“Life is lived forwards, but understood backwards”

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It must be open to doubt whether the 19th century Danish philosopher Kierkegaard was thinking of investment management when he produced his aphorism: “Life is lived forwards, but understood backwards”.  He might as well have been, however, as historical perspective is an essential and frequently undervalued ingredient in the formation of sound investment judgment.

Who can doubt that some of the worst excesses of the credit crunch could have been avoided had investors and issuers alike been fully aware of earlier episodes where derivatives and apparently secure bonds proved not to have a market value in conditions of extreme market dislocation? While Warren Buffett’s description of derivatives as “financial weapons of mass destruction” has obtained a wide currency, it is not so widely appreciated what he meant and how he arrived at this view.

His argument was not just that derivatives were complex instruments that few investors were competent to understand, but that in extreme conditions as liquidity dried up they would become impossible to value and effectively therefore worthless. While they appeared to diffuse risk, in practice they created systemic risk whose linkages even the banks that created them did not fully understand. His warnings foreshadowed precisely the problem that banks and investors are wrestling with today with CDOs, CLOs and all the other junk that is desperately trying to find a final resting home.

Buffett’s judgment was rooted in his own experience, including trying to unravel a complex bundle of derivatives that came after Berkshire Hathaway’s acquisition of General Re. (It would be no surprise, incidentally, on the basis of past experience, if more scandals like the one at Credit Suisse did not emerge once final 2007 banking results have been released and bonuses paid. No trader in his right mind is going to own up until to past misdemeanours until his bonus has been safely banked).

In the absence of direct experience, historical perspective is the only sure way to avoid such pitfalls. The latest edition of the ABN Amro Global Investment Returns Yearbook, researched by three London Business School academics, Elroy Dimson Paul Marsh and Mike Staunton, while it makes no predictions about the future, offers some characteristic reminders about the changing nature of investment returns across time and how they might develop in future.
 
It is true that the LBS findings about the power of momentum in investing, reported in FTfm last week, will not come as a great surprise to the professional investment community, although the scale and durability might.  The majority of hedge funds trade on what is essentially a momentum basis and few long only managers can afford to be unmindful of the dangers that come from failing to track current trends. If the first lesson of stock market history is that mean reversion is the long term norm, the second lesson is that many trends run on far longer than market participants expect, which in turn accentuates the pain that is frequently felt when turning points in the cycle are reached.

As the LBS professors point out, observers have been expecting a reversal in the dominant style themes of the last eight years, which have been value and small cap, for at least two or three years.  In the event, the themes continued to play well into 2007, only to suffer a violent reversal as the year progressed. Now that large cap and growth have picked up the running, it would be a brave soul who predicts that they will not now continue to lead for some time into the future. Historical experience certainly seems to point that way.
One striking finding from the LBS work is how powerful style factors can dominate market movements in absolute as well as relative terms. Despite the bear market of 2000-03, over the eight-year period 2000-2007, for example, investors in small cap stocks on average doubled their money in two thirds of the 21 largest markets covered by the LBS survey and trebled it in a third of them, while the world stock market overall struggled to produce a positive return.  

For value the story was similar, though less marked. Over the eight year period, the MSCI World Growth Index generated a minuscule positive return, while the Value Index generated 6.5% per annum and a positive return in all countries. After the final years of the 1990s bull market, when large cap growth stocks dominated the performance tables, the return of small cap and value was hardly unexpected.

The scale of the absolute returns they have produced has been. “What bear market?” is a legitimate question investors with the right style tilts might reasonably ask. It once more calls into question the opportunity costs involved in a benchmark/risk budget approach to portfolio management.

In the meantime, with oil at $100 a barrel and gold seemingly on the way to $1000 an ounce, the powerful upward trend in many commodities as yet shows no sign of slowing. The LBS professors note that mining, resource and utility companies together contributed roughly 100% of the UK’s aggregate, if modest, 5.1% stock market return last year. Banks, property and other financials contributed a negative 3%. The big unknown is which sector will play the part that tobacco stocks in hindsight played in 2000: unloved and yet destined to become to best performer of the subsequent eight years.


Jonathan Davis
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