Author archives: Alex Jamieson

The economic cycle of the herd

Alchemy has been around for centuries. It is based on the notion of being able to convert base metals into gold. For centuries, man has pursued this idea with a view to benefiting or making money from this mystical art form – with little success.

Market cycles and technical instruments to some extent follow a similar purist idea that one instrument, or collection of instruments, could potentially be created to accurately forecast the future direction of the markets, resulting in endless riches for the owner of this intellectual property.

What we know is that over time, the market does provide a wonderful, rich history of learnings and teachings, and when applied, these can be helpful. One example is when similar events take place, such as the 1918 Spanish Flu pandemic, compared to the COVID-19 pandemic just a little over a century later.

We see whispers of history repeating itself with varying degrees of accuracy, but like water, history’s liquid nature makes any firm footing difficult as a sense of reliability to make accurate calls on the markets. The resemblance of the 1908 banking panic compared to the 2007 GFC almost 100 years later was just not exact enough to use for widespread timing points or any scientific scrutiny of academic standing.

This makes the cycle-work and technical indicators part-art form, part-data science, part-probability analysis concoction. The reality of being exact in nature is a fluid idea compared to scientific precision of academic analysis.

The problem of technical indicators becomes exacerbated with the backdrop of high-frequency traders; algorithm traders spend millions on data scientists and programmers. They have already programmed in stop losses of 10%, 20%, and other round numbers, Fibonacci retracements, resistant and support lines – yep, they are also likely to be in there too. Today, they just playfully twist these indicators with large sums of money to potentially profit from them, taking the opposite viewpoint of what investors might do. One only has to take a skip across the Pond to look at the crypto market to see this in its extreme form; the US Justice Department has been investigating this area of the market for some time.

The question of not so much whether the rhythms of history should be discarded entirely, rather it’s a case of buyer beware coupled with a fair amount of common sense, logical thinking, and some expertise.

The notion of an ‘economic clock’ is one that has popped up through history as the idea of an exact instrument that helps investors to understand the cycles of the market. The US National Bureau of Economic Research cited that since 1854 there have been 33 business cycles, which follows a typical boom-bust scenario.

The accuracy of these changes in the market environment are not quite as exact as a Swiss watch. Take the inverted yield curve, which has historically been a bellwether indicator as a precursor to a recession since 1970, puzzles academics. Will its winning streak continue, or will it be twisted by some algo trading team in future years? A paper by Jonathan H. Wright, conducted by the Federal Reserve struggled to explain using scientific reasoning why they occur and like crop circles, it’s a puzzle that has perplexed academics for decades.

Historically the focus on the economic clock has often been on smart money or sophisticated investors, with less focus on the ‘herd’ or the mum-and-dad investor psyche.

An interesting trend we have observed has been the recurrence of ‘the economic clock of the herd’. The notion that less sophisticated investor/s follow a well-trodden goat track through the boom–bust business cycle is an interesting one to explore.

The idea is that during times of panic, the herd will rush to cash/fixed interest and gold, then as things start to improve, the economic landscape often has lower interest rates and banks are encouraged to start lending to stimulate the economy. Being hurt by the downturn, these investors will move towards hard assets such as property. As the economy starts to get into the later stages, they will start to pivot towards the high returns of shares, only to repeat the process over and over with varying degrees of success.

It is an interesting concept and, like the market signposts, with the whispers of time it will be interesting to see if this cycle holds some resemblance. Keep in mind, though, that like any stampede, the herd’s pattern is not where the smart money is headed – they’re off to greener pastures and this may explain the divergence of wealth creation. But it’s a puzzle we have not unpacked to date.

I would not recommend you try using technical indicators or market-cycle instruments due to their unreliability and not having any academic standing. It is important you seek professional guidance from a practising and suitably qualified financial planner that meets FASEA education obligations, such as AJ Financial Planning.

AJ Radio – Episode 27 (Recorded 29th April 2020)

In this 27th Episode of AJ Radio, we discuss the effects of COVID-19 pandemic on the markets. We explain what history has shown by way of patterns in panic behaviour and the bell curve response. We also share insight on how you can take advantage of opportunities in the present landscape and what this might mean for your investment portfolio.

AJ Radio – Episode 26 (Recorded 18th February 2020)

In this 26th Episode of AJ Radio, we reveal the latest acronyms the investment market love to use to summarize key investment opportunities. We also look at the year ahead and discuss interest rate projections and what this might mean for your investment portfolio.

AJ Radio – Episode 25 (Recorded 10th December 2019)

In this 25th Episode of AJ Radio we discuss the success and horror stories of speculative investments. Learn the top tips, how much to allocate in your portfolio, and the warnings signs you need to know to ensure you can eject at the right time!

Is your super fund using performance-enhancing drugs?

These days whenever I watch sport, I can’t help wondering whether the competitors that win are using performance-enhancing drugs. I think ever since the Lance Armstrong saga a number of years ago, many people are now sceptical of sport, particularly when there are large amounts of money on the table.

My suspicions were again aroused recently when I read an article in The Wall Street Journal. The journalists reported that Nike may have been directly involved in performance-enhancing programs or doping of their track and field athletes (see article).

There’s no doubt that drugs in sport gives players an unfair advantage over their competition. It’s certainly not a level playing field when the majority are not taking drugs and then somebody comes along and cleans up the trophies and the money because of artificial enhancement of their performance.

The problem can then progress over time to a situation where such a large proportion of the field is taking performance-enhancing drugs, anybody who is clean does not stand a chance of getting on the podium. The Lance Armstrong scenario is a case in point.

But what does all this have to do with superannuation? Well, recently APRA finally commenced its enquiry into the classification of superannuation investment options, such as which assets should be classified as defensive and which should be classified as growth.

So why is this such an issue?

Well, think of it like the performance-enhancing drug situation. You have a group of competitors (super fund asset managers) that are all abiding by the rules with 50% growth-based exposure and 50% defensive-based exposure portfolios. They all refer to them as ‘balanced’ and are competing on equal terms.

Whichever fund ‘wins’ the title of top-earning super fund receives the fame, the glory, and more importantly the cash influx of new investors joining the fund.

Then a new super fund asset manager comes on the scene that might say something like this: ‘Definition of growth exposure and defensive exposure is nonsense …” As a result, this fund manager believes it can break the rules and use what I will term ‘performance enhancing stimulants’ to boost its fund’s returns.

So while on the surface the fund manager might be calling the fund ‘balanced’, in reality, it puts very little exposure into defensive assets; in fact it reduces it down to, say, 10 or even 0%.

As you can imagine, the returns are higher, the fame and glory follows, and around $2 billion or so of new investor money rolls in the door. All these new investors think this is great; they are in a balanced fund and look how great the returns are. Yet these investors are unaware of what the fund might be doing with their lifetime savings and all the extra risk that comes with this investment option.

Now other fund managers might think this is unfair, and with the stakes so high, they also look to inject performance-enhancing stimulants into their portfolios too. Before long, we have moved onto phase two as I outlined above in the example of Lance Armstrong: whereas before just one fund tried it; it becomes prevalent to the detriment of investors.

In fact, this issue is happening right now, with a large number of industry superannuation funds having exposure to growth-based assets.

Will this end in tears? When it comes to investing, if it sounds too good to be true, then usually it is – but only time will tell.

I believe when a person chooses an investment option, it should be reflective of what they are expecting and should also be protected by regulator guidelines around what mix of assets can provide long-term conservative, balanced growth.

Unfortunately, it might be some time before this becomes a reality, so until then we are left to navigate this maze of performance-enhanced fund managers, and try to figure out which investment to choose that best matches your goals.

If you are trying to decide what investment options you need for your superannuation, I recommend you seek professional guidance from a suitably qualified and practising financial planner and of course, I recommend AJ Financial Planning.

AJ Radio – Episode 24 (Recorded 9th September 2019)

In this 24th Episode of AJ Radio we explore the world of ultra low interest rates, what this means for the future, and where investors can get a decent return.

Will QE tear apart Australian society?

These days formulating monetary policy, which is set by the Reserve Bank of Australia (RBA) and other central reserve banks such as the US Federal Reserve, may give the impression that it is a sophisticated process and an exact science. It’s reasonable to think that these micro-adjustments of interest rates are to ensure that our economy will stay healthy and that the changes are set to perfection.

If we were to put together a list of criteria that we thought could be the objectives of the RBA and other similar operations around the world, it would be fair to consider the following four factors to be important to decision makers:

  1. A stable and positive economic environment.
  2. A stable and positive employment and wage situation.
  3. A stable and fair cost of capital, for borrowers not paying too much, and investors or lenders being fairly rewarded for the risks they take on.
  4. A stable housing market where ownership is available to the average Australian in key capital cities.

If we take a scientific approach to this broad range of criteria over the past 100 years, the question arises as to whether they are being met over the long term. Or are we just see-sawing through the boom–bust–recovery–repeat cycle?

It is fairly early days, but questions are starting to be asked about monetary policy:

  1. Are the interest rate changes by the RBA (and others) a blunt instrument or a precision tool?
  2. Does the changing of interest rates discriminate between segments of the population?
  3. Are there more effective methods to regulate the economic health of our nation that should be applied first?

Let’s take a simple and recent example. Typically, when a housing market or economy got too heated, in the past the RBA would step in and gradually increase the cost of capital on borrowers by raising interest rates.

Now, the trade-off with this is that households are affected – and some might say hurt – financially. People on very tight budgets find they struggle to make ends meet, whereas people on high incomes who have surplus income are possibly less affected. The flip side of this is that lenders and investors make an instant higher rate of return on capital, either through loans, a term deposit or other fixed-interest investment.

The question is, has monetary policy targeted or discriminated against a specific group of the population, or was the pain felt equally across society for the greater good?

In more recent times we saw a change of approach, which I am not sure was deliberate but it highlights why I believe we should be thinking about this problem a different way.

Recently we saw APRA step in and raise the service rates that banks apply to evaluate a loan. The interest rates for existing borrowers did not change, yet any new borrowers, who were likely to be buyers of property, are now subject to a tougher lending regime. These new borrowers do not pay a higher interest rate, but are subjected to much tougher lending criteria.

This subtle change might have been one of the key reasons for the cooling and then stabilising of the housing market, which had started to overheat. If borrowers collectively can’t pay more for property, then prices will naturally adjust to meet this new status quo.

So was this approach more equitable for the citizens of Australia than the change in interest rates as in the earlier example?

At the time of writing this article, the market is forecasting further interest rates cut by the RBA, which will drop rates to ultra-low levels.

If this strategy plays out, it will likely favour anybody who has a home loan, but disadvantage anybody who wants to get a return on their retirement funds. It will certainly place tremendous pressure on retirees who invest capital into the markets to obtain a reasonable rate of return on the fixed-interest part of their portfolio.

My issue with this kind of monetary policy is that it directly and unfairly targets segments of the population.

The reality with monetary policy is that in most cases it is not black and white. Each change has a widespread knock-on effect on the economy and on citizens. Not enough work has been done in this area to properly consider these effects and ensure a socially equitable outcome.

Today the RBA cash rate sits at 1%. If the status quo of the boom–bust–recover–repeat cycle continues, we have historically used around 3% in cuts to interest rates when a meltdown occurs. So we don’t have much to play with, as a 3% cut would take our RBA cash rate into negative. You only have to look at Germany and Switzerland to see the reality of negative interest rates – so it’s not as crazy as it sounds.

Right now, Australian and New Zealand are apparently considering the option of using Quantitative Easing – otherwise known as QE – as another tool.

In our view this would be the equivalent of a nuclear bomb monetarily and societally. The main reason I say this is that it is effectively ‘printing money’. The ‘treatment’ is to try to stimulate the economy by injecting massive amounts of liquidity into the financial system: rather like gulping down a Red Bull.

Like any ‘quick-fix’ medicine, there are always side-effects. With QE, one side-effect is that it can inflate asset prices both of property and shares.

In my view this is troubling as it can widen the wealth gap. People who have assets can benefit significantly, whereas people who have little find attaining assets becomes further from their reach.

Populations that have very wide gaps in social structure often results in unstable political environments and general societal unrest. One might refer to this as the ‘populism cycle’. Social unrest has a history of reoccurrence. We have already seen the effects of this around the world, where housing becomes unaffordable and making ends meets becomes an insurmountable challenge.

Hopefully, before the RBA pushes the red button, there will be some widespread, open and frank discussion with decision makers and the Australian people about QE.

I would be bold enough to say, in fact, that a referendum on QE should be held, so that society is informed before this tool of mass destruction is unleashed.

Getting a return on fixed interest these days is fairly challenging for the average investor. If you are worried about where to get a decent fixed-interest return and what options might be available, I recommend you speak to a suitably qualified, practising financial planner and of course I recommend you contact AJ Financial Planning.

Australian Super’s Elephant Gun Problem

Back in 1987, Warren Buffet made the following statement in a letter to Berkshire Hathaway shareholders: ‘Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun …’

Before you gasp in horror, the elephant he was referring to was a metaphor for the purchase of a large business, and the gun meant having the available cash to transact quickly when others cannot, or if there are concerns about the future due to economic uncertainty (such as a share market crash). Historically, Warren has been able to secure such purchases on very favourable terms and a large number of them have proven to be very profitable.

In his letter he went onto say: “If we find the right sort of business elephant within the next five years or so, the wait will have been worthwhile.”

More recently Warren has routinely explained to shareholders at Berkshire Hathaway’s annual general meetings and at media interviews that as a company gets larger, it becomes harder to outperform the market. The company’s 2018 annual report valued its portfolio at around US$172 billion. Yet one only has to look at Berkshire Hathaway’s share price to see it has underperformed on the S&P index by around 15.28% over the past five years. So it would be fair to wonder whether the company is starting to come under some pressure for its performance. It is unclear if this is a long-term trend, or simply that the market has not had a crash for a long time, to allow Warren to deploy his elephant gun.

In portfolio theory we talk about the law of large numbers, and the main reason fund managers that are providing “active management” understand their limitations with the size of assets they actively manage. In a lot of cases, the good ones simply close the fund to new investors at some point as the fund cannot handle unlimited amounts of capital.

There are a few reasons why this law persists in our industry. The first has to do with position size. Let’s take a portfolio worth around $1 million. If you purchase an investment option worth around $10,000 and it goes up by 30%, you might say ‘Hey, what a great return!’ Well, not really. You just gave yourself an administrative stomach-ache. The return, although good, only moved up the value of your fund by 0.3%. As the size of the portfolio gets larger – say $150 billion plus – your ability to buy a large enough stake to make a worthwhile return gets harder and harder.

Another aspect of this law has to do with being able to move capital around in the portfolio. With such massive position sizes it can sometimes take six to twelve months just to sell out, which creates some questions about being nimble in a quickly changing market.

The third reason has to do with inflows. Each year a huge amount flows into Berkshire Hathaway from dividends of listed companies that Berkshire Hathaway owns and all the profits from the private companies they own too. Warren’s company needs to allocate this into existing or new investment options. This growing cash pile can make the situation worse: when there is too much cash not being deployed effectively we call this ‘cash drag’ because it can create a drag on performance returns.

So, what does all this have to do with Australian Super? Well, as at 30 June 2018 this super fund provider reported that they had about A$140 billion or so in funds, which they manage on behalf of members. They also have a huge amount in super contributions coming in, which they need to allocate each year to investment options.

The larger the super funds become should mean some increase in economics with hopefully cheaper fees in the long term based on economics of scale. This would normally be one of the selling points of increasing its size. However, it appears Australia Super did not get this memo, as they had close to doubled their administration fees by 30 June 2019.

The reality is that as these super funds get larger, they start to push the limits of what they can do as an outperformance fund and may simply just track or underperform the respective indexes. It will be just a case of time to see if this plays out.

As you can see, if your money is being lumped into a large pool and yet you are looking for an active management approach, you start to see a clash with these two strategies in the longer term.

So the next time you are thinking about selecting your investment options or a superannuation fund, it is important that you seek quality advice from a practising financial planner and of course, I recommend AJ Financial Planning.