A Game of Two Halves: Investment Framework Restated

  • The Global Cycle, the Rebalancing of the US$-Referenced World and the Volatility Regime
  • Europe's Revival: the 2013 Transition.
  • The Leadership Revolution: from the Global Producer to the Global Consumer.

Preface: What are we doing here?

Investment strategy requires a degree of anticipation of our investment future. Is this, by its nature, an exercise in self-delusion?

Knowledge of any field of human endeavour, however extensive, does not endow us with predictive ability. On the contrary, a high level of skills encourages the illusion of control. There are a host of emotional, cognitive and social factors that support exaggerated confidence in expert opinion. Surveys demonstrate that the attempts by experts to predict the future in their domain of competence are almost invariably fallacious.

The illusion of skill is especially prevalent in the financial world in which the confession of ignorance is seldom acceptable. Financial pundits are the archetype of over-confident experts. Are we engaged in an activity for which the logical basis is illusory? What are we doing here?

It is easier for us to answer the existential question than it used to be because the upheavals in the investment world of recent years have sharpened our sense of purpose. It seems clear to us that strategic thinking in the investment industry has become more inefficient as a result of financial crisis and economic distress. The inefficiency provides investment opportunity.

The conventional financial forecast is little more than the extrapolation of recent trends. Consensus thinking has no practical value to the extent that financial values already discount the outlook that is anticipated. The point is that extrapolative, consensual thinking has been discredited among investors by the disruptive experience of the last decade. The traumatism of 2008 ensured that the decade that began with historic overvaluation of equity assets has been the worst since the 1930s for returns on equity investment. It has produced the cult of anti-equity, suspicion of policy-makers and oversensitivity to the risk of improbable, extreme events.

If strategic investment thinking prior to 2008 was excessively extrapolative and consensual much of that produced since the great crash seems to have forgotten the most basic rules of investment accumulated through long experience.

Growth pessimism has become deeply entrenched within the investment community since 2008, especially in the countries in which the bursting of the credit bubble has caused the most damage. The psychological comfort zone of the NY-London axis that dominates the industry of financial commentary centres upon the discussion of deleveraging in the over-indebted West, the constraints upon growth and the supposed inevitability of debt monetisation by Central Banks. Strategic thinking has become impoverished because it is one-dimensional, dominated by the growth obsession.

A substantial section of the investment world has come to consider that growth is the only significant influence upon the pricing of risk assets in general, and upon the equity asset category in particular. To be precise, the constant reference is to the insufficiency of growth in the West. Hence the fallacy that you cannot buy equities if there is no macroeconomic feel-good factor. However, growth is of little value without stability and corporate profitability does not depend upon growth alone. The experience of the last four years has emphasised that equities are not just priced by reference to the growth regime. The price regime and the profitability regime can be just as influential.

Post-2008 financial commentary has become obsessed with the identification of "it's different this time", extreme tail risks. As a consequence of the discredit attached to the conduct of economic policy in the major economies and the behaviour of the investment industry the subversive advocacy of the self-styled investment maverick has entered the mainstream. To a large extent investment strategy has become an exercise in explaining what could go wrong. A cottage industry has emerged whose common theme is that only the naive buy publically-quoted equity assets. Telling stories about how everything will end badly is of no more practical value to investors than extrapolative thinking, although it is usually more entertaining.

Investment strategy is the evaluation of probable outcomes. Its basis is the identification of patterns of behaviour. Reference to historical precedent is indispensible.

There are two major types of recurrent behaviour in financial markets. The first relates to the business and investment cycle. The second relates to the phenomenon of investment leadership, which itself exhibits cyclicality because excess profitability is rarely sustainable. In both cases we observe reversion to the mean, which implies discontinuity of trend.

The post-2008 investment cycle has produced a textbook example of change in global investment leadership. As regards the cyclical framework it is the fixed income universe that has produced unanticipated discontinuity. By comparison the behaviour of global equity assets has been almost banal.

The twin pillars of investment strategy are the market message and the policy message, including the interaction between the two. The practice of investment strategy consists in large part in listening to what market behaviour and policy-makers are telling us. There is a huge amount of useful information to be obtained from the examination of market behaviour and asset pricing.

Central Bank policies, in one way or another, have been shaping the investment game to an extraordinary degree since the Greenspan era, and more explicitly so since the bursting of a credit bubble for which they themselves were in part responsible. However, the policy message consists of much more than the anticipation of what Central Banks might do next. It concerns the strategic goals of those who have the power to shape our investment future. Investors need to know what these people want and whether they have the conviction and resources to obtain their purpose. Generally speaking, investment outcomes are not shaped by our economic problems but by the responses to the problems.

In this respect it could be said that investment strategy at the present time is dominated by the interaction between two major strategic imperatives. On the one hand, we emphasise the agenda of growth with an inflation bias that prevails, to greater or lesser extent, throughout the US$-referenced world. On the other hand, the strategic commitment to European integration of the governments of the euro area provides the dominant reference for investment strategy in the European region. The euro zone is a political project.

A strategic investment framework provides the conviction that allows us to ignore the noise that results from the process of price adjustment and the output of the industry of financial commentary. This said, conviction should never over-rule pragmatism. We need to validate our ideas constantly. In particular, we need to know when we might be wrong. There are no investment gurus. There is only analysis and probable outcomes.