July 2011

Thoughts…….

Next week Mrs R and myself are off down to Padstow for a few days. This is likely to mark the end of the spell of summery weather, for which I apologise. If, by some miracle, the clouds clear I will dig out my well worn Speedos and, ignoring the opprobrium of the trendy beach dudes, waddle down to the waters edge for a spot of what used to be known as surfing – none of this flash Californian standing-up stuff, I adhere strongly to traditional British surfing which involves laying down on a piece of bent ply in the hope of catching a wave to take me back to somewhere near where I started.

I spent my boyhood summers in Cornwall, staying at the aptly named Tides Reach hotel which perched next to the beach at Perranporth. It would be unfair to say it could have been a model for Fawlty Towers but both establishments shared many of the idiosyncrasies that even in the sixties made staying in a small British hotel feel strangely like a ten year step back in time.

My memory of those days was that they were long and sunny. I suspect the reality wasn’t quite as idyllic. In my minds eye I see a lone dog-walker, well wrapped against the biting wind, standing on the beach, shaking his head at the folly of two skinny boys shivering neck deep in cold grey water under matching cold grey skies, as we spent hour upon hour waiting to catch the perfect wave – the one that, if we caught it right, would charge us through the white froth and dump us stranded high and dry on the beach. Of course, timing was everything. Get it wrong and we’d find ourselves in a maelstrom that spun us over, pinning us to the seabed before leaving us nursing grazed chins, knees and elbows once we had fought our way free and back to the surface.

Spotting a big wave coming was never easy. Immense rollers on the horizon would be spent and little more than a gentle swell by the time they reached us while a seemingly innocuous hump in an otherwise glassy sea would build and build to the point that when it reached us we could feel it pull us back into itself like a giant arm around our waists before spewing us forward towards the beach.

In many ways, little has changed. Much of my life now is spent looking for patterns in the waves, trying to decide which one is going to be the big breaker and which the gentle swell. The potential tsunami that was the Greek debt crisis seems to have abated but it still looks like we’ll be very lucky if we get away from this one without a severe dunking. Even if the Greek (and Portuguese, Irish, Spanish and Italian) government can carry through their austerity measures while avoiding a civil war there remains the concern that there are an awful lot of what Rumsfeld would have called known unknowns and unknown unknowns still floating around the banking world. To quote Jim Wood at Williams De Broe ‘The unknown is anyone’s indirect exposure. It is nigh on impossible to trace the tree all the way through – what happens if a British bank has lent to a French bank who has lent to a German bank who has lent to an Italian bank who has lent to a Belgian bank which is about to go under because it cannot take the losses on its portfolio of Greek debt?’. This sort of thinking is going to keep the markets jittery for long after the politicians claim they have delivered the remedy.

Elsewhere I find myself looking increasingly towards China – which has now firmly established itself as the lender of last resort for the Western world. The achievements of the Chinese government in creating a new age of prosperity, or shengshi, while maintaining control over their disparate population are remarkable. Recently there have been ripples of discontent that may yet build into tidal waves by the time they reach the shores of New York and London. Food and basic items account for a much greater proportion of expenditure in China than in the West and food price inflation has hit factory workers particularly hard. Industrial action is becoming more widespread with recent strikes and protests in Zengcheng (the so-called Jeans Capital, responsible for covering the ample backsides of the US in more ways than one) resulting in workers securing pay increases of 20%-30%.

This has two implications for us in the West. During the last decade cheap manufacturing in China has meant we have been able to import deflation – the cost of many everyday goods has fallen thanks to low Chinese wage rates. This is reversing and we can expect an acceleration in the convergence of Chinese and Western manufacturing costs leading to higher inflation.

The second implication is likely to be a result of the Chinese government’s desire to rebalance the country’s economy so that growth is led by consumption rather than by exports and foreign investment. In managing this enormously difficult transition, and the population’s expectations, the authorities will need to devote more of their reserves to internal improvements in preference to buying foreign debt. It doesn’t need the Chinese to start selling US debt – simply slowing the rate they are buying it would make life very difficult. Maybe even difficult enough to become a tsunami.

Of course the sea is always choppy and you shouldn’t go in if you don’t want to get buffeted around a bit. But if it was looking a bit rougher than usual you’d check the weather forecast before taking the plunge.

In the markets there is any number of would-be Michael Fishes waiting for the day when they can predict a hurricane – or not. Each has his own basis for crystal ball gazing but they tend to fall into two camps. The Fundamental analysts look at key ratios derived from classical economic theory, going right back to Ricardian rent theory and Adam Smith’s invisible hand and culminating in the Efficient Markets Hypothesis, while the Technical analysts, or chartists, look for trends in the past performance of assets.

The most flamboyant chartist I’ve come across made a point of parking his Bentley convertible (roof down, natch) on the grass by the door to the venue where, resplendent in a chalk-stripe suit and very wide red braces, he explained to an increasingly bemused audience his system based on Fibonacci’s golden spiral, arguing that a sequence that occurred so often in nature could also be used to predict markets which, being based on human interactions, are at their heart a natural phenomenon. I was unimpressed – not least because a fair bit of manipulation was needed to make market movements fit his theory. ‘if you sort of rotate it through 24° and apply a stretched mirror image over the second period while also squinting you’ll see its nearly an almost perfect match.’ You get the picture.

In spite of the best efforts of the lunatic fringe there remains growing support for the observation that markets tend to trend and that this tendency can be attributed to investor psychology.

Behavioural Finance is a developing field in psychological research that tries to resolve the tension between what classical economic theory says markets should do and what actually happens. I find this area very interesting. It is surprising to discover just how similar, and mistaken, we all are and how it doesn’t take a Paul McKenna to be able to predict our reactions.

The first thing to appreciate is that there seems to be very little to choose between the behaviour of ‘investment professionals’ and the rest of us. We make sense of a complex world by creating heuristics, or mental short-cuts, to which we then attribute too great a level of certainty. This leads to behavioural biases.

We can look at an example of the sort of trap heuristics can lead us into:

Linda is thirty-one, single, outspoken and very bright. She studied philosophy and as a student was concerned by issues of discrimination and social injustice. She frequently attended anti-nuclear demonstrations. Which is more likely?

1. Linda is a bank clerk
2. Linda is a bank clerk and active in the feminist movement

Despite the fact that “bank clerk” cannot be less probable than “bank clerk and feminist” (because the latter category is a more restrictive subset of the former), if you’re like almost 90 percent of the subjects tested by psychologists you would have selected the second response as the more likely alternative. The heuristic trap here is representativeness. Although increasing the amount of detail in a scenario will steadily decrease its probability we are drawn to believe the opposite, that more detail increases the likelihood of a scenario. A consequence of falling into this trap is that superficial similarities are given too much weight and too much emphasis can be placed on short-term trends.

The mental processes driving our reaction to loss are hugely complicated and often apparently in conflict. We tend to be loss adverse rather than risk adverse. Emotionally we feel a loss far more powerfully than a similar gain. This leads us to delay emotionally painful decisions. We would rather hold onto a poorly performing asset than confirm the loss by selling – even if this would give us the opportunity to reinvest in an investment with better prospects.

A further aspect of behavioural finance considers our attitude to the relationship between risk and loss. When faced with the choice of a certain gain of £500 or a 50:50 chance of £1000 most plump for the certain gain. However, when faced with a certain loss of £500 or a 50:50 chance of losing £1000 most go for the second option. This suggests we don’t like taking chances to get rich, but we are prepared to take a chance to avoid getting poor.

The combined effect of our behavioural biases means that markets develop an inbuilt delay before responding to information that classical economists would expect to drive asset prices, which in turn leads to extended bull and bear phases.

A chartist applies the effects of ‘market psychology’ to better understand the underlying direction of flow. We have recently introduced a ‘momentum investing’ option for our wealth management clients that utilises this type of analysis. By looking at market trends we are better positioned to avoid the worst of the large falls in value we have seen twice in the last decade. While in some market conditions this approach can improve returns the expectation should be for slightly lower absolute returns but with a significant reduction in risk.

Think of it as a bit like a tsunami early warning system that should reduce the chances of you being caught without your Speedos when the tide goes out.

RICHARD ROSS
JULY 2011

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This newsletter is intended for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us. Past performance is not a guide to future performance. The information in this newsletter was correct as at Jul 1, 2011 but may not apply at the time of reading.