Markets had another rough day on Friday.
In the US, the tech-heavy Nasdaq index is well into “correction” territory, down by nearly 15% from its most recent high.
Cryptocurrencies have also had a difficult weekend: bitcoin is now down nearly 50% on the record high it hit in November.
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And over in the bond market, the most notable event was that the ten-year German Bund yield turned positive for the first time in three years.
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There’s no doubt that the bubble in “jam tomorrow” assets has burst. Or at least taken a serious dent.
The question now is, what happens next?
“Story” stocks are giving way to boring old “reality” stocks
For a while I’ve been describing our current bubble as a bubble in “long duration” assets, or to use a less jargon-laden term, “jam tomorrow” assets.
What do I mean by that? “Duration” is a term used mainly in bond markets. There are two different types, but they are closely related. The longer a bond’s duration, the longer it takes to recoup the money you invested in the bond via its cash flows, and the more sensitive it is to changes in interest rates.
Why? If interest rates are rising, then the longer you have to wait for your money, the more interest you miss out on. That means future cash flows become less appealing as the interest-rate dial turns up. You don’t mind waiting for “jam tomorrow” if there isn’t much on offer today, but the appeal rapidly fades if you can get almost as much today without taking the risk of waiting.
As a result, a “long duration” asset benefits from falling interest rates, while a “short duration” asset copes better with rising rates. Logically, this implies that in an environment where rates just keep on falling, investors will be more drawn to “long duration” assets, and less interested in “short duration” ones.
In bonds, duration is specific and easy to measure. A bond will pay you a series of interest payments at explicit intervals and then give you your money back on a specific date. Assuming there is no credit risk (eg it’s a developed-world government bond) then the actual cash flows are very predictable. What you are willing to pay for those cash flows is the only thing that will change, and this is dictated by interest rates and inflation levels.
How can you apply this concept to equities, whose future cash flows are much less certain? It’s not that tricky as long as you’re not too pedantic about definitions.
A “long duration” equity would be one which doesn’t generate much (or any) profit right now, but offers the promise of fast growth and eventually massive profits (eg anything with the word “metaverse” in the pitch deck). A “short duration” equity would be one that produces a lot of cash today, but perhaps doesn’t have a very sexy growth story (eg an oil producer).
This rather helps to explain the vast gap between the performance of “growth” and “value” stocks, although the terms “growth” and “value” don’t really do it justice. A better term, as author and analyst Tren Griffin puts it on Twitter, is “story stocks”.
Warren Buffett versus Cathie Wood
There’s probably no better measure of this shift than the fact that Warren Buffett (who is always dismissed as an out-of-touch old has-been near the peak of every bubble) is now steadily catching up with Cathie Wood, the defining face of the “jam tomorrow” bubble.
As the FT reports, from the start of 2020 to the start of 2021, Wood’s Ark Innovation exchange-traded fund (ARKK) rose by more than 150%, while Buffett’s Berkshire Hathaway vehicle was barely changed. And yet since then, Berkshire has risen by 34%, while ARKK is down 43%.
If you’d owned ARKK since the start of 2020 rather than Berkshire, then you’re still ahead, but only by about eight percentage points. And of course, you’re also in the unpleasant situation of owning an asset that has lost almost a quarter of its value this year alone, whereas Berkshire’s investors have been sleeping easy.
The UK looks cheap in a reality-based world
This brings us to the obvious corollary of “sell long duration” assets – that is, “buy short duration” ones. So what counts as “short duration” in stocks?
One obvious example is shares that pay a dividend. You’re getting some of your cash flow paid out while you own the stock, as opposed to story stocks, where any money made is invested back into the business with the promise that it’ll pay off in the far future.
This helps to explain why the FTSE 100 has had a much better start to the year than pretty much any other major stockmarket index. It’s true that the UK has been shunned by global investors since Brexit (it’s small enough in terms of the global market for investors to stick it in the “too hard” basket without risking massive underperformance) and that this shunning has left the UK cheap (very much so in relative terms).
But as Simon French of Panmure Gordon notes on Twitter, the rebound in the UK so far this year isn’t about investors re-evaluating the overall market. Instead it’s very much about the fact that the UK is heavily exposed to sectors that should do well (or at least cope) with higher interest rates. So, for example, bank stocks are doing better – higher interest rates should translate into higher profit margins. And dividend stocks are in greater demand.
That’s all good news for the UK market. (In any case, I also suspect that the post-Brexit shunning and the perception of the UK as a “short duration” market have rather gone hand in hand, so we’ll see if we now get a virtuous upwards spiral as the backdrop becomes more appealing.)
You could just invest in a passive index fund, or an investment trust option we’ve mentioned a few times is the Temple Bar investment trust. You can find out more about the latter via Merryn’s recent podcast with the managers.
