Even Mark Carney and Jim Flaherty have different perspectives. Is this a bear market rally or an economic turnaround? Are we headed for deflation or inflation? Is the main action going to be on Main Street or Wall Street? Will the recovery be led by large cap or small cap stocks? Which sectors will lead? Is this the old normal or the new normal? What should we have learned from past experiences?
There’s an old saying on trading floors—when the suits come out of their offices and tell you it’s time to sell, you know it’s time to buy. This recent rally appeared to pick up steam just as market observers were ready to cry uncle. The best buying opportunities for financial assets may have already passed although alternative assets (such as real estate and hedge funds) may still have some interesting entry points ahead. Value investors have been excited by their margin of safety for some time now and price/earning ratios have now returned to the levels of their long-term averages.
As for inflation, there are three traditional sources—demand chasing insufficient supply, wages spiraling out of control and governments printing money to combat deficits. Only the latter would appear to be a viable threat, and even then only in certain jurisdictions, the most notable being the U.S. While we may yet see inflation down the road, the threats are not overly ominous at this point.
In selecting exposures, it may be noted that small caps have led large caps in the recoveries after 16 of the last 17 downturns, while those sectors hit the hardest in the downturns (e.g. finance) have also tended to lead in the recovery after the trough.
When asked what we would learn from this crisis, Jeremy Grantham, chief investment strategist of Grantham Mayo Van Otterloo & Co., explained, “In the short term—a lot; in the medium term—a little; in the long term—nothing at all”. What should we learn from the events of the last twelve months?
1. Main Street drives economic growth, the role of Wall Street is to facilitate it. We should have got suspicious when the financial markets started to use the expression “financial engineering,” indicating that they thought they had now taken over responsibility for manufacturing and industrial production (although perhaps Wall Street should have started building cars).
2. Theoretical financial models (such as CAPM and EMT) are just that—theoretical models. Once we started trading based on the mathematical formula we should have been afraid, very afraid.
3. Common sense trumps quantitative risk models every time. As hedge fund traders (and their investors) learned to their peril, value-at-risk limits do not put an upper limit on your losses, they merely put an upper limit on the inside range of your losses.
4. Fraud trumps common sense every time. If something sounds too good to be true, it probably is.
5. Correlations really do go to one in bad times. Portfolio diversification should protect against fraudulent exposure but does not protect against the vagaries of the market.
A new expression has emerged that we have now entered a “new normal.” I am personally not convinced that anything much will change, but history tells us that we are rarely aware that we are living in historic times until well after the fact. We may not be able to tell our grandchildren that we were at the epicenter in 2008 -2009, but at least we were nearby.