This Is Your Wake Up Call by Stephen Duneier
Issue 15-7 Published March 2, 2015
I’ve been advocating a long US equity position for more than 2 years. There are a whole host of factors that continue to be supportive of higher equity prices about which I have been writing for months now. Over the past week, I have given speeches, made presentations and argued my case face-to-face with a wide variety of audiences. While I have found people to be almost unanimously receptive to the reasoning, the great majority are reluctant to completely accept it. Even those who are long don’t seem to want to believe there is a solid fundamental case to support it. To be honest, I’m not surprised that very few people share my enthusiasm for equities.
Thing is, I’m not merely suggesting that investors should be overweight stocks, I believe they need little more than just two components in their holdings, large cap US equities and back-end US Treasuries. Yes, this moment is made for modern portfolio theory, and it’s important to understand how that puts our businesses, our careers and the investment industry as a whole, at risk. That’s why it is the topic for this edition of Seeds of Thought.
Blinded by Our Own Bias
Equities are the very epitome of beta investing. The returns of just about everything else are typically compared to those of simply holding the S&P 500. What that means is for everyone charging management or performance fees, in order to justify the additional cost to customers, we must outperform by at least that much. After all, no one in their right mind would pay a manager to simply maintain a portfolio that mimics the returns of something that can be obtained practically cost-free. As a result, investment managers and allocators are inherently incentivized to position elsewhere and are naturally biased against higher equity prices. Allocators and investment firms regularly seek managers whose portfolios “offer a good hedge” against stocks going down. That is, of course, unless stocks are rallying.
Truth is, investors seek investments that do well regardless of what is happening anywhere else. What managers fear is underperforming, because that causes AuM to recede and makes new assets harder to come by. As investment managers, we are competing with each other for assets. As portfolio managers, we are competing with each other for jobs. As it has become more and more difficult to raise assets and the job market has become tighter and tighter, participants have naturally become more focused on not screwing things up, than on outperforming. Risk aversion has taken over.
It makes sense. With returns so low across the board, underperformance is hardly a concern for anyone. If no one is knocking it out of the park, why take risk? If everyone is bearish equities, why step out of the pack and go long? You see, at moments like these, the real risk isn’t in underperformance, it is in stepping outside the pack and getting clipped, for if that were to happen you would surely lose either AuM or your job. Both of which are incredibly difficult to come by these days. In other words, career risk and business risk are real concerns weighing heavily on the minds of market participants and affecting their behavior accordingly.
It makes perfect sense then to be inclined to position for lower equity prices and higher rates, right? Wrong.
Think about what caused the drying up of the job market for investment professionals and forced the compression of fees. Was it a population boom that suddenly flooded the market with highly qualified people? No. It was the invasion of a whole new class of efficiency experts, with whom none of us can compete. Their ability to calculate, analyze, execute and service, and at a fraction of the cost it requires the rest of us, puts us in a precarious position. I’m speaking of course about technology. What does technology do best? Beta.
So, if we can’t possibly compete with technology at it’s own game, we better beat it where it struggles — lower equities, higher rates, chaos, high volatility. Intuitively, it makes sense then that the market consensus favors lower stocks, but should it? On a quarterly and annual basis since 1928, the S&P 500 has rallied twice as often as it has fallen. When snapped on a quarterly basis, the median year-on-year return has been 9.0%. While some may worry that we have experienced a 6 year bull run, truth is, 2011 wasn’t technically a positive year, but even if you count it, it still wouldn’t be cause for concern based on historical precedence. Also, as of the end of 2014, the S&P had rallied 85% in the five years prior. Sound like a lot? Turns out it has had a 5 year appreciation of at least that much, 12 times since 1954, and in the year that followed that performance, it still rallied twice as often as it fell, appreciating an average of 15% in those 8 positive years. As for rates, many people have used the term “long run average” to support their argument for a skewed risk / reward that favors being cautious, but here too the evidence doesn’t seem to support the position. I’ve included a few charts for perspective, but at the end of this piece, so as not to create a distraction.
The fundamental point I’m trying to make, is that while you may believe your best hope against beta and technology lies in lower stocks and higher rates, the odds are stacked against you. However, it’s even worse than that.
By positioning against beta and with the rest of the pack, at best you are playing for the status quo from an AuM and career perspective. If I am correct in my prediction that the real risk for equities is in a burst higher and that interest rates will not experience a sustainable shift higher, the downside could be catastrophic for the investment management business. It would mean underperformance, not relative to other managers, but versus your real competition — technology.
The seed I am attempting to plant here is the possibility that our investment risk analysis is being heavily influenced by our concerns over career and business risk, and ironically it is that very burden that is pushing us in the direction which actually puts our careers and businesses in the greatest danger. In other words, higher stocks is where the greatest long-term pain exists for the investment industry as a whole, and the individuals employed by it, by a wide margin.
For those of you who feel the need to have a lottery ticket, might I suggest buying low delta S&P calls, rather than puts? Also, the most common follow-up questions to my presentations have involved emerging markets, and that worries me. While it is possible risk assets could also rally if my macro expectations are met, my argument for higher equities is not based on increased appetite for risky assets. However, the belief that the two are somehow inexorably connected could set many up for the most costly outcome of all, higher US stocks accompanied by a selloff in risk assets. A very real possibility.
"While everyone else is scrambling to answer who, what, where and when, Duneier is focused on explaining the 'why'."
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in Fall 2017 (Wiley & Sons).
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 60,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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