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Averse and worse

“We have met the enemy and he is us,” said the political cartoonist, Walt Kelly. The importance of emotions in financial markets cannot be underestimated, as recent volatility has demonstrated.

Many believe the financial turmoil would have been impossible to predict but Jeremy Grantham, chairman and co-founder of the investment management firm, GMO, thinks otherwise. He believes many industry participants thought there would be a bear market but did not publicise their thoughts. Why? It can be safer in career terms for managers to follow the herd, even if that herd is wrong.

A well known example is one-time chief investment officer of Philips & Drew Investment Management, Tony Dye, whose pessimistic forecasts during the stockmarket boom of the 1990s cost him his job. Weeks later, however, his forecast came true as the technology bubble burst. Grantham contends that market inefficiencies are created as crowd psychology creates momentum, driving prices away from fair value.

The current situation may be the reverse of the quandary faced by Dye. The financial system appears to be suffering from excessive risk aversion. The overriding emotions have been fear and the desire for capital preservation.

Investing is not just about price, it is about timing and valuations. After a severe shock, it can take years for valuations to fall to levels from which a new bull market can begin as investors over-react to good news and under-react to bad news on stocks they like and respond in the opposite manner to those that are out of favour.

A study produced in 2000 by David Dreman and Eric Lufkin concludes that investors typically “forecast a future not very different from the recent past, that is, continuing improving fundamentals for favourites and deteriorating fundamentals for out-of-favour issues.”

This means “favourite” stocks are overpriced, while “out of favour” issues are priced at a substantial discount. It takes time to change these perceptions.

This is one reason why the New Star fund of funds team does not expect a prompt market turn-round. That said, significant bear market rallies are likely and it should be possible to benefit from them. Japan is an extreme long-term example. It has not regained its high of 1989 but has still provided some strong returns over the shorter term. If the UK follows a similar pattern and the next couple of years see a “sawtooth” market with periodic ups and downs, asset allocators can make good returns.

One area that appears to offer deep value is the credit market. Low interest rates are making yields on corporate bonds look particularly appealing while concerns that default rates will rise have led to corporate bonds being priced for depression-type circumstances, trading at significant discounts to their par values and offering unusually high yields. Provided the firms issuing these bonds do not default, investors will be repaid at par on maturity. Nothing can be certain in this volatile environment but the high levels of income on corporate bonds and potential for capital gains appear compelling.

Mark Harris is head of New Star Asset Management’s fund of funds team


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