I am sure that like me, the reader of this column was inundated between the beginning of November and the end of December by letters and economic outlooks from all variety of financial pundits. Let me be the first one to offer my condolences, since it is highly likely that none of those pundits called for the massive bull market in equities and bonds, and indeed for all assets at the end of December 2018, when the markets were in panic mode. The rhetoric is a lot less bearish today, and in some cases even bullish. With the “Longest, Calmest Bull Market Ever” being celebrated (Bloomberg Business Week Dec. 23, 2019), the skies look clear, the weather ahead looks friendly, and the risks of last year have all but faded from memory.
We all know the Fed pivoted from tightening to easing in the face of an imminent stock market meltdown, the ECB went deeper into negative rate territory, and despite a presidential impeachment in the U.S. and chaos on the trade front, the equity markets kept climbing even as buybacks from corporations continued at record pace. Every time a melt-down seemed imminent, Central Banks pre-emptively pumped in more money into the system, which resulted in “melt-ups” and required “right-tail” hedging rather than the more popular “left-tail” hedging. The melt-ups in the stock indices trounced almost all active managers, and not surprisingly, retail investors were largely left licking their (relative) wounds in cash and bonds, with an incredible amount of ammunition left now to buy stocks. The “wedge”, according to Goldman Sachs research between flows into bonds and money market funds, and money out of equities, grew to a record of over $1.2 trillion in 2019 (GS Tactical Flows Daily Report).
There are indeed now calls for retail investors to fall back in love with stocks this year as the bull market continues to defy the expectations of most experts. From a purely statistical perspective, the last decade has been one where the Sharpe ratio of the stock market has exceeded 1 for perhaps the first time (Source: Bloomberg), i.e. for each unit of risk taken the return has been higher than 1. That is incredible indeed, since delivering a Sharpe ratio of 1 over a decade by a lot of deep thought (and high fees?) and immaculate execution is almost the holy grail for many active managers. To have delivered passively for a decade is just mind blowing. It’s a case of the proverbial turtle comfortably beating the hare in a decade long race. Will this continue? If the answer is yes, then one should simply do more of what has worked over the last decade, i.e. buy and hold. If not, then what is the best strategy?
While I do not have an answer, I would like to address this question obliquely from the perspective of risk-reward tradeoffs.
I spent the last week of December reading some excellent books (to be discussed below), from widely different areas, and generally spending a few good hours every day in the snow, going both down some gnarly runs, and this year also training “uphill” (using climbing skins on my split snowboard) in the back-country, where avalanches can be a real risk. This gave me time to reflect on the year, but more importantly forced me to learn a lot about how to stay alive in avalanches. While not even close to being an expert, my reading of avalanche risk in the wild backcountry resulted in the confluence of a few ideas from three different books that stood out and might have a special relevance for markets in the next few years.
The first book that I read was Robert Shiller’s new “Narrative Economics”. The book highlights that perhaps more important than aggregate economic statistics are stories that catch the imagination of people and go “viral”. Even more important, the cold hard truth is not always a remedy against false narratives until, perhaps it is too late. When the cascade starts, old stories simply get washed away by new stories. People abandon their well-thought-out plans in the light of stories that seem to have immediate relevance. And this happens faster than one expects and with more force than anticipated.
For personal preservation, the second important book I read was “Staying Alive in Avalanche Terrain” by Bruce Tremper, who, unlike me, is a renown avalanche expert. In my opinion, what he says about having a “plan”, and a “method” to avoid being buried alive under thousands of tons of snow has eerie parallels and analogies to financial markets, especially when they are under a manic or depressive spell. The risk management strategy in this book has parallels to risk management strategies in other fields, e.g. the OODA (Observe/Orient/Decide/Act) loop that the Marines use, or similar rules that aviators have used for decades.
The third book I picked up was Mark Douglas’s twenty-year-old book on trading psychology appropriately called “Trading in the Zone”. The book’s primary conclusion is that market forecasting is for fools, and in the short run, anything can happen. The consequence of this observation is that over time, investing in the markets is a numbers game, or a game of using favorable odds in a statistically replicable manner. Critical in this observation, again, is to have a plan, and once the plan is implemented, to follow it and accept the consequences. To change the plan based on short term outcomes can only result in having no plan in the long run.
Let me now bring these themes together. As any avalanche expert will confirm, it is almost impossible to predict whether the next precarious run in avalanche territory may result in a disastrous outcome. But what matters for risk is not the probability of the disastrous outcome, but the product of the probability, the consequence (together the “hazard”) times the exposure, times the vulnerability. Remove or drive any of these factors to zero, and the risk goes down to nothing. However, and this is important, the risk of an avalanche is not random. It depends much on certain factors (terrain, weather, and human factors), which might not be exactly predictable in isolation, but where we can make intelligent judgment calls to control our risks.
For instance, humans cause most of the deadly avalanches. In other words, just a small amount of additional weight at the wrong place can result in a slab of snow sliding over a weak layer and creating havoc. So what we do when faced with precarious terrain and other conditions does matter.
Humans also cause market melt-ups and melt-downs. Narrative Economics echoes this. The “economy”, whatever it means, does not by itself cause market bubbles and crashes. Human participants in the markets do by collectively spinning stories and acting upon them.
When investors realize the bull market of the last decade slipped past them, the fear of missing out on the next bull market will be like venturing out on a beautiful, sunny day after a massive snowfall – setting up perfect conditions for an avalanche in the markets. If 2010-2019 was the decade when investors hated the bull market in equities, 2020-2029 could very well be the decade where investors fall back in love with asset markets, and could be severely disappointed by the potentially precarious conditions lurking just beneath the surface that are a consequence of elevated prices and extreme faith in central banks.
To deal with such euphoria and panics psychologically is not easy. One only has to look at the asymmetry of the potential outcomes to see that venturing out on an off-piste steep slope after a massive snow dump is asking for trouble. Yes, you might (and probably will) survive, but paraphrasing Joel Greenblatt, it is like “running in a dynamite factory with a burning match – you might live, but you are still an idiot”. Buying negatively yielding bonds (I have a whole paper on this topic, and many posts in this forum), is not much different. Pity the investor who bought the German 30-year bond in August of 2019 at a negative yield of -0.12% and is now sitting on more than 15% of losses without ever earning a “coupon” (most likely this bond is in some bond-focused ETF, and the ultimate owner does not even know or care that he is spending part of his investment on a bond that will never pay him a coupon!).
Such unprecedented anomalies aside, the beginning of the new decade and the new year is full of sunshine and fresh “pow” on the slopes. Things are good, the economy is purring along, inflation is low, the Fed is supportive of asset prices, and there is plenty of money to go around. It is hard not to follow other brave investors into the wild world of speculation when the last decade has created unprecedented wealth for the brave (and patient). The markets have responded in kind with an almost vertical ascent. The forecast of the weather, at least as measured by economic policy uncertainty, continues to send warning signals, even though all looks sunny right now.
However, embedded in this pristine set of conditions are the elements that cause market avalanches. Any unexpected change in the “narrative” or the “story” can trigger a cascade without warning. Watch out for it as you go riding the slopes or markets this year. Once an avalanche is triggered, it is almost impossible to race away from it. To use a quote from Dornbusch “In economics (and markets, my addition), things take longer to happen than you think they will, and then they happen faster than you thought they could”.