Spatial disorientation is the inability to determine true body position, motion, and altitude relative to the earth or other surroundings.
It’s believed spatial disorientation was the cause of John F Kennedy Junior’s fatal air crash.
Deep sea divers can also suffer from not knowing which way is up.
Disorientation can have disastrous outcomes.
And so can financial disorientation. You make investment decisions in the belief the ‘economic instruments’ are giving you the right signals, only to find out later you were actually flying blind.
As mentioned in yesterday’s Markets and Money, I’m suffering a form of financial disorientation. The investing world looks completely upside down to me.
Since former Federal Reserve chief Alan Greenspan first started manipulating markets in late 1987 (the now famous Greenspan put), discerning fact from fiction in markets has become more difficult.
Prior to Greenspan’s reign at the Fed, markets (for over a century) went through fairly natural boom and bust cycles. The market naturally corrected excesses and life moved on. From the ashes of the correction rose the phoenix of the next boom. Like the rejuvenation of a forest after a fire…gradual at first and then into full bloom.
Since Greenspan-Bernanke-Yellen’s self appointments as market saviours, the natural order of events seem no longer to apply.
Risk taking — such as the US$250 trillion in derivative bets — is no longer as risky. If things go pear shaped, Wall Street knows that either the US Federal Reserve or the taxpayer (or both) has their backs. All profits, no losses. Where do I sign up?
To regain our bearings on how markets used to function (and probably will again), we have to go back to a time before narcissism became a trend and central bankers were considered omnipotent.
In 1949 Benjamin Graham published his now famous The Intelligent Investor. Warren Buffett calls it the best book about investing ever written. Buffett even named his son Howard Graham.
Benjamin Graham is often called ‘the father of value investing’. And if ever there was a time to appreciate the value in investing it’s in today’s upside down world of distorted values.
There are five core principles underpinning Benjamin Graham’s philosophy on value investing:
1. Investing is most intelligent when it is most businesslike.
When you buy shares, you are buying a piece of a business. That business has an intrinsic value based on its underlying earnings and assets. Understanding the intrinsic value is critical in determining what price you should be prepared to pay for your share of the business. In the US, there is a valuation metric called Tobin Q, a calculation based on dividing the market value of all companies on the share market by the replacement value of the combined assets. At present ,the Tobin Q ratio is 1.14. In simple terms this means investors are currently paying $1.14 for $1 of assets. If buying assets at a discount is intelligent, then paying a premium is dumb.
2. Nobody can tell the future.
Graham warned against extrapolating past trends into the future to calculate a business’s intrinsic value. How many investors and analysts are guilty of projecting the past into the future?
Joseph Schumpeter said ‘Creative Destruction is the essential fact about capitalism.’
Exhibit A of Schumpeter’s observation:
‘The Eastman Kodak Company, the world’s largest producer of photographic products, reported yesterday that earnings in the first quarter climbed 29.1 percent on a sales increase of 7.9 percent.’ – New York Times, 30 April 1981
Digital photography together with poor management killed Kodak. Extrapolating Kodak’s glory day earnings into the future would have been a very costly mistake for investors.
No one knows the short or long term future for individual businesses. It’s for this reason the Gowdie Family Wealth model portfolio is based on buying index-based exchange-traded funds (ETFs). The stock specific risk is removed. The index will still be there tomorrow, but the companies that comprise the index could be completely different today.
3. The future is something to protect against.
Acknowledging Donald Rumsfeld’s unknown unknowns is a good start for sensible investing.
Events beyond our control and imagination can move markets very swiftly. You cannot predict these events but you can protect against them. Graham called this process ‘investing with a margin of safety’. Two fundamental margin of safety strategies are:
- Buy shares for less than they are worth. Sounds simple enough but as we can see from the Tobin Q ratio it isn’t practiced.
- Buy companies paying sustainable high dividend yields. This ‘bird in the hand’ approach maintains a good cash flow irrespective of price volatility. Far too many people look to invest for growth only, aiming to shoot the lights out. A strong income stream is far more reliable and valuable for long term wealth accumulation.
4. Investors are moved in large part by irrational forces.
Fear and greed have been around since Adam. Social mood has an enormous influence on asset values. A head over heart approach to your investment allocation is likely to save you from the dreaded ‘buy high, sell low’ curse that afflicts most investors.
How you put this principle into practice is to understand value. Most people are swept along with momentum, not fully appreciating exactly what they are paying for.
Keeping tabs on social mood is as important as understanding the math behind market valuations.
5. Mean reversion is a fundamental law.
In yesterday’s Markets and Money, I included the following table on the various valuation models pertaining to the US share market.
|Valuation metric||Current||Historical Mean||Year historical Mean measured from||Deviation from Mean|
|Shiller PE 10||27.2x||16.6x||1870||+64%|
|Market Cap/GDP (the Buffett Index)||123%||69%||1950||+78%|
|Tobin Q Ratio||1.14||0.68||1900||+68%|
Benjamin Graham knew in 1949 the irrefutable law of ‘reversion to the mean’.
Common sense tells us an average is arrived at by using various data points — some lower, some higher and some around the average. The above valuation metrics have decades of data points to draw upon (market highs, lows and in-betweens) to arrive at the mathematical mean.
At present the average deviation from the mean, for the three metrics, is 70%.
To ignore this data is to say decades of behavioural patterns of market participants is now no longer relevant.
The current 70% deviation from the mean (1.70 to 1.0) requires a correction of 40% to revert to the mean. However, there is no law that says the reversion must stop at the mean. Based on Benjamin Graham’s fifth core principle, the intelligent investor should brace themselves for the possibility of another 50%+ fall (similar to 2000/01 and 2008/09) in our near future.
Good old fashioned common sense backed by proven mathematical concepts is a sure way to dispel spatial disorientation.
For now the central bankers have turned the investing world upside down, but the law of gravity is destined to correct this aberration.
For Markets and Money