“There may be trouble ahead
But while there's moonlight and music
And love and romance
Let's face the music and dance.
Before the fiddlers have fled
Before they ask us to pay the bill
And while we still
Have the chance
Let's face the music and dance.
We'll be without the moon
Humming a diff'rent tune
There may be teardrops to shed
So while there's moonlight and music
And love and romance
Let's face the music and dance
Let's face the music and dance.”
Human beings are good at enduring extreme conditions and surviving in a wide range of habitats. We have mastered tools, speech, fire-making and the wearing of clothing. But our brains are insufficiently evolved to be able to handle financial markets easily. That goes doubly so for bankers. Words are admittedly cheap relative to actions, but the late Sir John Templeton summarised the issue neatly:
To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.
Prepare for rewards. The problem, and it is a critical problem through our inability to handle longer term planning easily, is that those rewards will not accrue overnight, but will take time and patience to be delivered to investors with Sir John’s brand of fortitude. We are hard-wired, sadly, for the short term.
In James Montier’s authoritative Behavioural Investing (John Wiley, 2007), the author points to evidence from neuroscience:
...that real pain and social pain are felt in exactly the same places in the brain. Eisenberger and Lieberman (2004) asked participants to play a computer game. Players think they are playing in a three-way game with two other players, throwing a ball back and forth.
In fact, the two other players are computer controlled. After a period of three-way play, the two other ‘players’ began to exclude the participant by throwing the ball back and forth between themselves. This social exclusion generates brain activity in the anterior cingulate cortex and the insula, both of which are also activated by real physical pain.
Contrarian strategies [such as buying quality stocks now, just as deleveraging investors are tossing them into the waste bin] are the investment equivalent of seeking out social pain. In order to implement such a strategy you will buy the things that everyone else is selling, and sell the stocks that everyone else is buying. [There is not much evidence of the latter at present. This is called an opportunity.] This is social pain. Eisenberger and Lieberman’s results suggest that following such a strategy is really like having your arm broken on a regular basis...
Notwithstanding the huge losses incurred in almost every asset class during 2008, there is good news, of sorts, in the form of comparably huge government intervention. Legg Mason’s Michael Mauboussin suggests that the scale of what he calls global government mobilizations will make this downturn more akin to those of the early 1970s, early 1980s or early 1990s than to the Great Depression. Quite how bad the downturn will be is impossible to say. It is dependent, not least, on the hopes, fears and actions of millions of people currently having the wits scared out of them by media coverage of the markets that is little short of irresponsible.
Mauboussin also makes a good case in the income argument for stocks. It is worth recalling some historic data on the topic. Two centuries of investment returns from Anglo-Saxon markets indicate that annualised real returns amount to between 6% and 7%. More than half of that return comes from compounded dividend income. And as Mauboussin points out:
The current dividend yield on the S&P 500 is only about 25 basis points below the yield on the 10 year Treasury note. You have to go back to the early 1960s to find a similar relationship. If you add in share buybacks, the yield is about 400 basis points above the 10 year note yield, and that’s with buybacks down sharply this year. And excluding the financial sector – and that’s a big exclusion – corporate balance sheets remain in decent shape.
Another perspective of Mauboussin’s that seems, at face value, to be bad news but which is almost certainly extremely positive for current investors is the paucity of returns over the recent past. He charts the rolling 10 year returns for large cap stocks:
Over the past century-plus, the market has tended to bottom out around zero percent rolling ten year returns. That happened in the 1930s and 1970s, and that is where we are today. The rolling 10 year figure is worth examining for psychological reasons, too. If the average investor is in a mutual fund, they have lost money after taking fees into consideration. Further, most investors lose an additional 200 basis points due to bad timing. So on a dollar-weighted basis, the average investor has been down substantially in the US stock market in the past decade. That is very psychologically damaging.
Perhaps our most dangerous psychological weakness is the tendency toward extrapolation. When markets are falling sharply and we are invested in them, the natural response is mentally to extrapolate the trend toward extinction. One need only reflect on the market’s tendency towards mean reversion to try and withstand this psychological pressure.
But not all of us are interested in tracking the markets, particularly when individual stocks, on a selective basis, are starting to indicate terrific value. And to follow Mauboussin, there are probably worse strategies than treating genuine blue chip stocks (ex-financials) as income-generating instruments – bonds, if you will – and letting fate handle the longer term potential capital growth.
We know there is trouble ahead. If the most difficult thing psychologically is to grit one’s teeth, face the music and dance, and reap the prospective benefit of owning quality stocks at throw-away prices into the bargain, then that is probably the right thing to do.