Up all night to get lucky........or sleep soundly at night?

            The song of the year winner at the Grammy's last week was awarded to Daft Punk and Pharrell Williams rather catchy tune "Get Lucky". It's often quite hard in the modern world to find successful people who have the confidence to attribute a chunk of their success to luck. However in his recent letter to investors, Howard Marks, Chairman of hedge fund Oaktree Capital Management, speaks about how much of his career he must attribute to luck. Now it's quite clear that Pharrell and Marks are talking about getting lucky in rather different ways in life and, as much as I'd like to analyse the song, it's really Marks' insights which provide the more thought provoking ideas.

           Marks talks in depth about how luck and circumstance come into our lives in many shapes and form. He uses the example of the country we're born into, the income level of the family we're born into and the year we're born all as having a significant factor in our ability to achieve certain objectives. All of these are pieces of luck, or, if you prefer, divine providence, which straight from the off give a better or worse chance of 2 people, with the same intelligence and knowledge of a subject, achieving the same results. It is these such circumstances he points out that are often neglected to be mentioned when we believe we have achieved something entirely through skill alone, yet will often be brought up ad nauseum should "events" conspire against us. As he points out the Twitter CEO's tweet of "Success is never accidental" and the popularity of the phrase "you make you're own luck" present a skewed view to the world that when we achieve success, it is purely due to our own making.

                 The truth, as Marks points out, is much more different than that. Even the most determined, intelligent and hard working individual may not get the desired events necessary for their plans to succeed. None of us in the modern world truly hold the ability to prophesise. However, as Marks points out:

       "We arrange our lives – or, in investing, our portfolios – in expectation of what we think will happen in the future. In general, we get the desired results if future events conform to our hopes or expectations, and less-desired results if they don’t.........even the most rigorously derived view of the future is far from sure to be right. Many other things may happen instead."
  
          In a nutshell, man proposes and g-d disposes.

              Harping briefly back to my last post with this in mind, it almost seems absurd when thinking about the analyst criticism heaped on the central banks for getting their projections of unemployment and economic improvement incorrect. If we accept that the future is an unknown, and that it can only be "modeled" and expectations "predicted" to a certain degree, we must also accept that future events sometimes don't always conform to what even those we consider expert to have predicted. Meanwhile we often heap continuous praise on those, as Marks puts it, "in the investment business who get famous for having been “right once in a row.”"

            As part of his realisation of the luck afforded him in his investment career, Marks talks of the opportunity landed to him to get involved in two inefficient markets early on, in both high yield bonds and distressed debt, before they became so well known as to remove the obvious inefficiencies which previously existed. Such opportunities in the information age, he points out, are now few and far between, with the ability of algorithms and widely availability of information on all topics making a true arbitrage opportunity hard to spot. It doesn't mean that there is a lack of undervalued investments in the market, after all he would have long retired if he believed that, it just means it is much harder to take advantage of them.

            The problem of course lies in the ability to truly pick those undervalued whilst they are still undervalued in the market. We might crunch all the right numbers and make all the right projections, but an unprecedented macro event could be the luck that causes our meticulous predictions to be undone turning a certain winner into a sure fire loser. The planning was all right, but the desired result unfortunately went against us.

                None of this means choosing the correct investments is entirely down to luck, but it serves as a warning for those of us who believe that they have superior skill to outperform the market on a constant basis. I can't help but agree with Howard Mark's final assertion that, "it makes sense to accept that most games are no longer as easy as they used to be, and that as a result free lunches are scarcer........it will be harder to earn superior risk-adjusted returns in the future, and the margin of superiority will be smaller."

If this is indeed the truth, then where does that leave those of us looking for a way to get a return on investment for our future?

If we are honest with ourselves, can we really believe that we have the ability to either pick the stocks or the fund managers that will outperform the market for our given time frame. As common sense will point out, the market return is simply the average return of all investors. Some will outperform the market and some will underperform the market. What is to say we will have the skill and luck required to be or to pick the ones with the ability to outperform the market. As John C. Bogle points out in a letter for the CFA institute:

"If “active” and “passive” management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar."

Hence by investing in funds that we believe will outperform the market there is the potential we will only achieve the average market returns at best, but at a greater cost. That is, if our luck even holds that much. 

So why put ourselves through this? Back in my post on December 4th I warned people to invest their money in what they do understand. The solution I believe is to stop telling ourselves that we need to outperform the market and instead to follow the market. If you are taking the true long term view (especially from a pension perspective in your 20's, 30's or 40's) then there is no need to fear the dips and falls which occur on a cyclical basis. The likelihood is that, over the 40 year span you are investing, then you will see the required level of growth in your portfolio. The fear of those with this strategy is that when the market falls (like it is now and certainly like it did in 2000-03 and 2008-10) they have lost out. But the comfort should lie in the fact that when the market rises they too will rise with it - they have removed an element of luck attributable to the active manager or stocks they might otherwise have chosen. 

So long as you are looking to a long term horizon, the palpitations associated with extreme market moves should be less than those associated with trusting your judgement and luck in picking an active fund hoping for it to outperform. As Pharrell might have put it, it's a question of waiting up all night to get lucky with your investments or doing your best to sleep soundly at night. You just have to hope that luck let's you sleep through.

The code, it's more what you call guidelines, than actual rules

         Thursday's rate decisions by the Bank of England and ECB provided no new sparks or additional pieces of information around timing of either rate rises in the UK or further stimulus in the eurozone. It didn't however stop speculation being rife about whether Mark Carney had actually set his forward guidance levels too conservatively. Debate raged on CNBC, Bloomberg and between analysts over whether Mark Carney was either going to have to raise interest rates later this year, sooner than expected, or make, in their words, 'an embarrassing about turn', and drastically reduce the level of unemployment he has set as the barrier level.

         Any regular readers of my articles will be familiar with the fact that I have been a fan of forward guidance in both the US and UK so far. Unfortunately I think it is in the most basic concept that many of these analysts panicking over an earlier rate rise, either in the UK or the US, are missing. The hint for me is in the name - forward guidance. Guidance isn't hard fast rules which must be followed.  

          I find it amusing that often the best way to explain analysts' current reaction to serious issues, and how they should be dealing with it, is by referencing the relationship of the Fed/BoE to the market as being akin to a parent child relationship. There are many analysts out there who seemingly hear the projections and the levels mentioned by the central banks and take them as being hard code, as rules. Parenting, not that I have much experience in such I may add, often requires the parent to guide their child in the right direction. Providing guidance to someone is more about pointing them in the right direction to help them get to where they want to be (or in some cases where you want them to be).

The real purpose, in my opinion, of the projections and guidance is, whilst trying to give a best estimation of where and when the central bank sees the economy as being, it is merely an indication. Whilst giving these indications and informing the markets of the sort of levels they view as being important to their interest rate decisions, they are hoping to 'guide' the market to realise that they are considering raising rates in the future, but only when the economy is able to handle it. The guidelines which they have mentioned (7% unemployment and inflation around the 2-2.5% mark in the UK, 6.5% unemployment and 2% inflation rate in the US) are indicators. If unemployment performs better than expected, like it currently is doing, but all else appears to remain the same, it becomes acceptable for the central bank to adjust their guidance levels of unemployment to an even lower level as a target and trigger for a potential rate rise. The Fed even says as such on it's own website:

"Neither the unemployment rate threshold nor the inflation threshold should be viewed as triggers that would automatically lead to the immediate withdrawal of accommodative policy. Policymakers recognize that no single indicator provides a complete assessment of labor market conditions or the outlook for inflation. In addition, when the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent"

The Bank of England has given similar statements in relation to it's own forward guidance. 

It seems remarkable that the same analysts at various banks (or on TV), who are continually readjusting their own projections and predictions, feel the need to criticise the central banks for the possibility they may need to adjust their own projections or guidance. In last week's article I assessed how the vast majority of analysts were predicting equity markets to go up further this year. What is the likelihood that the Citibank analyst who predicted the FTSE 100 to hit 8,000 or the JP Morgan analyst who predicted the S&P 500 to hit 2,000 in 2014 will turn round and admit they were wrong if it doesn't? The chances are that they will brush it under the carpet and, if the information available starts to change, they will adjust their predictions throughout the year to reflect the new reality. When we look at the central banks we need to accept they too are making predictions about the future, which is their current best assessment of the situation, and this may be done in a way to guide market rates and assets to where they need them to be. 

          Anyone familiar with Pirates of the Caribbean will know about the Pirate code. As Captain Barbossa, explains to Keira Knightly, "the code, it's more what you call guidelines, than actual rules". This is the theme throughout the films. So too with forward guidance, It's more what you call guidelines, than actual rules. They've managed those guidelines well so far and from those guidelines it seems the base rate isn't going anywhere. Certainly not until enough parts of the economy are showing true recovery, not just unemployment. 

Ask the experts and the only way is up!

        2014 has arrived and, as is the tradition for the start of any year, predictions are rife for what is going to happen to the economy and markets in the year ahead.

              Last year saw equity markets continue to plough ahead, with stronger growth in both the UK and US economies. As predicted, despite the threat (and start) of the US Fed tapering and the introduction of forward guidance into the UK, US equity markets hit record highs and UK, European and Japanese markets all saw strong positive returns. Whilst yield curves began to steepen following the fear of interest rate rises in both the US and UK in the coming couple of years, it would appear that the management of forward guidance by the Bank of England and Federal Reserve in the US acted to ensure that, after the initial panic, there is an acceptance that base rates will only rise when the economy is ready. 

            So to 2014. After the strained optimism of last year, with the bears and bulls fighting it out in almost equal numbers, market analysts and "experts" almost to a man are making optimistic predictions for the markets and economy in both the US and UK. I mean why shouldn't they? The US and the UK are growing again and look like picking up speed, unemployment on both sides of the Atlantic is coming down, the US has finally managed to come to an agreement on its budget and some measures of business confidence in the UK are at a 20 year high. All this appears to have convinced even the most skeptical (aside from the permanently pessimistic and critical Robert Peston) that the only way for markets is up.

               Renowned economic journalist Anatole Kaletsky sees US economic growth hitting 4% this year (a level many see as the sort of figure for sustainable growth) whilst also seeing global stock markets still having "a long way to go". Even in a potentially rising interest rate environment he believes that this is no sure reason to suppress equity market advances claiming that in an growing economic climate equities rise alongside bond yields. He even believes that the Euro will eventually weaken later in the year leading to a recovery in the much battered economies of Southern Europe. But whilst he is perhaps overly optimistic about the year ahead he is not alone in his assertions for a bumper year. A recent Daily Telegraph article approaching several market participants saw almost complete agreement that the FTSE 100 in the UK was set to drive even further forward. Whilst some estimates merely predict a modest movement above the 1999 high of 6,930 (it's currently around 6,750) there are many who are predicting a further 11% uptick to 7,500, meanwhile predictions from Citibank suggest an 18.5% increase to the 8,000 mark are not out of reach. An article by Business Insider saw similarly bullish sentiment for the year ahead on the US market. Not one analyst asked predicted a fall in equities over the year, with most predicting at least a 7% return, a figure which would extend a rally already over 170% since the low of 2009. 

           Even Dr Doom himself, Nouriel Roubini, is sounding remarkably upbeat in his start of year predictions. He was one of the few to predict the 2007/8 crash and someone who continued to predict doom and gloom in both his post crash book Crisis Economics and subsequent articles. The more reassuring part of Roubini's article however is that it is more cautiously optimistic. Whilst he sees modest growth in the "advanced" economies, he still believes that most of these economies will still remain below the sort of growth levels required to drive forward into a full recovery and economic boom. He also believes there has been a stabilisation of what he terms "tail-end risks", the kind of risk such as a euro implosion or US debt default likely to plunge the world back into crisis. 

            The seemingly rosy picture painted by those "in the know" is often used by everyday investors that now is the time to pump their savings right back into the equity market which so burned pension funds and personal investments just 5 years ago. It's this exact reason why a note of caution needs to be sounded to all those preparing to do just that. It is at the point of most exuberance that bubbles tend to get carried away and investors feel the need to get in before it is too late. The cost of this is the all too familiar losses seen by many retail investors post 1999 and 2007. The fear at the moment is that whilst we seem to be moving forwards in terms of improving fundamentals this does not guarantee that things will be rosy for years to come. There are still items for concern which could affect the outcome of the next few years.

           Among them the US debt ceiling debate is still continuing to rage on with the current extension only providing enough funding until February 17th. Whilst it is estimated that there will be enough funds available to allow the Treasury to function for about a month after that, the issue remains that this is still to be resolved in a conclusive manner. If further dithering in early February around negotiations to extend the ceiling fails to lead to a comprehensive extension, it will continue to cause unnecessary uncertainty on a global level. The eurozone, whilst seeing a marginally improving situation, is still sitting on an employment level of 12.2%, with more than twice than percentage of 18-25 year olds unemployed. In order to see a true recovery (and avoid similar catastrophe in any further recession) they will need to work substantially to resolve the structural issues currently associated with having a series of entirely independent states sharing the single currency. 

              As the UK and US continue to push towards an improvement in terms of general economic conditions, there also remains the fear that rising market interest rates could halt any economic growth. I believe the reality is that whilst private consumption is seemingly helping to drive forward the current growth, a gradual rise in rates as confidence increases may help to improve an important part of the economy, that of business investment. Whilst rising rates increase the cost of borrowing, one of the current issues is still the reluctance of banks to lend. An increase in rates will enable banks to get a higher margin on their loans and as a result could see more companies able and willing to carry out the sort of capital expenditure required to provide the boost to the economy enabling it to reach the "escape velocity" level. In turn this should lead to the substantial increase in corporate earnings required to justify a further equity market rise.

               The recovery phase of the economic business cycle is often believed historically to last between 3 and 4 years, which in itself has led many to question whether the current recovery has much longer to run. However recent analysis mentioned by Lance Roberts of STA Wealth and Cullen Roche of Pragmatic Capitalism has suggested that the previous 3 recessions (focusing on the US) have actually seen longer more gradual recoveries. The suggestion for this is that the downturns themselves are less severe due to the active management by central banks once the crisis begins to unfold (like we have seen so far). The longest recovery was apparent in 1991 which saw an almost 10 year period of growth, with the following in 2001 being 6 years in growth. If this adjustment in the timing length of economic cycles continues to hold true it would suggest that the current improvement may still have at least a couple more years left. 

Such analysis would indeed suggest for now that the only way is up, but we should always be wary about relying too much on history to enable us to time market entry and exit (there is a reason they say past performance are not an indication of future returns). As mentioned, there are still factors at play which could ultimately cause the existing recovery to stall, but the current facts point to a permissible optimism for now. As always though in what we do, we must think for the long term and not lose sight of the realities. As I always like to say, if you're not prepared to lose it, then don't be prepared to risk it.

So it Begins - Bernanke begins the taper hoping for less of a battle than Helms Deep

                "So it begins!" - The words of the fictional Theodan, King of Rohan at the start of the Battle of Helm's Deep in the epic The Two Towers. One wonders if potential Theodan doppleganger Ben Bernanke was having these same thoughts as he prepared to give the Fed's announcement on Wednesday that the time had come to taper. You can almost imagine him standing there looking out over Wall Street with tens of thousands of orcs (a.k.a traders) preparing an all out assault on bonds and stocks and Bernanke wondering if what he was about to unleash would be the right weapons to save the day. Turning to his fellow FOMC board members - "So it begins".

"So it begins" - Bernanke will be hoping to have an easier ride than Theodan at the Battle of Helms Deep

              And so it does begin. Slowly, a little bit at a time. After the markets original bet of a September start to tapering, Bernanke and the Fed finally began the reduction in the amount of stimulus being pumped into the market by $10bn. Starting in January the Fed announced that the size of the monthly QE stimulus would be $75bn a month ($35bn on Mortgage Bonds and $40bn on Treasuries). Initial market reaction to this was actually positive, a sharp contrast to the original response back in May on the suggestion of tapering. The S&P 500 and Dow Jones raced to fresh record highs up over 1.5%, whilst 5 year Treasury yields closed at 1.63% and 10 year at 2.94% yesterday. Whilst the yield increase represent an upword movement in future rate expectations, it is perhaps smaller than one would have expected given the fear the market previously showed at the mere mention of tapering.

          The positive stock market response and relatively mild increase in yields is a definite positive and reflects potentially a skilled handling of the situation from the Fed's perspective. Markets potentially had been expecting the first taper to be of a more dramatic nature, with some estimates of a $30-40bn reduction being used in the first round. By testing the market with only a slight $10bn reduction in monthly QE, the Fed effectively said we're not going to make you go completely cold turkey. Going back to my previous analogy comparing it to the kid trying to ride a bike, it's as if the child who was so afraid of his parent letting go of the handle bars suddenly realised that even though the parent has taken their hands off the handle bars, they've left the stabilisers still on. The market is now starting to realise that the Fed isn't just going to let go of the handlebars completely without support. Recent predictions since Wednesday's announcement seem to be suggesting that the Fed, under the new leadership of Janet Yellon from January, could withdraw $10bn each month over the next 7 meetings, a gradual, predictable weaning, which would allow the market to digest in an organised manner the consequences and begin to focus properly on the real economy.

        Even with this gradual withdrawal of monthly QE the Fed has also acted to control the further rise of interest rates through increasingly less rigid forward guidance. Whilst previous guidance had the market believing that inflation around and below 2% and an unemployment rate below 6.5% were set in stone levels that would see the base rate start to rise, Bernanke has now sought to further dispel this fact. The latest guidance suggests that rates will remain in the current 0-0.25% band potentially well past the point where unemployment is below 6.5%. This is especially the case should inflation continue to remain roughly half the target of 2%. Analysts now predict that we may not see any rate rises until mid 2015 or even 2016, a far cry from the end of 2014 most were predicting just a few months ago.

                  The beginning of the taper though is good news and the ultimate complete removal of the ongoing stimulus is likely to be beneficial for the economy. There is potential that inflation would not actually begin to rise again until the point that QE is no longer being pumped into the market. Some analysts suggest that far from being inflationary, QE actually is causing there to be less inflation. The inflationary impact of QE has of course been seen in asset prices, but there is potential that this is at the expense of other prices. This is not that I believe that by stopping monthly QE we will see a dramatic fall in asset prices. The approach the Fed appear to have taken by a staggered reduction in the stimulus will allow the market to focus on the fundamentals of the economy and individual company performance again. So long as these continue to grow then there is no reason the stock market cannot continue to sustain the current levels. We are by no means out of the woods yet. The US economy is still only predicted to grow between 2.5-3% over the next couple of years compared to an average of 3.2% coming out of the previous 2 recessions. But this must be put in context of the scale of this recession compared to 1991 and 2001 and the efforts required to ensure it didn't become like the 1930s. If the Fed can maintain what it has now begun, to the point where no additional stimulus is required towards the end of 2014 whilst still convincing the market that interest rates will remain low until that escape velocity is in full force, then it will have done it's job. Right now it seems it may just be succeeding.

       And so it begins. For now the ferocity of the orcs seems quite mild for Bernanke compared to what Theodan faced. Bernanke, and now Yellen (the future Gandalf?), will just be hoping their own Battle for Helms Deep in restoring the forces of order in the market continues along this smoother course than the King of Rohan. They may even be getting the orcs on their side!

Just because you don't understand it, it doesn't mean it's not useful to meet financial goals

                     Last week I found myself getting into two interesting and contrasting conversations over dinner about particular investments. A friend of mine was discussing with me his taste for trading stocks and ETFs on a weekly basis, effectively trying to time the market and get in and out of stocks from what he says was based entirely on analysts commentary and predictions. Now I've been pretty vocal on my thoughts of the folly of trying to trade on a short term basis by timing the ups and downs of the markets and individual stocks and I relayed this to him. He was very insistent so I suggested to him that if he wanted to predict on short term movements he should consider investing in an ETF on the VIX (An index often used as a proxy for future short term volatility of the S&P 500) in the lead up to the next US budget and debt ceiling issues and then sell just before deadline (after all we're likely to have another deja vu budget debacle!). I said to him this was probably more predictable and likely to give a higher short term return than any of his stock equivalents. (As way of example, investing in VIXY:US over the last budget crisis period could have netted a 20% return in 3 weeks). He however wasn't to be moved, telling me that whilst he didn't quite understand the product, investing in this type of index was pure gambling as opposed to his stock bets.

               It did get me thinking though that often we look at financial products we don't understand and think of them as purely speculative (or gambling) tools. It is understandable that after the effects of the last financial crisis many look at derivatives as just another invented way to make money. Warren Buffet has famously called them "financial weapons of mass destruction". But as with most of what we now perceive as being an investment class, the majority of derivatives were not created for the pure purpose of speculation. 

Derivatives weren't always purely speculative

               The first traded derivative contracts were futures on a variety of commodities. The idea was that farmers growing corn, for example, would be able to know exactly what price they would get for the corn they were delivering in March, as oppose to being faced with a lower price than expected if they were just to sell it on delivery. It provided a contract with a predetermined price which gave more financial certainty to both the buyer and the seller of the corn. Options also evolved as a form of insurance contract. Like a house insurance contract where you might be worried about losing value because of a fire in your home, a person who holds a stock, might purchase a put option to protect themselves should the stock price fall below a certain level over a certain timeframe. 

             I think it's fair to say that most derivatives began life this way, offering it's purchasers some form of security against an asset which they held. The aforementioned VIX futures were seen as a way for traders in US markets to protect themselves against market volatility, the idea being that when markets fall extensively is usually when they are at their most volatile. By holding a contract which makes money when markets become more volatile, you are giving yourself some protection when your stock holdings might be in freefall in a downturn. The Credit Default Swap (CDS), which is now a several hundred trillion dollar market, came about as a way for bondholders or loan issuers to insure themselves against the risk of default by those they had lent to. Even the more structured products often came about as a means of offering protection to holders of the underlyings, albeit by ever more complicated methods. Of course where one person seeks a means of protection for unwanted risks, there are many others who see this as an opportunity for speculation and financial gain. Hence why these markets, once started, often get out of hand and end up as another method for investors, individual and institutional, to ever increase their wealth (or decrease when the going gets tough!). The notional value of CDSs out there often outweighs the notional value of the bonds and loans upon which they provide insurance as speculators use it as a means to both receive premiums or hope for payoff through the survival or downfall of any number of corporates or countries. 

Are Derivatives really any different from other Asset Classes?

               If we're honest though, is this really any different from what we'd consider investing or speculating on other asset classes which we consider normal? After all, a house or a flat, for most of us, is a place for us to live, something which we all need. Somewhere at some point, someone realised that they could purchase many properties and charge other people to live in them because everyone needs a place to live so is willing to pay for that privilege. Yes bricks and mortar leaves you with something physical, but the reason for investing is just the same and carries risks of its own. I don't think there are many people who still believe in the belief that property always rises after the collapse in most developed countries from 2007. If your investment horizon ended then and you were left holding your property portfolio in Dublin with an over 50% decrease in value you definitely wouldn't think that way any more.

               People are always looking for new and innovative ways to invest their money and increase their wealth, with derivatives now being no different from property in that respect. All of which brings me to that second interesting dinner conversation from last week. Whilst pondering whether speculating using derivatives or property was really that much different, I remarked on Friday night that I didn't much see how art existed as a true investment type and wondered where the value was. To my surprise I was given a very interesting rundown on the workings of the art market and how there are specialists out there with a sharp eye looking for the next up and coming artists for investors wanting to diversify their portfolio (and prepared to wait for that patient 20-30 year return). Unless you already have that Monet or Manet in a family collection (or a celler in Munich) then investors now need to find what they hope will be the next big thing. Knowing now whether a Laura Sykes or Zachary Walsh artwork will eventually sell like an Andy Warhol or even a Master seemed to me like an impossibility to predict but, like any investment, there are specialist analysts out there who feel able to give an expert opinion on where the growth prospects are and the right pieces to buy and hold. There's now even funds set up with the sole purpose of investing in art, although the minimum entry is most certainly far beyond that of all but the more wealthy investors. As the number of wealthy investors from the Middle East and Asia look for increasingly diverse ways to preserve and grow their capital, it seems likely that investment in this area is certain to continue to grow, pushing further the value of some pieces. As with any up and coming investment, my dinner colleague maintained that the great thing about art was that "it never loses it's value". As interest in this area as an investment too grows, that interest will begin to spike and values will increase further, because when there's money to be made, everyone wants a piece. However as with all speculative investments be it property, stocks or derivatives there is always dips when money becomes tight and people need to get out and art will be no different, even if we can't see it now. 

Will a Laura Sykes piece be worth the same as an Andy Warhol in 40 years?

  Know what you're investing in

                  My being corrected on the value of art only served further to demonstrate that where one person may see a house as a dwelling or an option as protection, there are others who see the speculative investment prospects in such tools. Whilst I might like a nice painting to decorate my flat, I won't be out there buying art in the hope it'll be worth 200 fold in 20 years time. However that's because I don't claim to understand it. I accept that there are others that do and have the potential resources to take advantage. The truth is derivatives as an investment type isn't much different from any other asset. They all started out as a use for a more practical reasons and are now further tools to make money for those willing to risk it. Just because we don't understand something, doesn't mean there can't be financial benefits to it, but just make sure what you're sticking your money into you do understand. That's the mistake that people make.

               

Are we living life in a bubble?

                       Debate is currently raging amongst the many market commentators and economists as to whether or not we currently sit in the middle of an asset bubble driven by the Quantitative Easing being pumped into the market by the Fed. The US has seen the S&P 500 hit new all time highs in recent weeks over 1,800 as the exuberance shows no sign of abating, whilst the FTSE 100 is up 14% for the past year, up over 60% from the depths of 2008. Meanwhile you have companies like Twitter doing an IPO and seeing a price rise over 55% from the IPO level a month ago, despite not having ever made a profit. In fact it lost $80m last year and has already lost $133.9m for the first months of this year. At the time of it’s IPO it was valued at roughly 43 times its revenue. Of course the purpose of investing in a loss making company like this at IPO is that you are there to take advantage of the fact that you believe the company is the future and will really profit in the coming medium term.

             However, there are many who believe that it is a dangerous sign of a repeat of the perils of ‘99 where tech companies where sold off for increasingly nonsensical levels which ultimately resulted in the crash, the levels of which most market indices have struggled to get back to. Meanwhile, they argue that the prices of other companies are vastly overpriced already as investors pile their money into equities as a result of the belief that with QE that this is the only viable place to get a good yield and that the money will keep on coming so prices will keep on rising. There are those that think if you’re looking for a quick buck, then stick it into the current market and you’ll be alright because all you have to get out before it crashes. It’s all beginning to sound very much like the mentality of a bubble.

Performance of FTSE100 vs S&P500 since Nov 2008

                  So is it going to burst? With all the talk of tapering some markets have already started to see a retraction in prices, mainly in emerging markets, as investors begin to pull back funds from there which they may have borrowed to invest as the cost of investing increases. It would appear to many that for all the money pumped into the economy from QE, it has mainly acted to increase asset prices without having any real effect on the economy. However this is to ignore some fundamental truths. In his most recent letter to his investors, Niels Jensonfrom Absolute Return Partners makes the point that but for the use of QE, GDP would most likely be between 5 and 15% below its current levels in the US. The UK I’d imagine would be in a similar boat. That is quite a substantial figure to recover from and we would most likely have been in a depression the likes of which we would struggle to recover from for many, many more years. Just look at Greece and the struggles it is having with its economy roughly 25% below its peak before the crash. However, as Niels Jenson also argues, the positive effects of QE have reduced steadily in each phase, including its impact on asset prices. I’ve mentioned before that the Fed needs to begin its taper as soon as possible in order to help investors wean themselves off the easy money, but also to continue to try and keep real interest rates close to their current levels. For this to work it of course requires the market to truly believe that the Fed will not adjust their base rate too soon. A lot of commentary on the incumbent Fed Chief, Janet Yellen, is that she will work to use forward guidance and reduce the threshold unemployment level required before rates will rise to 5.5% and then even 5%. This should hopefully indicate to markets that rates are likely to stay low for a further required period while the economy continues to recover and reduce any panic which may occur should tapering begin soon.

                    Where does this all leave investors as to whether they should or shouldn't put money into equities? In one of my earlier articles I spoke about the thin line between speculation and gambling and how, in the current market, trading on a daily, weekly or monthly basis is, per the textbook definition, a gamble. The risk is just too hard to really assess versus the potential return. Investors need to have a proper plan as to what they are looking to achieve. Just under 9 years ago I wrote my Masters dissertation examining whether investing in value strategies in the UK really outperforms investing in pricier stocks once you account for the extra risk involved. A value investment strategy involves buying companies who have lower fundamentals compared to other stocks. For example, low price-earnings ratio, low price-cash flow ratio or low market value to book value. The research did find it was possible to invest in a portfolio of value stocks and make superior returns over 1, 3 and 5 years without any extra risk being involved, however in order to make it work you needed to invest in a portfolio of the 200 value stocks, a pretty large financial commitment for any individual investor.  But it does show it is possible to find opportunities without having a greater level of risk, so long as you are prepared to invest for the medium to long term. But to select just a handful of these “value” stocks and gamble that they would be the winners is to misunderstand the realities of investing.

                Of course, quite possibly the greatest investor of our time began life as a value investor.  The difference is that Warren Buffett doesn’t just look at the basic fundamentals but has always spent time understanding the company itself and most everything about it in order to determine whether a potential investment was underpriced in the long run as opposed to a company being in a permanent downturn (or worse).  Buffett’s company Berkshire Hathaway only holds stakes in about 50 listed companies globally but the likelihood is all these decisions have involved careful focus on the business as well as looking at market fundamentals indicating undervaluing. Buffett’s record over the last 60 years has proved that it is possible to pick substantially more winners than losers over a sustained period of time. The most remarkable thing about Warren Buffett is that he is very open about how he decides what to invest in, seemingly making it easy for the rest of us to just follow his mantra. Such a method should give us the reassurance in the current market to continue to invest in undervalued stocks even if a bubble is in existence. The reality is that the vast majority of investors have neither the patience nor discipline to follow in the Sage of Omaha’s footsteps. He however makes sure he invests for the medium to long term in most cases.   

               Therein lies the lesson to us all. Investing in equities must be done with a realistic long term view in mind, in terms of both the businesses we’re investing in and the timeframe we’re prepared to wait for our returns. Looking for a quick buck plunging capital into the latest fad may all sound great to everyone, but who really has the foresight (or is paying enough attention) to know when that fad is at an end before it’s too late. We all want to be the one who makes the superior investment call, but often it’s better to just make the average investment call. Investing in a market index fund or ETF in the knowledge that it may soon go down, but should go further up in the long term. It may not be exciting, but at least you know you’ll be average.

So are we in a bubble which is about to pop? Quite possibly.

               Is it going to pop because of tapering of QE? Not unless the real economic fundamentals which asset values should be based on drop back at the same time. We may see an initial pullback from the current highs we’re seeing in the initial phases following a taper, but the likelihood is that we will continue to see the current levels sustained (if not increased further) so long as the economy continues to progress. We’re a long way off seeing a full recovery just yet, but so long as things don’t get worse again there is no need to panic.

And what if the bubble does burst before it’s fully formed? Then make sure now you’ve made the right choices for your time-horizon so you can weather a couple year storm. Otherwise now is the time to remove that gamble before it’s too late.

Divergence in global monetary policy could see the Eurozone left behind

                   There's not much that takes the majority of the market too much by surprise these days. The complacency that the US politicians would reach an interim deal saw markets keep their calm in the lead up this time before rising steadily since. The lead up to most interest rate (or tapering decisions) on a monthly basis is already met with economist and analyst expectations predicting in the majority what the likelihood of the decision would be, generally days before the announcement, with the various markets pricing it all in. So last Thursday, with both the BoE and ECB predicted to keep the status quo in their respective announcements, there was no reason to think any different. After all, only 3 out of 70 economists that Bloomberg surveyed felt the ECB would reduce the base rate on the Euro this month. But they hadn't accounted for Super Mario Draghi and his mates.

     To the shock of many, the ECB decided to act sooner than predicted and promptly lowered the base rate on the euro from 0.5% to 0.25%. The ECB felt forced to act as inflation has plummeted from 2.2% in January to just 0.7% this month (it was as much as 1.6% in August). With such a sudden decline in just a short period of time, the spectre looms of potential deflation and Super Mario felt the need to act now before it was too late. The euro instantly dropped over 1.5 cents against both the dollar and pound.

       Whilst for most people the idea of no inflation sounds like a good thing (after all doesn't it mean things start to cost less?) on the whole broad deflation, if sustained, can be worse in many ways than a higher inflation rate. Robert Peston goes into the consequences of deflation (as well as the impact of ECBs cut on the UK) quite well in his blog on Thursday and it is worthwhile read. As he describes "If businesses and consumers began to believe that deflation was a serious prospect, they would defer purchases and investments to take advantage of falling prices.........there would be an even greater incentive for businesses, households and banks to reduce their debts - to save as if there's no tomorrow - because of the threat of deflation increasing the real burden of those debts"

               If you believe the price of something is going to reduce, then you will wait for it to cost less before you buy it. Of course if you delay too long on your purchases then the economy itself will suffer as companies begin to stutter again as they struggle to cover their costs. They will then seek to reduce costs, which itself could be a reduction in staff or reduction in wages paid to staff, again reducing the income the population has to spend on items further depressing the situation. Meanwhile, in a similar vein that the value of money becomes less over time due to inflation, the opposite is true during a deflationary period. Any debts will begin to increase in value, unless they are paid off, and people will be tempted to put all their money under the mattress to save for when things become even more affordable (and avoid suffering deflation on investing it). The more money stored and saved up by people and companies, means less money spent on investment of any kind which ultimately becomes detrimental economic growth. Once deflation hits, the downward spiral it causes can be difficult to find a way out of, as Japan has found over the last 2 decades.

                 Given how depressed the Eurozone economy has been over the last few years, especially in the periphery, it might come as a surprise to many that the ECB has waited so long to drop it's base rate. The policy direction of the ECB now however points to significant divergence between the 3 main western monetary policy makers. In the US, talk continues apace about the possibility of the Fed beginning their taper of QE as early as December as GDP looks like growing over 2.5% for the year. Meanwhile the UK's economy continues to speed up with some analysts predicting it will have shown an increase of over 3% for the whole of 2013. Meanwhile the UK has not introduced any additional QE stimulus from its targeted £375bn total it has had for many months and the most recent forward guidance from Mark Carney had indicated the status quo would remain for at least another couple of years. Should the UK continue on it's current trajectory there is every possibility that the Bank of England may feel the need to tighten sooner, especially should inflation also continue to remain close to 3%.

                   The recovery in both the UK and US is however still tentative. In the US, the continuous threat of no real resolution on the US budget deficit and debt ceiling overhangs any recovery. Whilst here in the UK further failing retail companies (with Blockbuster and Barretts amongst the latest to go back into administration) show signs that we're still not out of the woods. However at least compared with the Eurozone there appears to be some form of recovery which can be used as a platform to move forward. The lack of real performance across the eurozone makes it a realistic prospect that rates in Europe will not only remain even lower for the foreseeable future but the ECB may need to rewrite the rulebook as a last ditch action to prevent deflation if the latest rate cut fails to work.

                 This may be easier said than done, if the Germans decide to put their foot down. Germany is especially fearful of the consequences that inflation, and specifically hyperinflation could result in, which is understandable given it's own fight with it in the 1920s and the devastating ultimate consequences of that. Whilst a focus on history can be useful in helping to make wiser decisions, too much obsession in attempting to relate history to the present can be to the detriment of the present and future. The ECB has already shown itself to be sluggish to react at times to it's recent troubles acting with caution where it's fellow central bankers abroad have been more decisive. Germany will need to accept that being part of a union requires accepting what is best for that union as a whole. The ECB has tried to act quicker this time to ensure it will stop deflation before it is too late and hopefully help stimulate the eurozone recovery as an additional consequence. Any further dithering resulting from internal national differences may not only see the eurozone left behind in any recovery but worse still could drag the US and especially UK economies back down with it.