Research

INVEST LONG TERM – SPECULATE SHORT TERM

“The only function of economic forecasting is to make astrology look respectable.”
John Kenneth Galbraith

Every January, the financial industry and financial media in general appear to be hell-bent on forecasting this or that. The amount of short term forecasts predicting where the S&P will end up in the year ahead is mind-boggling, and quite frankly a little silly. As if anyone who could reliably predict the future would share their secrets!

To exemplify how bad short term forecasting often is, and just how careful one needs to be if relying on short term forecasts to construct one’s portfolio, take a look at the chart below. As the oil price collapse got more and more pronounced during 2014, analysts didn’t change their future price expectations one iota. The 3-month and 12-month forecasts were more or less the same premium over the spot price – the starting point (the spot price) just got lower and lower. Predicting short term oil prices (or anything else for that matter) can be a fool’s game.

Evolution of Brent oil price forecasts (USD per barrel)

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Note: Each line represents the spot price, the 3 month forecast and the 12 month forecast as available on the survey date indicated in the legend. Source: Financial Times, Consensus Economics.

When putting money to work, most people are pretty lousy at short term investing. The only consolation is that you are in good company. It is no big challenge to make short term profits in a bull market, because the rising tide will lift all boats. It is a great deal more difficult to generate a positive return over the short term when the beta is zero or negative.

It is important to distinguish between three time horizons when investing:

1. Very short term (mostly technical factors)
2. Short to medium term (mostly cyclical factors)
3. Long term (mostly structural or fundamental factors)

One of the biggest technical factors is the contrarian indicator. If the entire world is negative on asset x, we see it as a major positive. The logic is simple. The vast majority of people are smart enough to position themselves accordingly before they go public with a view. So, when the entire world is already negative, where is the selling pressure going to come from? The next move can only be on the buy side.

Another major technical indicator is mean reversion, which can be an extraordinarily powerful factor in the industry. If an asset does particularly poorly in one year, it is often near the top the next. So which asset classes performed the worst in 2014? Oil took the prize with Greek and Portuguese equities in close pursuit. A portfolio consisting of those assets would probably do surprisingly well over the next 12 months even if they have few friends at the moment.

Looking at the past, we believe the best results are achieved when investors have focused on structural factors and have looked several years ahead. Why is that?

Many investors genuinely believe that it is impossible to look 5-10 years into the future when investing. Too many technical and cyclical factors are likely to derail their strategy, or so the argument often goes.  The effect of this is overcrowding at the near end, making it all the more difficult to outperform near term, while those of us focusing on the long term operate in a far less crowded space, providing us with a comparative advantage. The added advantage, when focusing at the longer term, is that you often have a greater tolerance for volatility.

What are the structural or fundamental macro-economic trends to follow?

DEMOGRAPHICS – The aging of people in the mature world

Much has been written about demographics in the past. It is one of the easiest macro-economic trends to fathom. The struggle has only just begun. We live in a time where the number of elderly is about to grow explosively and, while many countries will not experience the peak of the problem until after 2030, you will be mistaken to think that you don’t have to be concerned.

Old Age Dependency Ratios for Selected Countries

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Source: UN3

Demographics represent the single most important structural trend that we are faced with today, and it will massively impact everything – economic growth, interest rates, public debt, stock markets, consumer demand, etc. One of the most important repercussions to investors is the effect it will have on our pension systems.

Quite a few European countries will see a substantial increase in the old age dependency ratio between 2020 and 2030. In Germany, for example, it will jump from just under 36% to over 47%. Such a drastic increase in the number of elderly will have a dramatic effect on everything, and it is only just beginning.

In the world of mature economies, the U.K. and the U.S. will suffer the least from aging. Only emerging market countries are in better shape, but don’t assume everything is fine in China. It is actually in a worse condition than both the U.K. and the U.S. At some point the one child per family will have a severe effect on demographics.

Unfunded pension liabilities fast approach £10 trillion in the UK with an annual UK GDP of about £1.86 trillion last year. The size of the liability compared to their total earnings as a country is enormous. Younger people today had better accept the fact that they likely won’t receive the pension entitlements that they have been promised. The government simply cannot afford to pay out at this rate over the next few decades. However, nobody wants to start the politically necessary discussion, as it is most certainly not a popular vote winner, bordering on political suicide.

The return to fundamentally driven investing

QE has changed the dynamics of investing. The obvious one is fixed income investing, but it doesn’t stop there. Because investors are now earning such low returns on bonds, much capital has been re-directed towards equities (and other asset classes as well), driving valuations higher. Nowhere has this been the case more so than in the U.S. equity market.

Obviously QE will not last forever. The Fed has already more or less ended its program, and although Europe is way behind in the recovery phase (we expect plenty more easing by the ECB in the short term), it will happen eventually. The big question is what will happen to bond prices when central banks are no longer a significant buyer? We still think inflationary pressures will remain very modest, suggesting low interest rates for quite some time to come.

Regardless of this projection, with no QE to beef up prices, at least in the U.S., investors are likely to pay increasing attention to fundamental factors. As we have argued over the past few months, a return to fundamentally driven investing is likely to happen at a time when those fundamentals are not the most promising to have ever come across. We believe that we have entered a period of below average economic growth and therefore also a period of disappointing earnings growth for many companies, limiting the upside potential on shares. However, don’t ignore the earlier comments about the missing connection between economic fundamentals and equity prices in the short term.

We still expect equity returns to be positive over the next several years but, on average, would expect returns to be lower than we have grown accustomed to since the start of the great equity bull market in the early 1980s.

Because economic growth is likely to disappoint, investors should remain only lukewarm on cyclical companies. Investors will almost certainly pay more attention to dividends than they have done in recent years as we have written extensively about the power of dividends several times before.

Given the ‘damage’ QE has done to valuation levels, as the market returns to a more fundamental approach, we can see that a high quality approach to equity investing is working quite well. Likewise we wouldn’t be surprised to see value stocks begin to outperform growth stocks again.

In a world of managed interest rates, currencies are the primary adjustment factor

The point is the following: When interest rates are managed (some say manipulated), markets are efficient enough to make the necessary adjustments elsewhere and, in this context, currencies play an important role. If one economy outperforms another (e.g. the U.S. outperforms Europe as is presently the case) but interest rates in both areas remain ‘managed’, the currency of the better performing country will simply outperform the currency of the weaker one (as USD presently does vis-à-vis EUR), in effect doing the job that the bond market would have done under normal circumstances.

Having said that, this adjustment mechanism doesn’t work very well in countries where the bond market is almost entirely controlled by domestic investors to whom changes in the exchange rate won’t have the same behavioral effect, which explains why it has never worked in Japan.

With this in mind, we find it difficult not to maintain a long-term bullishness on USD/EUR, despite the U.S. dollar’s recent gains. Current U.S. economic activity is too high to justify the low level of interest rates over there, and currency markets are likely to make the adjustments that politicians/central bankers are not willing to do.

The end of cheap oil

Despite the recent turmoil in global oil prices, nothing has fundamentally changed. The world will still run out of cheap oil (cheap as in approx. $25 per barrel of production cost, as is currently the average production cost in the Middle East) over the next decade or so. It is hard to predict exactly when, because OPEC members are not the most informative people in the world.

Note that it is fundamentally different from the widely acclaimed theme known as Peak Oil, the consequence of which is that oil production will be in terminal decline once production has peaked. Oil won’t run out anytime soon, but the price will be altogether different from the price the world got used to until relatively recently.

U.S. shale is changing the dynamics of oil

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Source: Econbrowser. Vox.com

Following six months of near constantly falling oil prices, you are probably surprised to see this listed in the first place. After the shale (fracking) revolution, how can anyone seriously suggest that energy supplies are dwindling? After years of massive investment, primarily in the U.S., shale has tipped the supply/demand balance.

Take a look at the chart above and pay particular attention to the green line on the extreme right. Most of what is named ‘tight oil’ in the U.S. is shale, and production has risen by almost 4 million barrels per day (mpd) since 2008. In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. However, only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.

A significant excess of oil supply has opened up

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Source: Vox, IEA

What happens next is anyone’s guess, though. It is now a highly political chess game and, as we have learned over the years, when politics enter the frame, logic (and therefore fundamentals) goes out the window.

OPEC (with Saudi Arabia in the driving seat) may exhaust itself and decide that enough is enough, or it may go for broke – in this case it would want U.S. shale producers to go bankrupt and exit the industry forever which, we note, is quite likely to happen for some producers, should the oil price stay at current levels or lower for any extended period of time. The U.S., on the other hand, will obviously benefit from lower oil prices despite its growing shale production. Consumers will benefit immensely, as will most of the rest of the country.

A number of U.S.-antagonistic countries around the world (think countries like Russia, Iran and Venezuela) will be seriously weakened as a result of lower oil prices, which will strengthen the position of the U.S. in global politics. At current oil prices, Russia alone stands to lose in excess of $100 billion annually in export revenues – an amount they can hardly afford. Who will give in first? We have no idea.

The long term point missed by most people in this quite fascinating chess game is that even modest changes in the balance between supply and demand can have a dramatic impact on price, provided demand for, and supply of, the commodity in question is inelastic, and that is precisely the case as far as oil is concerned.

The ‘demise’ of the consumer-driven growth model

The consumer very much dominates the U.K. as well as the U.S. economy – in fact so much so that it is the consumer more than anything else that dictates the direction of the economy in those two countries. Consumer spending in the U.S. accounts for nearly 70% of GDP, whereas the same number in the U.K. is in the mid-60s. By comparison, in Germany, which is known for its much more restrained consumers (which is not inevitably bad), consumer spending as a % of GDP is only in the mid-50s.

Two dynamics will reduce the impact of the consumer in the developed world over the next several years – demographics (as already mentioned) and debt levels which are worryingly high in the household sector. An economy not so dependent on the consumer is not necessarily a bad thing.

Research from Stanford University

It’s not the “Information” that counts;
It’s a superior interpretation of it that counts.

Modern efficient market theory claims you cannot legitimately beat the market and add “alpha.” After all, if everyone has the same data and information, then how could any one investor claim to be able to outperform others – except by being lucky or by possessing inside information? Seductive as it is, this claim is incorrect as extensive new research from Stanford University makes clear. For it is possible, to add alpha, by interpreting commonly available information, better than others do. That is, superior inferences from the data can be identified.

Concluding remarks

The point is quite simply that the smart investor will keep the long term outlook in mind. Our needs are long term, and will be affected ultimately by how structural trends play out. Only by trying to make sense of the long term outlook can we understand how to develop an investment strategy that is fit for the future.

So where does all of that leave us? How will equities perform this year and will interest rates go up, remain the same, or even trend down? As we have stated: No one knows the short term. We can say the following:

We are still in a post-crisis environment, and enough people are still negative on equities, and interest rates are low enough, to provide plenty of purchasing power. We therefore expect it to be an ok period for equities over the next year or two – not outstanding given our modest growth expectations, but ok.

Interest rates will continue to stay relatively low, but the pressure on various central banks – in particular the Fed – to increase the policy rate is rising, and the Fed has already said they expect to begin a cycle of higher rates relatively early this year.

The USD is likely to remain strong throughout the year. The trick is to be careful on emerging markets. If the U.S. dollar continues to be strong, it is an accident waiting to happen.

The star performer this year could very well be the worst performer for 2014… OIL, but expect an exceedingly bumpy road ahead and don’t be surprised if it touches $40 (even $30 is possible) before it resumes its journey north.

Finally, we expect some, but far from all, alternative strategies to perform well in this sort of environment. Rules prevent being more specific in this article, but after many years of lack luster returns, it is possible for a tailwind to return to alternatives.

It is important to remember to distinguish between three time horizons when investing:

1. Very short term (mostly technical factors)
2. Short to medium term (mostly cyclical factors)
3. Long term (mostly structural or fundamental factors)