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Market Commentary

Good Riddance To A Roller Coaster Year

By December 7, 2022July 25th, 2023No Comments

Market Comment: Good Riddance To A Roller Coaster Year

This update runs longer than normal.  There is a lot happening! 2022 has been a year of transition.  Not just the end of the Elizabethan Age, but the end of an extraordinary 40-year downtrend in inflation and interest rates. We have said many times that when the latter trend ends, it will be painful, and you have begun to see that in 2022 – but it is only the beginning of adjustments.

It has also been a year of transition for us at DW, or should I say a year of enhancements.  The highlight is not the minor change of name, nor even our new website, but rather the introduction of discretionary investment service – the result of years of hard work.

This note covers both matters.  They are very much connected, as you will see.  Let’s start with the financial markets in 2022.

 

Good Riddance To A Roller Coaster

As we enter December, we are already receiving mountains of research, cautiously peering into 2023, and including some soul searching and head-scratching as to what happened in 2022.

One is clear on the pain:

“As 2022 draws to a close, many investors are sitting on some steep losses.”

In contrast, another focusses just on the last two months and says quizzically:

“We have an inexplicable market rally to explain.”

In their way, these two quotations sum up the roller coaster nature of the year, and its frustrations.

We have not observed steep losses close at hand, with our clients over the year.  But such pain, which we might define as losses of 30%+, were certainly out there, and not always where you might expect.

Painful losses were predictable and widely anticipated in the Ponzi-esque crypto universe, and falls have exceeded 60%, with much worse for some.  FTX had 1 million clients, and a $32 billion valuation evaporated in days. FTX is just the latest crazy example, more will follow.

Bizarrely, it is the collapse in some “low risk” assets which has been the real shock in 2022, in particular, UK government bonds and index-linked bonds, ordinarily one of the quietest corners of the investment universe.  At one point falls exceeded 50%.  This kind of shock is very much an end-of-cycle phenomenon, as the weak points in the world’s financial plumbing are revealed – and it is a world problem, the UK aberration merely being the first reveal.

In 2023 you should expect similar collapses, derived from a mix of fraud, mis-sold financial models reliant on fictitious maths, and zombie companies built on sand piles of debt.

Why?  Because of the extreme vulnerability that has been created over 40 years in financial markets and economies.

 

Badges Of Continuing Vulnerability

The badges of that vulnerability have been the valuation bubble in the US (which has barely changed in 2022), and the investor mania.  That investor mania still simmers, and explains the “inexplicable market rally” of the last two months.  That such a “buy the dip” state of mind has not yet been eliminated informs us that the bear market, the downturn, is far from over.

In October we thought stock markets were breaking lower (in the US and UK, among others) but they turned around and went up, based on some fairly lightweight news on US inflation.  This is not what happens anywhere near the end of a bear market, certainly not the scale of a bear market which is needed to clear out the dead wood at the end of a multi-decade uptrend.

 

So the extreme vulnerability remains, and the risks continue to grow.

Events in China in recent weeks have added another degree of uncertainty to markets – as if we were lacking!  We went from more lockdowns one week, to widespread riots the following weekend, to the easing of lockdowns and zero-Covid being announced this week.  And a pause as we write.  Does this matter to you?

 

China is an extremely important cog in the world economy.  In 2008, as the world economy looked into the abyss, China introduced a huge stimulus package which was vital in pulling the world back from the brink.  They have contributed an out-sized 30%+ of world economic growth in most of the last decade.

The world needs a Chinese economy firing on all cylinders, which means without lockdowns and social unrest.  No lockdowns will, at least initially, please the predominantly younger people on the streets – but China is fundamentally unprepared for the surge in Covid infections which will rip through the country.  The quality of vaccines is unclear, there have not been the requisite 6 monthly boosters, and their health service has woeful intensive care coverage.  It feels like a health accident waiting to happen.

A few weeks ago President Xi went to great lengths to show a softer face to the world.  With the Covid uptick, and social unrest last weekend, this is already under threat.  He now needs a lot of luck to get through to next Spring without one of two extreme outcomes: either social unrest combined with severe lockdowns or millions dying because there is no effective lockdown.  Sadly, the markets are placing their bets on the latter outcome as they feel it would be best for the rest of the world, as their economy would stay largely open.

 

The 40-Year Uptrend Is Rolling Over

The FTSE100, the one we all tend to focus on in the UK, has gone nowhere over the last 5 years, up just 3%, and the more domestically focussed FTSE 250 index is down 3%.  The German index is a bit better, up 9%, but not much.  China is down 3%, Japan is up 29%.  The US stock market, driven by a crazy investor mania, is up 50%, though we fully expect this to be wiped out.

Over just the last year, the FTSE 100 index has moved more sideways than down, though this can change quickly, and has done on occasion in 2022. This has, to a considerable extent, been driven by investors buying this index’s global commodity stocks, a rare bright spot in the last year.

Many indices are not so benign, from the S&P 500 in the US, or our own FTSE 250 index and UK small companies – they all remain in clear downtrends, despite the bounce since mid-October.

Yet most such downtrends have developed in an orderly fashion in 2022, without a scary global crash in stock markets. Bearing in mind the determination of the Federal Reserve to get rates higher, an unfolding global recession, elevated geopolitical risks, and a persistent US valuation bubble, this is surprising.

It is this lack of a more determined downtrend, and regular bounces, which have also frustrated those betting on lower prices.  For them, so far, it is the wrong kind of bear market.

In a nutshell, if you took a strong view on markets in 2022, whether up or down, it was a “A Year Of Pain”, as the FT put it

 

Complacency Persists – DIY Investors

For all of that talk of pain, particularly for investors taking more focussed positions (and thereby more risk), for most retail investors the year has probably not felt that bad. That can be a problem as it breeds complacency.

Those retail investors will fall into one of two camps, either DIY or advised.

If they are DIY, or self-advised, the last 40 years have “taught them” that sitting tight is a good plan.  But most of these investors do not have the historical perspective which is now vital.  When a stock market has been driven to extraordinary peak valuations by an investor mania, falls of 50% are the minimum expectation.  When that stock market is the US, by far the world’s biggest, this will get uncomfortable for us all.

This is the vital lesson at a personal level.  As a DIY investor you have to unlearn what the last 40 years “taught” you.  Things like “buy the dips” and “the markets always bounce back”.  Of course markets always bounce back, at some point.  But will they bounce back from the current reset, which remains in its early stages, in a timely manner which fits your life plans?…

Remember “The Japan Problem” which we have frequently highlighted in recent years.

Their stock market has been down for more than 30 years. It suffered falls of 80%+ at worst, and is still down nearly 30% – after more than 30 years! If you were living in Japan in the late 1980s you probably had most of your investments in Japan, your home market – your financial plans were devastated.

The market is brutal in confronting investors with the fact that they are often wrong. It will always probe for basic human weaknesses – greed and fear, vanity and ignorance.

The point is not to get complacent about stock market returns. They won’t be delivered to you in a nice neat package with a ribbon, which happens to coincide with the timing of your life plans.

Such complacency is persistently encouraged by our industry, who are always trying to sell you the dream.  This is a good point to move from the perspective of a DIY investor to one who is advised.

 

Selling The Dream, Making Up The Maths – The Adviser Problem

Our industry is a huge sales machine, always selling the dream.  Apologies to those fund managers or advisers reading this who don’t fall into this category, but you are the exception.

You might be surprised that to this point we have mentioned neither inflation nor recession, not even the dreaded stagflation.  Why?

Stagflation is nasty, but precedents are few.  Knowing that we are in such a period helps you as an investor to a point – you know that it is likely to be dangerous for financial markets and that you must keep your guard up e.g. be ready to apply stop-losses and/or have a much bigger weighting to cash that you would ordinarily.  But it does not inform you precisely which investments you should emphasise, nor when.

Volumes are written about whether or not we are now in a recession.  The UK and much of the developed world has probably been in recession since the Spring, with the first energy price shock changing people’s behaviour – which is precisely what triggers a recession.  But again, knowing that wouldn’t have provided practical guidance on precisely what to do and when.

It is the same with inflation, but even worse.  The overwhelming volume of analysis includes a myriad of projections based on mythical maths models.  They tell you nothing useful about precisely how you should be investing, but are a considerable distraction for advisers.

Lord Mervyn King, whom some of you might recall when he was governor of the Bank of England, talks of “radical uncertainty.”  Essentially the models used by economists, central banks, and institutional investors, are doomed to fail, he tells us.  He should know.  Similar comments have been made on many prior occasions, as far back as the 1920s by JM Keynes.

Why are they doomed to fail?  Because the environment which they try and model is so complex, and so full of hidden risks (the unknown unknowns) that no maths, however smart, can get even close to the reality which they try to mimic.

That is why financial markets blow up every so often – certainly more often than any of these models would have you believe they should.  It is why in 2008 financial markets were on the edge of the abyss.  In the UK we were within hours of cash machines on our high streets having to be shut.

Again this Summer, when Kwasi Kwarteng was supposed to have, almost, blown up the UK pension industry and gilt market.  He did a few silly things, but that cannot be laid at his door.  The problem was financial institutions full of clever people who could create oh-so-clever models to solve the (unsolvable?) problem of guaranteed pensions, and who sold these into the desperate but naïve pension schemes.  The maths was wrong, the model blew up, and a big problem remains. (For the avoidance of doubt, the shock downturn in UK government bonds began in 2021, when most people had never heard of Kwasi.)

If you use an advisory firm, the problem is that the only “research” which most of them read is based on this sort of bad maths and dodgy economic assumptions.  This, combined with little or no historical perspective, means they are too often blinded to the real risks in financial markets, which is a problem as we look into 2023.

Of course, it could be different if your adviser had a long-term commitment to truly independent in-house research.  Sadly that is an exception amongst advisory firms.

 

Complex World, Simple Solutions

This isn’t an advert for DW.  As a regular reader, some of you over many years know that we have a fundamental commitment to just that research which is missing with so many firms. From these regular updates, to our very detailed TopFunds Guide, and including research notes back to the 1990s which still have great relevance today, such as “Opportunity Knocks Or Apocalypse Postponed?”.  For DIY investors a huge effort went into developing FundExpert, the online research hub of our sister company.

Now we have launched our discretionary fund management (DFM) service, based on more than 15 years of research, and four years of very hard work building up the team and technology to make this available to our loyal clients – we have a waiting list to join this, even though it has not been advertised yet.

 

Why is this discretionary service so important?

A successful investment strategy must have two elements, attack and defence.  The attack is how you select the best possible funds.  Following years of internal research, we identified objective processes for fund selection which generated a very high probability of better than average performance in the period after purchase.  The back-testing was extremely impressive. (See research in the blog we link to in 2 paragraphs).

The defence is how you protect the value of your investments, particularly against the sharpest and most prolonged falls (see The Japan Problem above).  The most straightforward and objective way to do this is to apply a Stop-Loss – you literally stop the loss, by selling when a fund has fallen by a certain amount, typically 10%.

Again our back-testing showed considerable success applying such a strategy.  You can see more details here “Stop losses and momentum investing, let’s look at the evidence”.

All of this was built into the launch of our research hub for DIY investors, FundExpert.  But to build it into the advisory service for our DW clients certainly could not be done overnight.  The nature of our service until 2022 meant that we had to contact clients for any and every adjustment to portfolios.  In applying our new research to client portfolios this would have been completely impractical e.g. emailing or ringing hundreds of clients at every portfolio twitch.

The answer was to ask the regulators, FCA, for permission to introduce a discretionary service, so we could act without continually asking for your permission.  That required considerable work:  building out a detailed business plan for their approval; researching the best investment platforms for this service; investing in new technology; enhancing the research team; employing new compliance consultants.  The list was a long one.

But we persisted, and received that discretionary permission from the FCA, because we believe that this will provide better outcomes for clients.  That belief is based on many years of painstaking research – it is based on the evidence.

Now is also the right time for this enhancement in our investment offering to you, our advisory clients.  On the one hand, in the world now unfolding we must be able to act quickly, and we can do that with this new discretionary service.

On the other hand, once financial markets settle (they will) we believe this could represent some of the best investment opportunities of our and your lifetimes.  That is very exciting, and our internal shopping list of opportunities and funds is growing.

 

We just need to be patient.

Two final points:

  • We remain cautious about financial markets for all the reasons set out above, and in a variety of formats going back for some time. But if you ever take a different view, and want to take more risk, please do say so.
  • If you want to hear more about the discretionary fund management service, please get in contact with your adviser.

 

FURTHER READING

Dennehy Wealth