11 December 2017
How long can the cycle go on for?
If you follow the FT’s John Authers, you’ll know that there is a good chance he’ll be warning you about some impending crisis - ‘Ageing bull’ is a particularly fine example. Royal London Asset Management strikes a more bullish tone, telling us that ‘Bull markets don’t die of old age’*. They point out that the usual signs of a bear market - excessive growth, valuation and leverage - are not there. Pictet Asset Management agrees with them for broadly the same reasons.
"Markets can remain irrational longer than you can remain solvent." John Maynard Keynes
What can trigger the end of the cycle?
Former Goldman Sachs chief economist, Gavyn Davies, offers three theories that could trigger the end of the cycle, placing the highest probability, 5%, on the Fed being behind the curve. Davies also forecasts a 30% probability that the end of the cycle will occur within 24 months - that was in March 2017, so there’s a maximum of 16 months left of this bull market according to him.
If you can get your hands on Goldman Sachs’ ‘Bear necessities’* and Deutsche Bank’s ‘The next financial crisis’, they are worth taking the time to read and offer a valuable historical context. Between them they cover debt, central bank balance sheets, valuations, populism, China, Italy, Japan, Brexit, inflation, unemployment, and a lot more.
The CFA Institute tells us that it isn’t black swans we should be looking out for; its gray rhinos - highly likely yet ignored events.
"Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria." - Sir John Templeton
How can investors protect themselves?
Factor Research discusses using factor exposure, obviously. Cambrian Investments proposes buying puts, while the rocket scientists from AQR think protective puts are ineffective* because of the costs and difficulties of perfect alignment with market movements.
The Black Monday crash of October 1987 has been blamed on portfolio insurance. Markets are now much more liquid, and Invesco believes variations of the strategy can play a role in limiting portfolio drawdown.
"More money has been lost trying to anticipate and protect from corrections than actually in them." - Peter Lynch
What do renowned investors say?
In the first half of the year, perma-bear investor, Jeremy Grantham, was widely reported as giving up his mean reversion belief after he published that this time it is different. But what he actually meant was that the US market will mean revert, only very slowly.
Greenlight Capital founder, David Einhorn, asks the important question of whether the basis for equity valuation has changed from expected future earnings to the capacity for a company to be disruptive. Another legendary value investor, Howards Marks of Oaktree Capital, in his excellent memo cautions those engaging in reckless risk-taking*, while his colleagues opine on how to navigate cycles.
"Don't confuse brains with a bull market." - Humphrey B. Neill
What can regulatory authorities do?
The Economist looks through the end of the cycle and discusses potential policy tools given that lowering interest rates is no longer an option. One approach is to adopt Ben Bernanke’s temporary price-level targeting, and another is greater reliance on fiscal policy, as championed by Olivier Blanchard and Lawrence Summers (you can watch the eminent economists grilled on their idea here). The Economist concludes that neither approach is ideal, but experimentation may be the only option.
"In the old legend the wise men finally boiled down the history of mortal affairs into a single phrase: ‘This too will pass.’" - Benjamin Graham
Academic work on the subject
The idiom ‘calm before the storm’ is reinforced by one paper which finds that in approximately two-thirds of 40 historical bubbles studied, the crash was preceded by a period of lower volatility. Momentum Crashes discusses the downside of momentum strategies and proposes a more dynamic approach incorporating forecasts of mean and variance. The Flash Crash: A New Deconstruction examines events in May 2010 and puts the blame not so much on a spoofing rogue trader, but on systemic issues around data feed integrity.
In a wide-ranging survey*, Robert Shiller et al find that individual and institutional investors alike consistently underestimate the probability of a severe, single-day stock market crash. The academics put the cause down to availability bias.
There are numerous books on market cycle turns, but here’s just a short selection. Manias, Panics and Crashes reviews hundreds of years of crashes, drawing out common lessons, albeit in a somewhat dry style. Anatomy of the Bear covers just four crashes, but in much more detail and with more readability. Lords of Finance* describes the great depression through the eyes of four powerful central bankers. And, after Zhou Xiaochuan, governor of China’s central bank, warned of a “Minsky moment” on the side lines of October’s communist party congress, it’s worth rediscovering Why Minsky Matters.
Reminiscences of a Stock Operator* is a classic - full of insights from an infamous trader who went broke three times and experienced numerous market bubbles including in high-tech, railroads and real estate.
Something lighter - film and fiction
The best movies on the last financial crash are Margin Call* and 99 Homes (The Big Short has had plenty of exposure already). Both deal with the housing crisis but from completely different perspectives: one from the gilded glass towers of Wall Street and the other from the humdrum suburban Main Street of Florida.
Highly recommended list
- Bull markets don’t die of old age - Royal London Asset Management
- Bear necessities - Goldman Sachs
- Protective puts are ineffective - AQR
- Reckless risk-taking - Howards Marks, Oaktree Capital
- Survey - Robert Shiller et al
- Lords of Finance - Liaquat Ahmed
- Reminiscences of a Stock Operator - Edwin Lefevre
- Margin Call - Directed by J.C.Chandor
The opinions expressed are as at December 2017 and may change as subsequent conditions vary
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