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The Expanding Toolbox Of The Intelligent Investor


In a recent article entitled “Divorced from a ‘boring’ reality” (available to clients on the company’s research website), Jeff Currie, the head of global Commodities Research for Goldman Sachs, makes the case that economic cycles have become smoother and less forward-looking, leaving swings in sentiment to be the primary source of volatility and driver of markets today. (Full disclosure: Goldman Sachs is a broker of Richmond Global Compass Fund and a former employer of the author.)

His thesis is that in the 1980s, 1990s and even the 2000s, economic cycles were driven by consumer demand for durable goods and long-cycle capital expenditures (CAPEX) by firms. These expenditures would be the main factor in guiding expectations in the real economy and bear responsibility for the boom and bust cycles. Consumers and companies will delay consumption and CAPEX if there is concern about the future.

Since the last financial crisis, three trends have changed this scenario. First, durable goods become obsolete faster than before. That is mainly a function of these goods requiring increasingly more software than hardware. That also contributes to lower prices for those goods, increasing repeated sales and decreasing the duration of those goods. Second, the surge in leasing options and the introduction of the sharing economy fragmented the ownership of big-ticket items. The first two trends also contribute to a faster CAPEX cycle. Third, emerging markets became much more aggressive in managing cycles with counter-cyclical policies.

To sum up this article, the idea put forward is that the market’s “animal spirits” are in the driver seat today, and prices and volatility are not grounded in reality anymore. It is refreshing to read a sell-side report acknowledging the importance of psychological and sociological factors affecting the market. However, is this a new phenomenon that started in the past decade or so?

The work of behavioral economists would tell you that this is not new. During his Nobel Prize lecture, Robert Shiller, who I was lucky to have as a professor, said, “a speculative bubble is a peculiar kind of fad or social epidemic that is regularly seen in speculative markets; not a wild orgy of delusions but a natural consequence of the principles of social psychology coupled with imperfect news media and information channels.”

By looking at the real level of the stock market since 1871 and the present value of future real dividends, Shiller was able to test for “excess volatility” and found that the information about future fundamentals did not explain most of the variability of the stock market. Using a fixed discount rate, allowing for the discount rate to depend on the time-varying one-period rate of interest or using the marginal rate of substitution between consumption in successive periods as a discount rate did not change the finding.

The idea that fundamentals drive aggregate stock prices appears inherently flawed when looking at this picture. If that were true, the stock market should be less variable than the present value of future real dividends. New and relevant information should change the market price, but those only occur sporadically and not as frequently as seen in the data. In other words, participants in the market when making trading decisions did not act as if they knew what the fundamentals would be in the future. Moreover, if they did not understand what fundamentals would be in the future, prices should have changed much less than they did.

As an investment professional, the ability to assess the current position of the market cycle, based on economic data and fundamentals, is of utmost importance. However, the realization that prices can be driven by more than so-called “fundamentals” is extremely important when making investment decisions and should be met with dedicated analysis. This knowledge provides an investor with the basis to recognize divergences between current market prices and fundamentals. By acting cautiously when others are greedy and by acting with poise when others are fearful, the intelligent investor aims to provide absolute returns in the long term. The understanding of behavioral economics is a necessary tool in the expanding toolbox of the modern investor.

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