“That men do not learn very much from the lessons of history is the most important of all the lessons of history.”
– Aldous Huxley.
Wise man, Huxley. The financial markets are now brimming over with examples of cognitive dissonance. Observers in the West gaze in disbelief at the $200 billion provided by China’s state-owned banks to help prop up their equity markets. Those same observers are either blind to the trillions of dollars, pounds and euros that have been printed by western states to help prop up their bond markets – or they choose wilfully to ignore them.
Attitudes to the protagonists in the euro zone debt crisis are similarly conflicted and wildly illogical. The Germans are widely perceived to be the bad guys, and the Greeks somehow innocent victims of some kind of coup. But it is the Germans who have been virtually a lone voice in Europe warning of the risks of unsound money and credit expansion. It is only the Bundesbank and its diminishing number of “hard money” advocates in Europe who have fought to keep Mario Draghi’s ECB from abandoning sound money principles altogether.
A rich vein of unreality runs through the capital markets of 2015. The word “unhinged” barely does them justice. Doug Noland does an excellent job of chronicling the confusion. On the one hand, financial market participants hang on every word of our monetary policy-makers in anticipation of a tightening in interest rates – fully seven yearsafter the financial crisis reached fever pitch. On the other, there is barely any debate over the efficacy of allowing the most important price in the market, that of money itself, to be controlled by a small, private banking cabal. As Doug Noland shrewdly observes,
“..a promoter of asset price inflation sacrifices its capacity to be an effective financial regulator.”
It is all very well to identify the problem(s): too much faith in central bankers and not enough faith in free markets to direct capital to its most productive ends. But investors also require some kind of solution, some means of protecting their capital from the more injurious actions of monetary policy agents and guiding it towards more profitable havens.
The crowning irony of the current financial situation is that policy makers in conjunction with regulators have made traditionally safe assets the most unsafe investments of any. Western market government bonds no longer offer any attraction either in terms of income or capital preservation. They are simply instruments of confiscation yet to be fully recognised as such.
That clearly leaves equities as the preferred risk asset, by – and pardon the inadvertent but relevant pun – default. But what sort of equities ?
History offers some useful clues.
James O’Shaughnessy in his book ‘What works on Wall Street’ conducted extensive research on common stocks in the US market. Perhaps the most compelling strategy for delivering attractive long term returns came from value investing.
O’Shaughnessy analysed a 3,000 stock universe over a period of 52 years. For each year he identified the 50 most expensive and least expensive stocks by a variety of metrics. He then rebalanced that 50 stock portfolio each year, ensuring that only the most and least expensive stocks were retained. The results were instructive.
If you had bought the 50 ‘growth’ stocks with the highest price / earnings ratio, for example, after 52 years, a portfolio with an initial value of $10,000 would have grown to $793,558. That sounds like a decent return. Until you compare it with a portfolio comprising the 50 stocks with the lowest price / earnings ratio. This ‘value’ portfolio, with an initial value of $10,000, would have grown to $8,189,182.
If you had bought the 50 ‘growth’ stocks with the highest price / book ratio, the results were even more extraordinary. Your initial $10,000 would have compounded, over time, to $267,147. But if you had bought instead the 50 ‘value’ stocks with the lowest price / book ratio, a portfolio with a starting value of $10,000 would have grown, over time, to be worth $22,004,691.
A period of 52 years is a statistically meaningful period of time. The O’Shaughnessy study strongly suggests that over time, ‘value’ completely trumps growth. A bias to ‘value’ may not work every year, but it’s unlikely that any strategy will. ‘Value’ investing requires an element of patience, not least because it has much in common with contrarian investing, and it takes time for the crowd to appreciate, or be taught at its own expense, that it’s wrong.
But the problem today – for the conventionally minded – is that many traditional markets are expensive. The US stock market, for example, currently accounts for over 56% of the MSCI World Equity Index. Anybody benchmarked against the MSCI World is obligated to own US stocks to a greater extent than those of any other market. Robert Shiller’s cyclically adjusted price / earnings (CAPE) ratio for the S&P 500 index currently stands at 27.3. On a CAPE basis, the US stock market has only realistically been more expensive twice in history – once in 1929, and once in early 2000. Its long run average is 16.6.
Not all stock markets are as expensive as those of the US. Roughly 70% of the US market trades on a price / book ratio, for example, above 2 times. Roughly 40% of the Japanese stock market (which incidentally accounts for just 8.7% of the MSCI World Equity Index) trades on a price / book ratio of less than 1. So it should hardly be a surprise to learn that within our own fund, for example, Japan is our single largest country exposure. Or that Asia accounts for the majority of our holdings. Asia, by comparison with Europe, we would suggest, has, on average, superior demographics, superior prospects for economic growth, a far lower welfare burden, and a healthier banking system. At a time when headlines are dominated by the travails of the euro zone and a deeply indebted West more generally, the real investment news is quietly been made elsewhere.
