Traditional investment advice has had a bad decade

Published in the Sunday Times on 26th September 2021.

Traditional advice

Don’t speculate. Only invest in things you understand. Don’t chase yield. Average into markets. Don’t expect to get rich quickly. Only invest in assets where you can determine intrinsic value. 

This is well-reasoned investment advice for which the past year has been very unkind. In fact, it hasn’t been a great decade for investment textbooks. This cycle has defied expectations in myriad ways.

Apple is valued at $2.5tn. Tesla trades at 17 times sales. Online traders have driven a stratospheric rise in the price of so-called “meme stocks”, such as video game retailer Gamestop.

And the fireworks are not confined to the stock market. The yield on European high-yield bonds recently hit 2.34%, marking the first time buyers of so-called high yield bonds – which may need to be renamed – have accepted payments below consumer price inflation in the eurozone, which hit a decade high of 3% in August. 

Or for the ultimate example of casino capitalism, you need look no further than the crazed world of cryptocurrency. “When Lambo?” is a common phrase on crypto forums, understood to mean when will I be rich enough to buy a Lamborghini. I’ve had several moments when I was reminded of the silliness of markets in early 2000 and we all know how that ended.

You want to avoid a crash but also protect the real value of savings

So what is an investor to make of it all? Investors want to protect their savings from a crash, but they also want to protect them from the guaranteed loss of purchasing power involved in staying out of the stock market at a time when interest rates are lower than inflation.

It is notoriously hard to invest during a bubble – even if you diagnose one correctly, the wait for it to burst can be unendurable. With markets consistently making new highs, I find it hard to be bullish. But I find it even harder to be bearish. I think you need to be invested and here’s why.

A long list of narratives have been put forward to explain how markets have ridden to such extremes. These narratives include low interest rates; the pandemic accelerating the adoption of technologies that raise productivity and growth in earnings and the increased participation of retail investors to name but a few. 

There’s truth in all of these. The market is richly valued, but ultimately S&P 500 earnings have beaten the bottom-up analyst consensus estimate by an unprecedented 15-20% for five quarters running. Add to this the fact that expectations of what governments and central banks can achieve with fiscal and monetary largesse which have been catapulted higher and you have the recipe for a market melt-up. But melt-up doesn’t necessarily have to be followed by a melt-down.

When is a bubble not a bubble?

A recent article in the Financial Times about the US housing market in 2007/08 asks the question; when is a bubble not a bubble? Rather than asserting there was no housing bubble in the US in 2007/08, their claim is that it stemmed from a real change in the fundamentals for housing, which is why the bust was followed by a rebound, rather than evaporating as if it were never there. 

I’ve no idea whether we are on the precipice of a large stock market sell-off or not. Yes, this market looks to have pulled forward much of the returns of this recovery, but a valuation correction can happen slowly. If prices rise by less than earnings grow, the froth can dissipate without a big market drawdown. And even if we do get a large market sell-off, the argument in favour of a rebound in prices if the original increase was the result of a real change in fundamentals sounds more like an opportunity than a threat to investors.

The long-term slide in interest rates – which makes any given stream of future cash flows more valuable combined with the rapid rise of online business models that require little physical capital investment, look genuinely valuable for investors. 

Inflation and interest rates

This is why the current debate in markets around inflation and interest rates is essentially the only debate that matters. A rise in interest rates and/or inflation beyond what the market expects could be damaging for asset classes where valuations embed a considerable bet on the predictability and effectiveness of monetary support.

This is not a time to try to be too clever. Keep enough powder dry to make a bold decision if the market excess unwinds rapidly. Alternatively, if the froth dissipates without a significant sell-off, the Lamborghini may just take a little longer than normal, as the current base is pointing to more modest future returns. 

Either way, you have to be playing the game as the alternatives are non-existent. For those on the sidelines, there will always be reasons to stay away.