The majority of investors’ frameworks are based on their most recent experiences, which can make them quite easily forget what they used to believe in, particularly when their fundamental views have been profoundly challenged.
This can cause an environment of ‘loose anchors’ in financial markets, where people lose their sense of what fair value for an asset is because they have just experienced something they did not consider plausible previously. In this situation, it is harder to maintain high-conviction gravity of beliefs based on economics.
When markets have loose anchors, prices can go anywhere, as we have seen in the most recent phases of government bond volatility. This happens when investors have long-run ideas about a trading range – for example, what is plausible for bond yields – which is contradicted by short-run trends persisting for longer than they expected and morphing into their long-run views. This means people end up adjusting their beliefs without realising it; they respond to what they have just experienced and give up on rational approaches.
This provides part of the reason why momentum strategies can work for certain periods while markets adjust to a ‘new normal’. For example, during the dotcom boom of the late 1990s, technology stocks continued to go up beyond the point that was justified by fundamentals, amid a growing sense that the old rules of equity valuation no longer applied.
There is a strong emotional pull to backing a winner. It is far more psychologically comfortable to buy assets that have recently performed well than it is to buy assets that have experienced significant declines recently. The problem is that prices can keep going up longer than is expected in an environment of loose anchors, but it is very difficult to accurately predict when this rally will eventually come to an end. When there is a very low level of conviction about where valuations for anything should be, asset prices can move violently and suddenly in either direction, as the eventual bursting of the dotcom bubble illustrated.
Timing isn’t everything
Trying to time the market is dangerous, too. Investments should be made on a long-term basis supported by fundamentals. There are always three key variables to any investment: the price you buy at, the price you sell at, and the nature of the journey in between.
Of these, investors can only ever be certain about the first. As future unknowns, the other two are highly unpredictable. Energies and resources can be better spent researching and analysing the current prices of assets.
This focus on valuations is far more likely to put the odds in an investor’s favour than trying to anticipate the path an asset will take to arrive at its fair price. It is dangerous to trade on the idea that a price is wrong; identifying an asset’s true worth, and therefore whether or not it is currently mispriced, is a complicated enough process. Attempting to predict when exactly that mispricing will correct is most likely impossible.
A framework based on observable facts about where asset valuations are today versus where they have been in the past creates rigour and discipline. However, it should not mean trying to create a mechanistic approach. There is danger in being too anchored, especially when the market has very loose anchors.
Therefore, it is key to overlay valuation analysis with questions about why valuations might have moved away from long-term averages. Sometimes the answers lie in shifts in the fundamental economic facts. But more often, it is a shift in sentiment – which is less likely to be permanent and can present compelling investment opportunities for those with the fortitude to take them on and the patience to see them out.
Investors are more likely to be successful buying assets that have fallen in value than chasing the consensus into overpriced assets as they become more and more expensive.
It is important to acknowledge that the market can be wrong about something fundamental and can keep being wrong for a long time. Illogical price movements can happen and markets can go anywhere for longer than you might think. So investors still get surprised, but they should expect to. However, being ready to respond to that is key to navigating an uncertain environment.
Steven Andrew is manager of the M&G Episode Income fund
