Information is everywhere. Sometimes it coalesces around an unexpected event that promises to change markets radically, like Brexit or the election of Donald Trump as US president.
While these events didn’t precipitate the sudden market downturn many expected, they have provided important investment lessons.
For example, reaction to Trump’s victory in November is a classic instance of speculation triggered by fear, greed and mixed investment signals. Analysts predicted the US sharemarket would post major losses, the futures market at one stage predicted the Dow to plunge by more than 800 points, and 10-year treasuries initially surged as investors looked for a safe haven.
The drop didn’t even last a day. Bond markets plunged in response to higher inflation expectations and investors pushed US shares to new highs amid expectations of higher growth.
Follow hunches at your peril
What is driving this optimism for growth? Many investors are making decisions based on Trump’s proposed policies, including massive corporate and personal tax cuts as well as new infrastructure and defence spending. This is expected to drive growth despite his anti-growth immigration and pro-tariff policies.
It remains to be seen which policies he ultimately sticks to and which ones get enacted but regardless, strong GDP growth rarely equates to strong sharemarket growth. In fact, a number of academic studies have even found a negative correlation between the two. Many long-term sharemarket investors in strongly growing emerging markets have experienced this phenomenon firsthand.
If anything, markets tend to be a leading indicator – they go down before economies crash and up ahead
of stronger economic growth.
Since 2009, the US sharemarket has posted one of the strongest bull runs in history on the back of one of the weakest economic recoveries on record. This was due to markets being incredibly cheap, interest rates being slashed and central banks scooping up billions of dollars in assets.
Now, the situation is vastly different. The US sharemarket is no longer cheap, interest rates are rising, and the quantitative easing tap has been turned off.
It’s rare to see a bear market start from already low valuations and a bull market start when valuations are high.
Take the predictable approach
Investors need to look through the current euphoria about potentially rising US economic growth and instead focus on a sound, predictable investment process.
This is one effective way to control the behavioural biases that affect all investors – even the experts. For example, a 2006 survey of 300 fund managers found that almost three-quarters believed they had delivered above-average performance.
Other common biases affecting investors include anchoring (letting irrelevant figures or events affect decision-making), short-termism (overweighting quick gains at the expense of long-term ones), or chasing trends (usually by extrapolating recent
results into the future).
Valuations should underpin investment
Market downturns have a variety of catalysts: a liquidity crisis, a tech-stock bubble, an Asian economic meltdown, an oil supply shock, even the escalating price of tulips. The list goes on and on and no one can reliably predict the next catalyst.
However, the vast majority of downturns do all share a common factor: they were preceded by expensive markets.
An investment that starts with a high valuation understandably sets the scene for a low probability of high long-term returns. Or, as Warren Buffett once said: “Price is what you pay. Value is what you get.”
A systematic process based on fundamental valuations should substantially reduce investors’ exposure to overvalued assets ahead of downturns. It often means leaving some money on the table in the short term as speculative markets race ahead, but successful investing is about far more than short-term returns, it’s about long-term risk management.
Unexpected events like Trump and Brexit are just bumps on the road but fundamental valuation criteria remain a major signpost on the path to investment success.
