Who said: “Investment results largely depend on how one behaves near the top and near the bottom” [of the market cycle]? The answer is Keynes, whose remark is quoted in a collection of some of his most famous comments about investment in the latest issue of the Journal of Portfolio Management. In my experience, that statement is broadly true, as indeed anyone who cares to think through the implications and study the evidence has to concede.
In fact, many of the world’s most successful investors, according to the studies I have seen, owe their outperformance of the market primarily to their performance during bear markets, when two factors typically come into play. One is minimising drawdown through anticipation of an impending crisis and the second is retaining the flexibility to take advantage of the valuation anomalies which severe market crashes invariably throw up. Both imply a willingness to hold cash in excess of normal levels during abnormal times.
Having come to believe it was right to ride out short-term volatility in the few high conviction investments he thought should constitute the core of a serious investor’s portfolio, Keynes thought the second objective was the more practical of the two. His view on bear markets, quoted in the same issue of the Journal of Portfolio Management, was: “In the main, therefore, slumps are experiences to be lived through and survived with as much equanimity and patience as possible. Advantage can be taken of them more because individual securities fall out of their reasonable parity with other securities on such occasions, than by attempts at wholesale shifts into and out of equities as a whole.”
Keynes himself had abandoned his early belief in credit cycle investing, a form of early tactical asset allocation, after finding it unworkable. But while his statement about the importance of behaviour at the top and bottom of market cycles is evidently true, it flies in the face of current conventional investment thinking, which asserts that market timing is a futile exercise, and that investors should not, in any circumstances, move too far from their broad and pre-determined asset allocation parameters.
Given that many investment managers and advisers expressly deny themselves the opportunity to move into cash to any significant degree, they remain vulnerable to market corrections. Institutional holdings of cash tend to be at their lowest at the big downturns in the market cycle and relatively high at the low points. The comforting rationale is that calling the turning points is impossible to achieve with any precision, as market returns cannot be forecast over periods of one to two years.
Nobody would dream of saying that calling the turning points in the market cycle is easy, and it can certainly never be done with precision. If it were, more people would do it, and the cycles themselves would not be as extreme as they are. But does that mean that the effort should be abandoned altogether? Professional investors, some might say, are prone to shy away from hard decisions that could make a big difference, in favour of less demanding ones that do not. Regulators, meanwhile, remain wedded to simplistic and unrealistic risk models that not only fail to mimic reality, but positively encourage market participants not to pay attention to that reality.
As the man who first thought up the beauty contest metaphor for professional investment, Keynes himself was under no illusions about the shortcomings of conventional thinking. Yet were he alive today, he would surely have something to say about the fact that turning points in the market cycle remain such a neglected area of study, something for which short-termism, momentum investing and the cult of relative performance have a lot to answer. As the post 2009 market recovery appears to be stalling, the year of 2011 is likely to prove to be a good year to start remedying the defect.
One of the highlights of a recent trip to New York was a visit to the recently refurbished Morgan Library and Museum on the corner of Madison Avenue and 37th Street. Entering the study where JP Morgan famously corralled the leading bankers and trust directors of the day to hammer out a solution to the 1907 stock market panic one is reminded of the extraordinary power and wealth that individuals could accumulate in those days of rapid but haphazard economic growth, at a time when government intervention was minimal.
Standing under the watchful gaze of Mr Morgan’s favourite portrait, one that disguised his horribly disfigured nose, and looking around at the marvellous surviving pieces from his collection of early Renaissance art, prompted several thoughts. One is to wonder why nobody has ever made a film about the 1907 market panic. The denouement in that crisis, with Mr Morgan locking the participants in his library and sitting in a side room playing patience into the small hours while waiting for the assembled crowd next door to agree on a rescue package, would surely be as riveting a scene as any recent examples.
Jonathan Davis 