

Whilst we have reduced in many cases your exposure to risk assets in general, we have also studiously avoided the most over-stretched parts of the market such as profitless tech or deeply overpriced bonds. We also pursued a bias in the portfolio towards US dollar assets. So far this has worked well, but we are going to tweak things a little more in terms of the companies in the portfolio to focus a bit more on businesses with quality balance sheets and high cash generation.

In summary, there are likely to be storm winds ahead but stay calm. We have positioned your portfolio for this and we have stuck to Warren Buffett’s advice of being “fearful when others are greedy”; we hope to soon become “greedy when others are fearful”, as the Sage of Omaha advised. Many assets have started to look much cheaper, but we remain patient.

ADDENDUM

“If voting made any difference, they wouldn’t let us do it.”

— Mark Twain

Since we started writing this Quarterly, we have had yet another change of what passes for leadership in the UK. Whilst the speed of the Truss defenestration was a surprise, the overall political instability is not. As we previously stated we had, with little enthusiasm, a preference for Truss due to the growth orientated policies but were sceptical that Conservative Party unity would hold regardless of who won the leadership election.
We still think modestly reducing the tax burden was the right thing to do given the wider macro-economic conditions. But even we were surprised of how much Truss and Kwarteng were attempting. It appears too much, too soon and—most importantly—badly handled.

What happens next is anybody’s guess. As usual ‘events’ may intrude and also macro conditions might improve for the better. Had Kwarteng waited, the falling energy prices would have reduced the size of the bailout and perhaps the markets would have been less spooked—who knows?

However, since we are usually asked by our investors, this is our base case for what it’s worth.

We wish him well but our ‘Seas’ short-term view is that Sunak—assuming he even survives until the next election—will probably lead the Conservative Party to a large election loss, possibly on par with 1997 depending on conditions at the time. We base our view on two elements.

The first element is the economics. As we have pointed out earlier, the financial conditions we experience today are because of previous policies. We are not qualified to opine on whether the Covid lockdowns were necessary but there is no doubt they were divisive and caused immense – and uneven – damage to the economy which has not fully healed. They also created a huge amount of new debt of the type usually associated with a major war, though without any of the related economic activity. Dealing with this would have been challenging enough but this has been compounded by the massive money printing by the Bank of England, a particularly questionable response given that the collapse in demand was likely to be temporary.

It was into this volatile mix the Truss administration blundered. As we identified in our last note promising tax reductions whilst dealing with deficits was always going to be a difficult balancing act and we were sceptical the Conservative party would follow through with it and so it proved to be.

Removing a new administration after a few days of operation because ‘it’s what the markets wanted’, and claiming all the national economic problems are result of just one speech, is not remotely credible. It ignores the various shortcomings of the BoE—something even its recent governor & deputy governor have highlighted—or the multi-year actions of the previous regime. It is akin to throwing human sacrifices into a volcano to appease it: it may please the crowd but doesn’t really deal with the real problem. It also sets a precedent that the various vested interests that removed Truss may come to regret, that the actions of various financial markets should dictate immediate changes in government.

So, we now have the new Hunt/Sunak regime triggering some of the harshest fiscal tightening seen in the UK for generations, where at the same time there is both monetary tightening and a cost-of-living shock. This is likely to be deeply unpopular with the general population. It’s against the manifesto the Government was elected in on and, worse for the Conservatives, it’s likely to be especially detrimental to some of the Red Wall seats that the Tories depend on for their majority.

Our biggest concern is that ‘Hunak’ is doing this into an already-slowing global economy, and doing it by using a particularly damaging mix of taxes for future growth. We suspect this is likely to end badly and the evidence both from the UK and abroad is not encouraging; it tends to be counterproductive. Indeed, many of the productivity and growth issues we are seeing in the economy today appear to start with the Coalition’s austerity policies starting in 2010. As one of the principal architects of these problems, we have difficulty seeing Sunak being able to distance himself from it.

The second point is the politics. Winning a fifth election victory was always likely to be hard in the UK political system, even more so given the suspect track record of the past 12 years. It is likely to be even harder for Sunak given that he lacks the support of nearly half his own MPs and a big chunk of his own party membership. His coronation lacks any sort of legitimacy or widespread support which—like Gordon Brown before him—we suspect is likely to dog his brief premiership.

We continue to believe his career experience is very much overstated and he lacks competence. His time in the Treasury did nothing to dissuade us of this. If alleged experience of markets is the most important factor at this current time, as many of Sunak’s supporters are claiming, then Sajiv Javid is far better qualified. Yet he isn’t being mentioned probably because it’s about politics not fundamentals. Politically, we have seen nothing so far to suggest Sunak has any broad popular appeal and struggle to see an extremely wealthy ex-banker as an obvious unifying figure to champion austerity into a cost-of-living crisis.

Based on this, we struggle to see any sustained recovery in the Conservative polling and with it we suspect a resumption of infighting as their fate becomes clear.

Thinking in Oceans: “The Centre Cannot Hold”

As we have stated in our previous notes, we believe we have reached the end of a long economic cycle and a lot of financial chickens are coming home to roost. This is a global phenomenon and—as is often the case—the UK is unfortunate to be under the spotlight. As we stated earlier, the full force of the Federal Reserve’s tightening is likely to be felt next year, just as the UK is also tightening fiscally & monetarily.

As historian Dominic Sandbrook notes, we appear to have a political class that is made up of lawyers and former activists, desperately short of commercial or real-world experience. More importantly, it doesn’t appear to understand what creates value or increases productivity. Our political class seems to believe we can return to a golden age of false prosperity with both consumers and the Government being able to run up massive debts and run huge trade deficits.

Unfortunately, the current incarnation of the Labour Party doesn’t appear to have much of an idea how to deal with this either. This may change as we get closer to the election and more detailed plans are unveiled, but we are sceptical. We suspect the Labour’s Party own contradictions will likely come to light once they are in power: indeed, they may even surface as they just get close to it.

Before we get to this point, it seems likely Labour will try a different mix of tax and spend. With a large majority plus low support amongst asset rich pensioners vs the younger voters where the bulk of their support comes from, the obvious area for them to pursue is more aggressive inheritance tax to finance their policies. Therefore, IHT planning over the remaining life of this Parliament would be prudent and in the near future we will talk about an IHT strategy we have developed by applying our data driven, systematic strategies to AIM stocks.

The UK is not unique in its political and economic woes: established political parties are collapsing across the West. It’s more obvious in countries with PR as we can see the gradual realignment of voters. In countries with entrenched two-party systems such as the US or UK we are seeing increased fragmentation between various factions and more volatile voting outcomes reflective of the underlying shifts. This is driven by a number of factors – demographics, technological shifts – but post-Cold War, what passes for the economic ‘centre’ is largely a replication of a series of policies that have failed before.

Whilst the Conservatives appear to want to repeat the mistakes of the 1920s, we suspect the next few years may have parallels with the 1970s: as Karl Marx observed, “history repeats itself, first as tragedy, second as farce”. Whether Labour or the Conservatives manage the wider political transition remains to be seen. The once-great Liberal Party did not survive the 1920s.

Despite the chaos of the late 1970s, it ultimately proved an excellent time to buy and certain UK assets are starting to look very cheap indeed. We are also going through a period of profound technological change and the UK is one of the key countries in the world that should be able to benefit from it. Combined with our belief that governments, like the UK, will be forced to pursue more growth-orientated policies at some point, we are long-term optimistic but remain patient for the time being and are watching events closely.