The Behavioral Impact on Asset Prices
(Guest Commentary by Rick Konrad – August 25, 2011)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
Rick originally penned this week's for David Korn's (who has been a guest commentator for us) weekend commentary. His insights on the recent (and likely longer-term) behavioral of asset prices are definitely worth reading twice! Rick discusses investor behavioral patterns such as cognitive dissonance, disaster myopia, and how such behavior has contributed to the recent financial crisis and likely much less risk-taking going forward. Rick also addresses the dearth of leadership in Washington. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Mike Tyson and the Economic Punch in the Mouth” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
A few weeks ago, David asked me if to write a guest post for you this week as he was travelling and lecturing in Europe. As always, I am honored to be asked and to try to compile a few thoughts for this audience. After almost thirty five years in the business and many cycles, we have generally felt quite dauntless in expressing investment opinions. We rely heavily on fundamentals and cold, rational logic in coming to investment conclusions; yet, in the wake of recent notable if not epochal events, I do feel somewhat overwhelmed, a little like a golf ball in the tall grass where too often, my drives land.
One of the dangers in investing is behavioral, called cognitive dissonance. First described by a Stanford professor, Leon Festinger in 1957, and applied much later to investing. In essence, the more committed we are to a belief, the harder it is to relinquish, even in the face of overwhelming contrary evidence. Historically, most behavioral finance literature has focused on investors' unwillingness to sell losers, to sell “bad” stocks. We have all made these kinds of mistakes- accepting new information only selectively, concentrating only on the positive news about an industry or stock, respecting and accepting only the analysts with positive views, and ignoring all the bad news and contrary opinion. In my opinion, we are seeing the other side of cognitive dissonance, investors' unwillingness to purchase fundamentally sound stocks.
Why is this? Let's describe the phenomenon of “disaster myopia”. It's been only four years since the onset of the “Great Recession.” Because prior to this, we had been through such a long period of economic stability and growth, investors and especially banks underestimated the probability of the economic catastrophe that we experienced. Too many of the prevailing beliefs were sadly mistaken:
- Residential real estate prices would continue to move upward
- Unemployment rates in the US would stay below 5%
- Low commodity prices were a permanent feature of the world economy
During the golden era, bank competition simultaneously drove down returns on assets and drove up target returns on equity. Caught in this cross-fire, higher leverage became banks' only means of keeping up with the Jones's. Bank management resorted to the roulette wheel. As the seemingly low probability but high severity recession occurred that detonated these beliefs (a “Black Swan” kind of event), this evolved into disaster magnification, or massive risk aversion.
To be sure, we have witnessed some momentous events that are unprecedented. All of you have seen our comments regarding the S&P downgrade of US long term debt. Following the downgrade, US bonds were viewed as a safe haven and their yields dropped to even less than 2% for the ten-year Treasury. Investors headed for the hills with their equity holdings. The speed of the declines in US stock prices in the first week of August was even faster than the sell-off on the day that Lehman Brothers collapsed nearly three years ago.
As the volatility has increased, we have noticed some incredible volumes, largely attributable to the actions of high frequency or algorithmic traders. High-frequency trading is a technique that relies on the rapid and automated placement of orders, many of which are immediately updated or canceled, as part of strategies such as market making and statistical arbitrage and tactics based on momentum. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment. It is estimated that in August, almost 75% of trading volume has come from such high frequency trading. As a result, the average holding period for a stock is reported to be down to an incredible 11 seconds.
Hence, it is quite easy to see why there is such risk aversion. Digging a little deeper, risk aversion comes down to psychological scarring, and more tangibly, balance sheet repair.
Let's address the psychological scarring issue first. When FDR gave his inaugural address in 1933, his famous quote “We have nothing to fear but fear itself” certainly captured the fear factor that prevailed in this country as the Great Depression wore on. Certainly my parents, who had experienced the Great Depression first-hand, never developed much of an appetite for risk. That fear factor is pervasive today as the clouds of uncertainty continue to obscure our economic path. Memories of the financial disaster remain fresh, just like those of my parents, and are causing an over-estimation of the probability of a repeat disaster. In these situations, psychological scarring is likely to result in risk appetite and risk-taking being lower than reality might suggest. Risk will be over-priced. Today, the very disaster myopia that caused the crisis I think is retarding the recovery.
Financial trauma, like any personal trauma, can increase this detachment from fundamentals. The Great Depression left risk-taking scars that lasted a lifetime. Who knows if the scars of the last few years will permanently impact the risk-taking appetite of 30 year olds of this generation? Any new appetite for risk may take some years to develop…much more time than the healthy and impressive fundamentals would suggest.
Turning to balance sheet repair, this is a mixed picture. Things are improving in most sectors. At the height of the pre-crisis, global bank balance sheets operated on 40 times leverage, sort of the equivalent of having 97.5 cents of debt for every dollar of assets…in other words a 97.5% loan to value mortgage. After the crisis, de-leveraging has become de rigeur and leverage has dropped to more conservative levels of about 20 times leverage, a more conservative but still scary 95% loan to value mortgage. Dodd- Frank and other international regulatory issues will force continued progress and hamper the industry's propensity to lend. We continue to see a rather dismal outlook for bank profitability. We have been through three decades where bank ROEs (return on equity) were well above the average corporate ROE. Over the long run, it has always made sense to me that the profitability of banks should be about the same as the profitability of its customers.
Among non-financial corporations, the balance sheets generally need little repair in most of the developed countries. In many US corporations, the balance sheets are awash with cash despite interest rates that should encourage companies to assume much higher leverage. Like most of us, US corporations have also adopted a wait and see attitude as far as committing capital to new projects.
Household de-leveraging is also well underway. Savings are increasing following years of greater and greater debt accumulation. Unfortunately, there remains a sizable tail of over-indebted households vulnerable to a worsening of financial conditions. In the US, the proportion of households in negative equity is 1 in 4. With house prices falling, that fraction may rise further.
Government finances are the one exception to the de-leveraging of the system. There are sovereign debt concerns in parts of Europe as well as the United States. The International Monetary Fund expects that debt-to-GDP ratios in the G7 economies this year to breach 100% of GDP for the first time since the Second World War. Historically, ratios in excess of 90-100% of GDP have been found to exert a lasting drag on growth, perhaps of around 1 percentage point. At these levels, government debt has in the past been growth-sapping – and fear-enhancing.
Perhaps the ugliest political situation resides in Europe. The European Union is a confederation of states that outsources day-to-day management of many policy spheres to a bureaucratic arm (the European Commission) and monetary policy to the European Central Bank. The important policy issues, such as defense, foreign policy and taxation, remain the sole prerogatives of the states. The states still meet in various formats to deal with these problems. Hence, every significant decision requires that the states meet and reach a mutually acceptable solution, often producing non-optimal outcomes that are products of compromise. It is important to realize that though the Greek fiscal situation is a rather sad joke, Greece represents only 2.5 percent of the Eurozone's gross domestic product (GDP), and the total bloc's fiscal numbers are not that bad when looked at in the aggregate. Its overall deficit and debt figures are in a better shape than those of the United States — the U.S. budget deficit stood at 10.6 percent of GDP in 2010, compared to 6.4 percent for the European Union — yet the focus continues to be on Europe. Our own political situation in the States almost defies logical comment and instills resentment and disgust. In my opinion, we have a crisis of leadership, a surplus of politicians, and a dire shortage of statesmen.
Market volumes tend to pick up as a consequence of being factories of rumors as the media invents crisis and exaggerates risks. Traders with 11 second investment horizons snap at the resulting sound bites. Several European nations are now under attack by 'the market' notably France which has found itself at the center of speculation about its ability to meet its obligations. Whenever the market is mentioned, the “Investor” word is used; but these people, surely, are not investors; rather they are not even money “managers”; they are traders in business for short term profit. Too many are governed by the automated, computerized trading we described earlier. The “Investor” word is misplaced, and wrong. People like Warren Buffet, Bruce Berkowitz, and David Einhorn are investors we can admire with thoughtful long term decision-making; not these traders, eager to make a fast buck, keen to bring down sovereign nations using other peoples' money. They should be recognized for what they are - predators, and piranhas sensing blood in the water.
It is also very important to maintain some global perspective on the economy. CNBC would have us believe that the world is divided into two parts, America and Europe. We cannot forget the impact of Chinese growth on the global economy. The value of this year's growth in the Chinese economy is equal to about 4 times the value of the entire Greek economy or equal to the entire value of the South Korean economy.
What conclusions can we draw? The behavioral elements outside of economics are a strong headwind for us as investors. Disaster myopia, intrinsic uncertainty and deep trauma will place a heavy foot on the brake for some time despite the monetary authorities pedal to the medal attempt at acceleration Risk capital is in a stop-start mode.
The way out depends on leadership much as Roosevelt provided in his discussion of “fear itself.” If risk is as over-priced as I believe it is, and investors over-pessimistic as I believe they are, communicating that might help in correcting overshoots in risk appetite in either direction.
Regulation, under Dodd-Frank and other BIS constraints may be too over-bearing. In 1938, the US was facing a double-dip recession. Criticism of banks' unwillingness to lend to the real economy was rampant. Fear in financial markets was mounting. It sure sounds a lot like today!
At that time, the Roosevelt Administration developed “The Uniform Agreement on Bank Supervisory Procedures,” which relaxed the august standards introduced early in the crisis and made bank examinations them “dynamically adjustable to current economic policies.” It worked…banks started to lend again.
In the interim, capital markets have very little appetite for risk. The demand for “safe” assets has risen significantly. At a 10-year maturity, US government benchmark bond yields are at around their lowest levels in over two centuries– despite the recent scare over US debt ceilings and subsequent downgrade. The price of gold has risen even more dramatically. Real gold prices have more than doubled since 2008. In my view, neither place represents much of a safe harbor any longer.
Stock markets are discounting very bad news whether sovereign defaults, a dollar crisis, or social unrest spreading from the Middle East, to Britain and potentially to other Western countries. It is important to remind ourselves that on average, corporate balance sheets are in the best shape they have been in three decades. There is more than $2 trillion in cash and equivalents on corporate balance sheets. Earnings are up about 18% year over year. At current levels, the forward price to earnings ratio is about 10.3 times, well below the ten year average of 15.2 times. Relative to government debt, where US Treasury yields are scraping bottom, the S&P yield is about 2.3%. More than 40% of S&P 500 earnings come from overseas, and these companies receive the benefit of a weaker dollar. We should also keep in mind that many Asian markets are not as directly exposed to the sovereign debt strains engulfing Europe and weighing on the US. Their superior fiscal position, lower debt, and faster-growing economies continue to draw our attention.
We expect that there is great recovery potential in the US and other stock markets. Regrettably, there is a great chance for further grinding and congestion as the world sorts itself out. As one of my friends expressed it so well when looking at his portfolio, “It probably represents excellent value, but it's likely to stay there.”
Stick with quality balance sheets and quality businesses that have international and especially Far Eastern revenues and brand presence. Equities, in my view are the new safe haven but expect little appreciation for now. Defensive is expensive. Take advantage of the reverse cognitive dissonance I referred to earlier. Too many investors are unwilling to buy fundamentally sound stocks.