What we can learn from the Credit Crisis

By Erik L. van Dijk

 

On Feb 11, 2009 one the brighest minds in asset allocation, Robert Arnott, gave an interview to US market information provider Morningstar. Arnott, the founder/former CEO of First Quadrant, a firm specializing in asset allocation strategies, made a few things clear:

1) As we already knew from earlier work from French scholar Prof. Bruno Solnik, the only thing that will certainly go up in a period of crisis is global correlation levels. With the exception of maybe gold and frontier markets that are truly secluded – like for instance the IR Iran, the topic of our previous post – everything will one way or another be hurt. Even the Fixed Income markets are not really providing investors with a safe alternative in a period when panic strikes, risk premiums go up and even the safest of the safe end up in big turmoil. The developments in the financial sector were indicative in this respect.

2) When looking at a Diversification 101 lesson that can be learned from our own Harry Markowitz’ s work, or from any MBA text book, the basic idea ‘Stocks for the long run, and Fixed Income and other securities for the periods in between when stocks are not delivering’ is fine. However, we should never forget to define our risk budget in a clear way and above all: stick to it.

3) With respect to 2): the lesson to be learned from Behavioral Finance is that people tend to overestimate their skills in good times, and then – when disappointed – turn to a kind of total disbelief in their own or other’s skills. The outbreak of panic that will follow can lead to disasters, similar to what can be seen in tragic accidents in football or soccer stadiums, when a little fire can cause many deaths in the audience. Not because of the fire itself, but because – in panic – most people want to leave via the same exit. It is the stampede that follows that kills, not the fire. Actually: if all those people running away from the scene would have joined forces, take of their jackets and throw them on the fire it is quite certain that the problem would be solved. The big killer in the crisis is the actions/trades of the ones in panic.

4) So basically, what will happen then, when markets slide into an enormous downfall because of the massive sell-off of shares with all ‘smart’ loss-takers thinking the same smart thing at the same time – as a result of which it is not that smart anymore – is that a situation is created in which smart money can earn a lot. Real winners are made in periods of crisis, not in normal periods. However, when everybody gets crazy and the savvy hold their breath and wait for the bottom level of the market to arise, we should be aware of the fact that the best investors that want to wither the storms by telling their followers that markets are exaggerating will look just as wrong as bad investors do in a normal period. Distinguishing between a top-level investor and an idiot becomes harder in a crisis period.

5) And there will be chances, a lot. Especially further from home, in niche markets that are allegedly risky in the eyes of the global investment community. It is a given that both private and institutional investors tend to have a stronger home bias in crisis times than in other periods. Result: the sell-off was largest in the Emerging and Frontier markets, notwithstanding the fact that economic growth numbers in these markets were not as bad as those in the West. And this is especially strange when also taking into account that these countries have a much smaller percentage of their market cap weights in financials, the sector were it all begun in the 2007/08 (and maybe 09?) market meltdown. I am sure that there will be blue chip investment opportunities in market leaders in Emerging Markets at a price of 3-5 times earnings. PE’s that low do not make sense, and neither does the  fact that the global market cap weight of Emerging Markets is down to 7 percent, a similar level as before the 1997-98 Emerging Market crisis. Things are really different in these countries this time around. China, India, Brazil and Russia (the BRIC nations) are big players now with solid economic home bases, notwithstanding their short term problems because of the crisis. Oil and gas prices are higher than back then and will definitely go up again to levels that might not be as high as what they were last year, but still.

6) But now we have another problem that haunts us. It is risk budgeting related. Institutional investors work with risk budgets, and they should. The ones that apply this technique in a prudent way and directly link it into their asset liability modelling should actually apply the technique in such a way that they do – as an average over the cycle – take a bit more risk when prices are low and less when prices are high. Unfortunately, we often see the opposite. Above average risk taking in times of positive momentum and high stock price levels and below average risk taking when prices are low. Reason being primarily that it is easier to convince the board to allow more risk when you can show nice, upwardly pointing stock price graphs than when you see disastrous graphs with share prices going down, lots of firms going bankrupt et cetera. Psychologically, investment specialists in the pension plan community are normally not fired when buying stocks with nice track records too high (”How could I have known that some kind of change of fortune was on its way? All colleagues were buying this stock too!”), but when something goes wrong with their investment advice when things are going down the drain, the risk of being fired is much higher. This kind of people risk, is a behavioral factor that is still playing an important role in day-to-day institutional money management. Actually, a much bigger role than it should.

7) Now, the problem with market extremes is the following. A simple mathematical exercise will provide you with a clear example:

When prices drop 10 percent (from 100 to 90), we need an 11 percent (10/90) increase to be back at the 100 level. When prices drop 20 percent (from 100 to 80) we need a 25 percent increase (20/80) to be back at the 100 level. When prices drop 50 percent (from 100 to 50) we need a 100 percent increase (50/50) to get back to the 100 level, et cetera.

In other words: the rebound of a market has to be bigger the bigger the crisis is. And the current one was and is big.

8 ) Now, another characteristic of crisis periods is that most risk indicators – like market volatility – go up tremendously. Often to levels 50 or more percent higher than normal. This will imply that market participants that are willing and able to take the plunge and act countercyclically to be among the first to benefit from the crisis will need big risk budgets to benefit. And often, besides being counterintuitive because of the personal risk involved, they don’t have space for that after the calamities that have happened during the crisis.

9) This will in turn imply that two things are really important during the recovery period after a crisis:

9a) Try to find recovery opportunites that add as little additional risk to your portfolio as possible. That is why actually some frontier markets might be of extreme interest (low correlations; compare Iran in our previous post), or asset classes that normally get a relatively low weight.

9b) Buy quality for the longer run. One of the characteristics of a crisis is that people in panic don’t care about anything anymore. For them shares are not securities that entitle them to a share in the firm’s profit, but lottery tickets or casino games that only cost them money. And not just that, they are financial instruments that embarrass them. Sell, sell, sell! But this implies that – when the crisis reaches its end – the battle field will be full with quality firms with now amazingly high dividend yiels (often many times higher than the interest rates available in the market), low PEs and huge potential for growth in the years ahead of us. These strong firms will have themselves nice opportunities to acquire struggling colleagues so as to stimulate revenue growth further, et cetera. In other words: it is the period when the difference between growth and value stocks, and growth and value markets is smaller than ever. Use that fact.

10) Are guys like Arnott and ourselves optimists? Nope, we are just the ‘boring guys’ (Harry Markowitz once used this phrase). Most people – be they institutional or private investors – don’t like what we do in good times (since we don’t take enough risk and are not willing to pay 50-100 times earnings for great momentum stocks in IT, Biotech et cetera) and neither do they like our relative calmness in periods of collapse and crisis. This is not the end of the world, just the end of momentum hunters that went in too late when markets were going up, and now go out too quickly when markets go down. Since we do not know exactly when the shift into upwardly trending markets will be there, it is quite well possible that we will be too early. If that is the case, we will loose a bit before we will win. That is the price of being a smart asset allocator: people will not really like you in the upward phase of a cycle and neither will they in a crisis period. They will only love you over the whole cycle, and even more so over more cycles. This is about sticking to a long-term rational philosophy in which the technique of how to do things is universal and eternal. The individual stocks, asset classes, countries that we like and don’t like do however change, because they will be going through phases. Paul Kennedy’s book The Rise and Fall of the Great Powers gives a good example of how this same line of reasoning applies in history and politics as well.

11) Last but not least: it is not the end of the world. The growing opportunity set is already visible. Be prepared – if and only if you do have space in your risk budget – to try something, but be also prepared to buy things you didn’t buy before. Fundamental indexing is an interesting tool to help you now. Analyzing the difference between stock markets based on market value weights vis-a-vis fundamental weights based on PE, PC, PB, dividend yield, earnings growth and/or revenues might reveal easily where the opportunities are. At the same token, we should concentrate again on Emerging Markets: the fundamental weights of this part of the world are indeed already in the 30-35 percent area with market cap weights now as low as 5-10 percent. That is a huge mismatch. In other words: due to behavioral factors too much money flew back into Western stock markets or savings accounts when things went wrong. Now, with rock-bottom stock price levels and interest rates, it might be worth the effort to look for the true gem stones in the emerging markets. But, never ever forget the risk budget. And the old Markowitz diversifications lessons: when understanding that Gazprom in Russia is now really to cheap, don’t put all available equity money in that stock but add the best opportunity in an country/industry least correlated with Russia and Oil/Gas that also provides you with a quality bet. Optimization and risk management become more important in a period like the one immediately after the crisis, because a good approach in that area will help you recover quicker with relatively less risk which will improve the return/risk profile of the portfolio substantially. And that is really necesssary after the disaster of the crisis period that has just ended.

For the full 4-5 minute interview of Arnott with Morningstar CLICK HERE.

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