Resisting the temptation to over-invest

A little more than seven months have passed since (11 March) the World Health Organization declared Covid-19 a pandemic and continues the navigation on sight in the globally acquired awareness that, since mass vaccination is not close, this unpleasant coexistence will last quite a while. The virus continues to spread and to make victims but the economic scenario appears unchanged and the stock indices are more or less at the same level as at the beginning of August. Let's see what are the key points of the economic picture and what conclusions can be drawn.

1) We are not facing an economic cycle. The trend of the financial markets in recent months has not been dictated by economic factors. That is, we have not witnessed the textbook recession: an economy that is doing so well as to generate growth to the point of euphoria; an inevitable correction resulting from overly optimistic expectations; after the contraction, a good dose of stimulus that allows the economy to restart and start a new cycle. Something different has happened in recent months. The correction of the markets was the daughter of a factor external to the economy (the pandemic) and the recession was a consequence, not a cause. It was the closure of shops and offices to limit interpersonal contacts that generated the recession, not vice versa. This contraction of the economy cannot be cured only with an economic stimulus but requires the control of the virus, therefore the arrival of a vaccine and the general adoption of preventive behaviors.

2) The pandemic will leave deep marks. The evolution of certain economic sectors, already underway before the pandemic, is set to accelerate. Large companies, for example, will continue to automate processes and procedures, streamline production and value chains. A large number of small businesses such as restaurants and shops will close their doors forever. For millions of people, tomorrow's work will be different from today's. This will involve the acquisition of new skills and therefore time. The expectation of a generalised "V" shaped recovery of the economy therefore seems optimistic.

3) Governments will have to do their part. The increase in public spending, in Europe and in the United States, will be crucial in the coming years to relaunch the economy. Europe has given a strong signal in this sense by rapidly launching a public financing plan that is innovative in its approach, structure and objectives. In the United States, upcoming elections prevent similar decisions for the time being. Neither of the two contenders wants to expose themselves before 2 November: the risk of giving an advantage to the opponent is too high. Therefore, we will hardly see a recovery plan before the elections.

This point deserves a clarification though. The interventions carried out so far must not be confused with a stimulus for the economy: it was rather a matter of support for citizens in the form of cash (especially in the United States and Great Britain) to meet basic needs. A way to keep the economy alive rather than to stimulate it to grow. Now, in the United States, these contributions have ended and the economy is facing problems that, at least in the short term, are difficult to overcome.

There are many sectors that will have to go through a painful, profound transformation. Let's take, just to give an example, cinemas, which have lost spectators and are now also affected by the scarcity of films produced, and football, which has so far been fueled by the big business of TV rights which is now going towards a downsizing. One of the consequences of this general contraction will be the reduction of the tax revenues of the states which, on the other hand, will be essential for the recovery, on both sides of the ocean. A nice puzzle, undoubtedly.

The impact of Zero interest-rate policies (ZIRP)

One of the key facts of the year was the massive rebound in the stock market from March to today. As we have observed in our newsletters, the historical analysis of the data indicates that, after market corrections such as the one that occurred at the explosion of the pandemic (never seen in terms of magnitudo and concentration on records), in over 70% of cases the market has tested new lows after a short rally. The rally that began on March 20 is therefore anomalous as well as objectively unfounded and can only be explained by the low level of interest rates, both in Europe and in the United States. Let's try to analyze the effects of this situation.

First, more obvious: a reduction in rates by central banks in itself exerts a stimulating effect on the economy (assuming industrial risk takers are willing to invest).

Second: low rates cause a decrease in the discount rate in the discounting of cash flows with a consequent positive impact on the valuation of shares. From a theoretical point of view, in fact, the present value of future cash flows increases, ceteris paribus, as the discount rate decreases. Leaving aside for a moment the considerations on risk and expected inflation, with lower interest rates the present value of the cash flows of investments increases.

Third: in absolute terms, a decrease in the risk free interest rate lowers the investment efficient frontier, so to aim for the same return it is necessary to increase the risk component. If the risk-free rate falls towards zero (or, in the case of real rates, it becomes negative), all absolute expected returns fall (for the same level of risk). To obtain the same return, it will be necessary to move to the north-east of the efficiency curve, passing the point of tangency, or taking an inefficient risk (a level of risk that is beyond the optima combination risk/return). This is a not so welcome and less obvious first consequence of zero rates.

Fourth: the reduction in rates and the consequent reduction in returns pushes valuations up. This practical implication is easily observable today. Trivially, the multiple of the S&P 500 earnings from postwar to today is 15.4 while now we are at around 23. This is another way to describe the impact of low rates on the price of investments. Low rates mean high prices for stocks as well as bonds.

All this does not prevent central banks from further lowering yields by buying bonds, which is also a way to keep the credit issuance market alive. In addition to lowering rates, central banks can buy government bonds, a phenomenon that, in the United States, has become particularly evident since March when the Federal Reserve announced the start of buying commercial debt too, but has been widely practiced since of the great crisis (2008) and, in Europe, from Mario Draghi's “Whatever it takes” (2012).

Because risk tolerance is now greater...

The need to go further along the efficient return on capital curve implies the assumption of a greater amount of inefficient risk. For investors (institutional and private), it is a novelty that partly explains the boom in private equity and venture capital even among non-professional investors.

Investors often remain anchored to return objectives based on past experience or psychological levels (rule of thumb) which, at this stage, have not been adjusted to the reduction in discount rates central banks opted for.

With zero interest rates, practically zero bond yields and a historical equity return of 5-6%, what are the alternatives for an investor who has set, for example, a 7% target? Inevitable answer: increase inefficient risk.

In this scenario, risk aversion is a difficult discipline to practice, while taking greater risks is considered more and more an acceptable behavior even if it involves going beyond the optimal risk/return point. The logical alternative would be to temporarily accept returns below expectations. In 2007, on the eve of the crisis, when we started advising that we should be 90% risk averse, there was a lot of resistance among our investors. Only in 2009, when market conditions began to clear up, did we start to be much more aggressive with the newly born Simplify 02, then recording a performance of 38% with minimal exposure to the market.

Investors today seem driven by a fear of missing out (FOMO), far superior to risk aversion or the fear of losing money, which could have unpleasant consequences. Being able to reconcile a fair aversion to risk, a reasonable participation in the markets and, above all, the patience to wait for the next big thing, as Steve Jobs would say, seems to be the most difficult thing to think and practice.

PS. In times of crisis, credit markets normally close their doors until pessimism runs out and investors return to making capital available to the system (ie buying risky bonds). Today, fortunately, this is the real news, central banks, especially the Federal Reserve, have ensured that the credit window will remain open. This will entice investors and lead them to look beyond the ford (and see the glass half full) when the next crisis hits. Credit is widely available today and bond issuances are at record levels. During the largest GDP reduction in history, hundreds of billions of new corporate bonds were issued and bought by investors - a new fact. In the next newsletter we will analyze the changes that have taken place in the stock market with the fork between tech companies and the rest of the world.

Best regards

Federico Polese

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