Good, until it is not

Faith is the firm conviction that things would pan out, as they are supposed to. It is the confidence in the outcome despite an unknowable environment. However, faith alone without the backup of preparation & effort, can be a recipe of disaster. Investors are by nature an optimistic lot & are prone to putting excessive faith on financial projections, historical patterns, efficiency of markets & guidance by central banks.

The combined impact of excessive reliance on accepted truths, herding behavior (following the actions of others rather than personal belief) & recency bias (chasing the latest fad) can be such that market distortions thus created, could continue for a significantly long time before getting corrected. The economic logic may be managed by powers that be but it certainly cannot be denied. A free lunch is not be had!

Default Assumption of Investors

Investors & advisors depend on certain assumptions to decide on their strategic asset allocation, build portfolios & establish expectations for risks & returns. Overtime, megatrends (trends that occur on global or large scale) have the effect of imprinting such assumptions in the minds of investor community as default condition, instead of a variable that would change with changing economic, social or political environment. It becomes a heuristic (mental short cut to investment decisions) & is no longer subjected to intense scrutiny.

When market trends make you wonder if economic logic no longer applies then maybe it is time to revisit the assumptions.

  • Interest rates in all power house economies have been low for better part of last 40 years (were even negative for some time) on back of low inflation economic set up – hence the market assumption that interest rates cannot rise, much less shoot up!
  • Equity valuations the world over, are at all-time high despite the pandemic, low expected growth in world GDP & increasing political tensions – on assumption of near zero% interest rates for foreseeable future, equity valuations have only one way to go i.e., UP!
  • Real Estate market constitutes a significant portion of developed economies & is strong even beyond the scale last seen at the time of 2008 crisis – on assumption of low interest rates to continue, 2008 is not expected to repeat.
  • Crypto-currencies continue to attract large funds, when it does not create any value or cash flow & facilitates illegal fund transfer – on assumption that it could replace fiat currency when governments give up their very source of power.
  • Central Banks continue to expand their balance sheet by printing money on expectation that inflation will continue to remain in check. Markets expect central banks to come to rescue of markets, in case of another crisis – on assumption that they have not already exhausted all their options to manage ever increasing size of a crisis that follows the previous one!

Anyone born in last four decades would have experienced the current economic environment of low inflation, high GDP growth & increasing valuations (despite short term hiccups) & would not know other possible economic possibilities. In fact, investors & policy makers seem to believe that world has permanently moved beyond the possibilities of war, high inflation, stagflation, low growth rates & political instability. It would be prudent though, to consider long term historical data.

  • US 10-Year Bond Yield remained in a band of 1.5% to 3.5% from 1913 onwards till it increased to 5.1% in 1979 & had shot up to 15.7% by 1981. Following that peak, interest rates have been kept down to the extent that real interest rate yield are negative.
  • It had taken just 8 years (1973 – 1981) of high inflation (8.5% to 12.5%) to yank interest rates from 3% range to 15%.
  • S&P 500 Index gave 0% return from 1929 to 1956 (27 years), from 1968 to 1987 (19 years), from 2000 to 2015 (15 years) & since then has moved up from 2450.47 to 4766.18 as at 2021 end.

For it is good, until it is not.

Nassim Nicholas Taleb once said “Most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk.”

To those who are betting their economic future on interest rates remaining forever low, inflation always in check and equity (& crypto) being valued as per the Greater Fool Method’, it would be do well to remember that

  • Markets have been so pushed to such an extreme by adventurous policy making that if one or more pieces of the above jigsaw puzzle come off then things could unravel very fast. The trigger could be anything – maybe not even economic or health concern.
  • When next financial crisis occurs, if central bankers don’t come / cannot come / come but are ineffective then value destruction across all asset classes would be huge.
  • Equity valuations rise inevitably after every fall & after a short period, is a mistaken notion. As historical data suggests, investors need to be prepared for a lost decade or two.
  • Pension Funds & retirees dependent on bonds, investing in negative interest yields are actively looking at a crisis-in-the-making.
  • There are already some 8000 types of crypto-currencies. Even if crypto survives the regulatory challenges, for these essentially bet against official currency & find some application, only the ones that remain in fray will have value. The rest will go bust.

The idea is not be an alarmist but to remain open to possibilities that the scene could change & in a big way. If that were to happen one should not have been pushed oneself into a corner & left no space to maneuver.

Asset Allocation, goal-based approach & re-balancing should help traverse the tricky period that seems ahead.

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