Ardevora Quarterly Review - Third quarter 2018

It's the End of The World as We Know It (And I Feel Fine)

This is supposed to be a review of the third quarter of 2018, but October has rather overtaken us. Global stock markets are in a panic and October falls have erased the ephemeral gains for the year. From our perspective the behaviour of only one of the three blocks of people we try to track has changed: investors.

When you have lived through a lot of ups and downs of stock markets like me, you tend to trawl your memory banks for reference points when something out of the ordinary happens. It is called the Representative Heuristic, and is one of the ways we try to cope with fuzzy, complex problems. The Representative Heuristic is a good way of dealing with complexity if you have a big bank of relevant experience, but it can also be a profound source of bias if your experience is shallow, or you rely on a memory which isn’t relevant at all. Whether the Representative Heuristic is a source of bias or help is essentially a debate about the usefulness of history: does history repeat itself or do we just try to make sense of inherently unpredictable current events by over-fitting them to the past, regardless of logic?

We believe in the usefulness of history as long as one approaches it carefully, logically and you don’t get dazzled by the Affect Heuristic. The Affect Heuristic is the tendency to focus on similarity of outcome rather than similarity of causes, as a reference. With all of this in mind, what is going on now feels a lot like 1987 to me, so let’s explore this Representative Heuristic a little and see if it is or isn’t just a bad case of Affect Bias.

What happened in 1987? I remember belting out the REM song, “It’s the End of The World as We Know It (And I Feel Fine)” whenever it came on the car radio. The first episode of the Simpsons was aired; it’s still going, so no change there. They started building the Channel Tunnel; it doesn’t look like we’ll be needing that now. There was the great southern British storm and I woke up to find my car under a tree, which was traumatic for me, but otherwise completely irrelevant. The first criminal was convicted on DNA evidence and the first drug for AIDS was discovered; now DNA research is spawning an explosion of R&D in the drug industry. A US frigate was attacked by Iraqi missiles; reminding us how long the Middle East has been a source of angst. And stock markets crashed around the world.

My memory of the violent stock market crash was it seemed to come out of nowhere. Afterwards, metaphorical fingers were pointed at a small rise in German interest rates and the role of automated trading programs called portfolio insurance. There wasn’t any obvious economic trauma building, just an overheating housing market, a bit of a pick-up in inflation and some gentle monetary tightening in a few places. This is why my Representative Heuristic draws me to 1987.

Back then I didn’t think in terms of investor, analyst and management behaviour. I was still young and naïve and believed in dividend discount models, accurate forecasts, macroeconomics and rational man. Now I know better. Most problems in stock markets, in my experience, stem from the herding of management behaviour. Company managers get over-confident and reckless and over-invest in the pursuit of growth, while assuming recessions have been banished. They overpromise, under-deliver and so mislead analysts (who generally trust them) and investors (who forget they are generally not to be trusted). But sometimes investors operate in their own bubble. In 1987 they drove the stock market up on the same “news” they then drove it down on. It was blamed on a belief stock markets could be turned into riskless investing by portfolio insurance. The result was a strangely strong stock market in the first three quarters of the year and then a violent “correction” in the fourth quarter. As stock markets fell, a feedback loop of anxiety kicked in: investors worried whether the falling stock market was either signalling an oncoming recession, which no-one had seen coming, or would actually trigger a recession through negative wealth effects. Such is the circularity of ad hoc causation. A year later stock markets had crawled back to their highs, before climbing for another three years. On a long-term chart of stock markets, 1987 looks like a blip. But it didn’t feel like it at the time.

There is a lot of the 1987 background which seems to feel familiar now. No-one is really worrying about an imminent recession. In fact most worries focus on the potential for inflation to accelerate, hence some tentative interest rate rises; just like 1987. Company managers don’t seem to be over-exuberant, or overconfident. Most companies are not delivering surprisingly awful results triggering large forecast misses from analysts. Investment robots also seem to lurk. Portfolio insurance trading has been replaced by a market dominated by “smart” passive investing in thematically driven ETFs, Smart-Beta and Risk-Parity. Pockets of stocks burst into accelerating momentum and then out-of-nowhere short sharp selloffs. It’s not quite the same as 1987, but the mechanisms feel familiar: automatic buying/selling based on nothing but a stock price and a description; investor behaviour with an unusually elastic tether to the underlying success or failure of companies and their management.

We don’t subscribe to the view that history endlessly repeats itself. We do believe it can repeat, but in different clothes. Our instincts tell us we are in a rough, violent period for stock markets. It seems likely we will have some more terrible feeling days/weeks but we would expect to feel a lot better in six months’ time. Investors will have been scared, scarred and we can get back to a healthy environment of scepticism for everyone.

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Previous Commentaries

Quarterly Commentary Period ending June 2018
Quarterly Commentary Period ending March 2018
Annual Commentary Period ending December 2017
Quarterly Commentary Period ending September 2017
Quarterly Commentary Period ending June 2017

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