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Don’t sweat the big stuff

It is amazing how much brainpower is dedicated to thinking about the big-picture macro issues and staying up-to-date on the minutia of the daily financial news flow. News on US non-farm payrolls, China’s latest PMI reading, and Yellen’s latest utterance consume considerable media and investor attention. In our opinion, all of this can be a time-consuming distraction for investors and confuses their ultimate goal: building and protecting wealth.

The economy is unpredictable

Investment success is ultimately determined by what happens in the future, and trying to pick the big-picture macro issues is extremely difficult.

The economy is practically infinite in size, is interlinked, and is self-adapting. In science speak, the economy is a ‘complex adaptive system’. In simple terms, it is all over the place. Just one of the many reasons given for the recent run up in the iron ore price was a flower show in October in Tangshan, an important industrial Chinese city whose steel mills have been told to shut down in an effort to reduce pollution in time for the show. Notice of the shutdown brought about a build-up in steel inventories beforehand, bringing forward demand for iron ore which is used in its production. Thus, to ensure some healthy gerberas in China, we saw the iron ore price run up hard, Fortescue’s stock price double, Western Australian and Federal Government budgets get a boost, and a range of other economic consequences including a strengthening Australian dollar. It is doubtful, however, that economists will incorporate flower shows into their calendar of important upcoming events.

At least in hindsight, the effects on an economy of a flower show can make sense. Less rational factors can also come to bear on how an economy evolves. To take an example that has troubled the Reserve Bank of Australia (RBA), Australian business investment has been lacklustre in recent years despite supportive low interest rates. The culprit in the RBA’s view has been a lack of ‘animal spirits’. Factors like boardroom confidence, consumer confidence, and banks' risk appetites are obviously not easily given to financial modelling or forecasts, yet they can have a significant impact. The economy is the sum of a great number of transactions entered into by real people in which human nature inevitably plays a part.

To summarise, the range of factors affecting the wider economy is virtually infinite, and not all are given to rational analysis.

Very few investors have done well by placing their bets largely behind economic forecasts; indeed, many like Warren Buffett have succeeded by ignoring them. Paul Samuelson, a US economist, famously said in the 1960s that the stock market has predicted nine out of the last five recessions. In recent Australian history, the record has been worse. Taking some other examples:

  • offshore hedge funds have predicted nine of the last zero Australian housing busts and lost bundles shorting the Australian banks in the process
  • almost no one predicted the oil price falling from US$100 to US$30 a barrel and the significant loss of value from holding oil stocks like Origin and Santos
  • only a few characters depicted in The Big Short movie saw the mayhem start to unfold in the US housing and mortgage markets that gave rise to the GFC.

Yet despite the difficulties, the media and investors spend considerable time second-guessing the Fed and the RBA’s next rate decision, whether GDP growth will be 2.5% or 2.7%, and the year-end level of the All Ordinaries. Even when we don’t believe in the data itself, as is the case for Chinese GDP and other data, we still insist on having a guess on what it will be. But for what?

Predicting the economy and investing as separate endeavours

Even if investors could accurately predict the big macro variables, it does not follow that they will enjoy strong investment returns. Studies reveal that there is little correlation between GDP growth and the share market’s return, and to the extent that there is a relationship, it is slightly negative. This may seem a somewhat surprising conclusion. No market commentator will say, “The economy is continuing to deteriorate and so I remain bullish on the stock market.” Interestingly, this line of thinking has proven itself to work for most of the time since the GFC. Bad economic news has been taken as reason for further monetary easing, which in turn provided support for share prices. Bad news for the economy was therefore good news for stocks. Some investors whose macro predictions from some years ago now look like nonsense have produced some of the best investments returns, and vice versa.

One of the intricacies of investing is that successfully predicting the future does not ensure success. Asset prices are discounting mechanisms, meaning that markets discount, or incorporate, expectations of future earnings, interest rates, oil prices, and other relevant variables. Taking the example of stocks, there is little prospect for investment outperformance by holding a stock whose earnings perform in line with expectations, and which was probably therefore priced right after all. Investment outperformance generally requires that a company actually exceeds expectations, however bullish they might be. Thus, investment outperformance often requires the investor to have both a differentiated view and that it ultimately proves correct. In this respect, investors should consider where they might find an investment ‘edge’.

Finding your edge by recognising levels of complexity

In our view, it is far easier to find such an edge once it is broken down into bite-size pieces. We admit to having no skill, for example, in accurately forecasting currencies. Here, the game is played across a large and complex world, quite literally, and it involves an almost infinite number of inter-related variables (flower shows included). The less variables that come into play, and the more predictable the outcomes, the more likely investors can find an edge.

Moving down the difficulty scale, the oil price is a somewhat more manageable game to play. Unlike most commodities, demand for oil is quite stable, growing slowly on a global basis. Likewise, those that put in the effort can get a reasonable handle on oil production. While understanding the supply-demand dynamics might not afford precise oil forecasts for the near term, it can give rise to some reasonable assumptions over the medium and longer term that could be used in assessing oil company valuations.

Further still down the difficulty scale is demographics, where predictions of an ageing population can form a useful view on the growing need for healthcare services. Or in a specific industry such as the supermarket or fast food industries, it is possible to understand which operators might eventually win and lose.

At Bennelong Australian Equity Partners, we tend to keep it simple by focusing on the more predictable companies, typically those high quality businesses selling recurring and often relatively-defensive products. These are the types of companies that will see through difficult economies and prosper over time. Two examples our funds have owned for many years are Ramsay Health Care, the largest private hospital operator in Australia and which benefits from an ageing population, and Domino’s Pizza, the pizza shop business that has clearly beaten its competition through innovation and an improved customer offering.

Of course, it is not necessary to find a personal investing edge to achieve a decent return if you can find someone else with an edge. A fund manager with a successful long term track record is the obvious place to start. Genuine diversification is vital, not the type from concentrating a portfolio in the big banks, Telstra or Woolworths, and a resource stock or two. Genuine diversification means a portfolio spread across a range of macro exposures. Such a portfolio can better deal with the unpredictable and should provide the investor with the comfort that comes with being prepared for any macro eventuality.

Conclusion

We are inundated with negative headlines, dire economic outlooks and even predictions of imminent doom. Unfortunately, the reasoning behind this negativity often seems to make sense, and indeed, sounds prudent. The alternative argument, rarely put forward and seemingly blasé, is that capitalism will find a way for the economy and markets to advance through whatever arises, as it always eventually has.

In our opinion, trying to second guess the broad macro variables such as currencies and GDP growth offers limited 'value add' over time. Investors are better advised to focus their efforts on the actual task of building wealth and setting up a portfolio to deal with continuing economic uncertainty and that makes use of any investment edge.

 

Mark East is Chief Investment Officer of Bennelong Australian Equity Partners (BAEP). This article is general information and does not consider the circumstances of any individual.

6 Comments
Pete
May 20, 2016

This was a really good read Mark. Now to find the next Ramsay or Domino's. They're hard to find from my experience.

Paige
May 20, 2016

Great article. The macro cannot be dismissed, but it can't unfortunately be predicted.

George freeman
April 16, 2016

Great article. Very well written but more importantly it's something that rings true. I have been thinking the same for some time now. I just don't know how you can get the same information that a fund manager gets.

Feeani
April 14, 2016

That is excellent and thought-provoking stuff. Why do we spend so much time on the big macro factors when it matters little and is too hard to genuinely get on top of anyway?

Warren Bird
April 14, 2016

This is exactly why I moved away from being an economist in the financial markets to being a decision-maker and business manager. There's a role for understanding economic trends and significant pressures, but (a) predicting them is difficult, if not impossible and (b) the link with investment market returns is variable at best and often tenuous.

A good financial markets economist is a good story teller, able to talk about what the audience believes they know (what's happening to business, unemployment, prices, etc) in an interesting way, thus building the 'brand' of their employer. A really good one can also build some helpful investment perspectives off the back of the macro themes, but not by pretending there's a straightforward economic model that always works in predictable ways.

For me, the most important economic perspective I've had in recent years is that I have a Wicksellian view of the way the economy and interest rates interact. I have therefore not been holding out for a return to higher rates like so many others, because to me zero cash rates are normal in the sort of economic context the US and Europe now operates in. (See Martin Wolf's article in The Financial Times this week for a good summary.) That says nothing about the fluctuations in bond yields and equity markets over the past few years, but has proved helpful for me in many investment contexts. Nevertheless, predicting when economies will start to support a positive rate of return on risk free capital - and thus positive real cash rates - is not easy and we're more likely to only recognise it after the event.

Gary M
April 14, 2016

Good story. Insto investors have floors full of economists costing millions of dollars collectively who are paid to study and write about macro economics – but completely useless as it is unrelated to market returns for a variety of reasons. It has absolutely zero impact or input on asset class and portfolio construction decisions. It is irrelevant to running a portfolio. It’s like Steve Martin’s first movie “The Jerk” saying wisely “Aaaaah…x amount!” pretending to understand financial advisers who are deliberately speaking gibberish to see how much he understood about investing so they could defraud him.

 

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