Poetry is nearer to vital truth than history.
In our recent discussions about the Couch Potato style of investing, I mentioned that this strategy relies on historical market returns. I pointed out that including a component that reflects valuations might improve the strategy. This is basically the Valuation Informed Indexing approach about which Rob Bennett often writes.
I mentioned in my last post that I like to look at historical data regarding market performance and valuations, but that I didn’t want to rely on it completely. I’ll explain my thinking here and you guys can let me know what you think.
Past Performance Is Not Indicative of Future Results
“History is a vast early warning system.”
One of the things about the financial services industry that always gives me a chuckle is that most advisors and fund managers will try to get you to buy their products by showing you those 100-year charts of the major indices, which of course look like they only ever go up. In the fine print of every prospectus, however, is the standard CYA phrase “Past performance is not indicative of future results.” Translation: “You need to pile into stocks because they’ve risen for 100 years, but we can’t guarantee they won’t go down after you buy. If they do, you’re on your own. (Oh – and by the way, we’ll still get paid.)”
Now I know that neither the Potato investors nor the Valuation Informed Index investors would claim that history will repeat itself exactly. They’re just using it to determine investment probabilities. That’s how I use historical data too. But I also like to incorporate a few other variables, which others may or may not find useful, but have served me well so far:
- Macroeconomic Context: I look at the economy on several levels: 1) What is happening now? 2) What’s happened over the past 10 – 20 years? 3) Where are we in the big, big picture? These are only rough time frames, but the first one might equate to the cyclical economic trend, the second, to the secular trend, and the third to much larger generational factors.
- Technical Factors: I look at technical analysis for various markets. I consider myself a novice, and I’m still refining my skills in this area. Still, when I look at a chart today, I see a lot more information than I did 10 years ago and I’ve learned to trust the charts more than the fundamentals at times. Markets reflect collective psychology and charts are the Rorschach test that maps that psychology. Interpreting them is an art, not a science.
When I look at historical data, I don’t only include market returns or valuations. I will look at charts and macroeconomic factors on multiple time frames as well. This doesn’t mean I catch every market move, get every trade right or accurately predict the future. Far from it. But I’ve managed my risk based on these factors and avoided all of the market carnage of the recent financial crises. I’ve also missed out on some of the gains. I’m OK with that because my portfolio is in the black.
Waiting for Spring
“Each time history repeats itself, the price goes up.“
In an article called Get Me Through December, I went through generational cycles based on the Kondratieff seasons. A lot of people think this is bunk, but if you actually read what’s involved in the cycles you might recognize that current economic events look very much like those in a Kondratieff winter. Check out some of the charts and see what you think.
On financial crises: Have you noticed that they’re coming with more frequency and severity? (It’s sort of like labour contractions.) This is actually in line with the idea of a Kondratieff winter and I would expect (hope?) that once “spring” arrives, we will be able to enjoy the birth of a new economic model. This one’s broken.
When I look at the balance sheet problems facing countries worldwide, I can’t help but get much more cautious with my investing approach. That’s one reason I’ve avoided investing very much in the markets for several years now. The bailouts that sparked the 2009-2011 rally did not get at the root causes of the crisis. They only served to transfer the toxic debt from bank balance sheets onto sovereign/taxpayer balance sheets.
Here’s where knowing some macroeconomic history can help our interpretation of real time events. Reinhart and Rogoff looked at “Eight Centuries of Financial Folly” in their book This Time Is Different and found that banking crises are usually followed by sovereign debt crises. I think it’s safe to say we’re there.
While you can’t anticipate every market-moving event, some are pretty obvious well in advance if you take the time to inform yourself. The recent/ongoing crises are perfect examples. It’s a little baffling that those who do the macro research necessary to anticipate these events are often called lucky when they actually come to pass. Those who were looking at a limited set of other factors and missed it feel like they (and their portfolios) were victims of collective misfortune.
Why History Only Rhymes
Mark Twain said “History doesn’t repeat itself, but it does rhyme.” So we can indeed use historical patterns as an early warning signal, but we need to remember that history cannot repeat itself exactly. Why? Because each new historical development affects the next. There are market forces that exist today that did not exist during the historical period that the data cover.
I’ll give you just a few examples of the ones I think will have the most effect on the markets in the near to medium term:
- Derivatives: If I had to choose the single biggest game-changer for how markets play out, this might be the one. Credit default swaps and other derivative products did not exist for most historically documented market periods. Many are aware that if a number of CDS were triggered, there isn’t enough cash in the system to back them. This ticking time bomb is the reason the EU officials were so intent on making sure the “partial default” by Greece was not considered a credit event. That would have triggered the CDS and a cascade of counter party risk that could bring the financial system down – again.
- The European Union: Here’s what I wrote on the topic back in May of 2010: “The European Union wasn’t established until 1993. The mechanics of 27 distinct countries operating under a single monetary policy are complicated. What if one member has run up huge debts and can’t pay them back? Should the healthier nations be obliged to rescue them?” This is one of the factors contributing to the most recent market meltdown.
- Computerized Trading: Many large financial institutions use sophisticated computer models to trade using technical analysis. This can cause a lot of extreme “risk on” and “risk off” moves in the market as similar computer models execute trades at the same time.
Diversify Your Context
While I love to use history as a guide, I’m careful not to ignore the information coming from other sources. We can’t understand every variable affecting markets at any given moment. Nor can we know the future. It’s human nature to use prior experiences as a context for future decisions and there’s nothing wrong with that. But, to borrow from an article I highlighted in 20 Cents from July, You Are Not an Equation. I’ll reproduce the money quote for you:
“In finance, people built models that use mathematics to describe markets and to describe people and the participants in the markets. And it becomes tempting for them to believe that the mathematics is a theory and forget that it’s actually an analogy [i.e. model] that only has limited extension.”
We can look at data and study history and calculate returns as much as we like, but in the end we need to try to take in as much of the whole picture as we can. Reliance on studies, statistics, and mathematics can only take you so far when you’re dealing with matters of psychology. Markets are collective psychology. That’s why trying to interpret them can often feel more like art than science and why science alone probably won’t make you a better investor. Mixing in some new contexts and a dash of common sense can help.
To what extent do you rely on historical data to make your investment decisions? Do you consider the economic context of your portfolio?