I had a moment of clarity at the weekend.
I got an annual statement from an old workplace pension. Without getting into loads of dull detail, it's basically a global equity tracker to which I haven’t contributed anything – or paid a lot of attention to – in the past year.
Now, since last August, there’s been a global pandemic (like you hadn’t noticed). Geopolitical relationships around the world have gone from strained to a bit more strained. Pretty much every country in the world has seen a recession, with record collapses in GDP.
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How has this affected this particular pension pot? It’s up about 0.01%. In the context, that feels like a double-bagger. And it also feels very, very strange.
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Investors are incredibly confident that everything will go right
It was both pleasing and somewhat surreal to see that in a year of such unprecedented (there’s that word again) economic chaos, this forgotten pension pot had barely suffered.
And I’m not the only one to find this a little odd. Behavioural investing expert James Montier has a new paper out from his perch at US asset manager GMO. The opening line is: “Never before have I seen a market so highly valued in the face of overwhelming uncertainty.”
Now, Montier has a recent history of being bearish (and wrong on that front). However, I’ve followed his work since he was at Société Générale with Albert Edwards and I would point out that he’s not a permabear by any means. He was one of the first analysts to come out with a stellar set of buying opportunities following the 2008 crash, for example.
So, while this isn’t a new stance for him, he’s also not averse to being bullish. And Montier isn’t even arguing that it’s all going to go pear-shaped from here. He isn’t saying that Covid-19 is going to have a second wave. “I have no idea what the shape of the recovery will be, I have no idea how easy it will be to get all the unemployed back to work.”
However, he notes, “I do know that these questions exist. And that means I should demand a margin of safety – wriggle room for bad outcomes, if you like.”
On this, the market plainly “does not share my view”. Equities – in the US particularly – appear to have “priced in a truly Panglossian future where everything is for the best in the best of all possible worlds."
One key point that Montier makes – which GMO founder Jeremy Grantham has also made – is that markets tend to suffer greatly from extrapolation. They get more and more optimistic as markets go up, and they get more and more pessimistic as they go down.
That translates as investors paying ever-higher price/earnings (p/e) ratios as earnings go up – so that eventually they are paying the most for earnings just as those earnings are hitting a cyclical peak. They do exactly the same on the way down – shunning stocks when earnings are at their lowest ebb, even although that’s precisely when they’re at their cheapest.
Today, however, it’s different. P/e ratios – in effect, the amount investors are willing to pay for every given £1 of earnings – are near record highs. But earnings are set to come in way below average, purely because of the massive economic hit that we’ve taken.
So this time, even although the economic backdrop is awful, investors are pricing stocks as though things couldn’t be better. Maybe that is what we’ll see, but as Montier points out, the sheer “certainty with which a V-shaped recovery is being priced in reflects a potentially dangerous level of overconfidence”.
Montier is also sceptical that the Federal Reserve – America’s central bank – can keep the party rolling along. Unlike many others (and I’ve been known to say this myself) he doesn’t see this as the Fed’s “fault” as such, because he simply doesn’t see any obvious causal relationship “between the stockmarket and the Fed’s actions.”
In short, markets – in the US specifically – are simply overconfident.
What’s the alternative?
Now, I’m not sure I agree with him entirely on the Fed. I can see that there is no mechanical relationship between quantitative easing and share prices. However, if your central bank effectively outlaws bankruptcy, then that takes away (or vastly reduces) one massive risk inherent in owning equities.
So I suspect the Fed is at least partly responsible for rocketing share prices, and not just purely because investors have “faith in the Fed”. But his overall take – that investors in the US are paying an awful lot for exposure to stocks and assuming that most things will go right – doesn’t seem unfair.
Montier has been suggesting emerging markets as an alternative for a while. Having at least some emerging exposure in your portfolio (along with other cheaper assets) does strike me as a good idea. Certainly, if the US dollar continues to go down then emerging markets should do well.
My colleague Cris suggested one particularly promising option in a recent issue of MoneyWeek magazine. If you’re not already a subscriber, then get your first six issues free here.
