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Chris Gilchrist: Beware dancing to yesterday’s tune

Chris Gilchrist MM blog

J M Keynes believed that ‘animal spirits’ held the key to business cycles. Neoclassical economists rubbished such archaic thinking and said there were no business cycles, simply random fluctuations around the equilibrium that is the economy’s natural aiming point – a notion that recent experience has consigned to the rubbish bin.

There is no way of anchoring what the stock market describes as ‘sentiment’ or ‘confidence’ in algorithms or equations. We live in a world that we seem deeply motivated to see in terms of dreams or nightmares. As for reality, well, as the hippies used to say: “That’s something else.”

As many insightful investors have said, stocks sell at high prices when they represent dreams, as tech stocks did in 1999-2000 and railway stocks did a century before. Interestingly, today’s most successful tech stocks no longer sell at dream prices – Apple and Google could both be viewed as relatively cheap stocks given their sales, profit margins and cash generation. At times when so much gloom is in the air and nightmares abound, that’s not surprising.

Where will the next set of dreams come from? Some entrepreneurs believe it will be Web 3.0 and social media types put their faith in next-generation Facebooks.

On the evidence of history, this isn’t likely. Each phase of optimism, in which Keynes’ animal spirits revive, tends to have a new focus.

The legendary founder of Fidelity, Edward Johnson, put it like this: “The thin air of the music we all heard has died away. It lasted a long time, but the best rule is: When the music stops, forget the old music… In times of unreality the market is saying: ‘You don’t understand me any more; don’t trust me until you understand me.’”

If you didn’t know about Mr Johnson you might dismiss this as waffle. But it was Mr Johnson who created the cult of the stockpicking star fund manager and he owned and invented what has become today’s world-dominant fund management group. He was several leagues smarter than any of today’s fund bosses and was resolute in his view that fund management is not a science but an art. Most of the good portfolio managers I’ve met would agree.

There is science in investment management, just as there is science in the chemistry of paint, but chemists aren’t artists and nor are pointy-headed quants fund managers. That’s a fashionable view which investment management groups get away with because most people don’t understand finance and portfolio theory.

Have we forgotten 1987, when clever portfolio insurance crashed the market? Or Long Term Capital Management, the hedge fund run by Nobel laureates in economics that almost bust the US financial system?

In markets dominated by fear, traders’ techniques – which is all the quant stuff amounts to – are popular. But once there’s some new music to hum along to, investors will lose interest in something as chronically dull as algorithms.

My money is on the new tunes being aspects of save-the-planet greenery and ‘sustainability’.

Maybe that will be just one of the more cheerful tunes when the mood changes, but it could give a lot of scope to artistic, stockpicking fund managers.

Of course ‘value’ (for which read ‘history’) is today’s Land of Hope and Glory. And tomorrow’s tunes will sound just like discordant noise at first. That’s why we have to keep listening.

Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS Report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning

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