The Four Pillars of Global Thematic Investing
We are pleased to present the first chapter of Eoin Treacy?s new book, ?Crowd Money.? Financial Sense founder Jim Puplava considers it a MUST READ for market professionals and novices alike.
Chapter 1: The Four Pillars of Global Thematic Investing
It might seem so obvious as to appear facile but it is easier to make money in a bull market. Anyone who has ever taken part in a bull market that has persisted for any meaningful length of time has been pleasantly surprised by how well their investments do and how easy it all seems. The challenges lie in identifying it as it develops, employing a reliable trend-following strategy and having the emotional strength to identify when a market is topping and you should sell.
Everyone is familiar with at least some major investment themes if for no other reason than the bear markets that follow them. Today people talk about the tech bust of 2000 but often fail to mention the two-decade bull market that began in the early 1980s and created wealth for so many people. The 1929 crash remains a legendary event in the annals of stock market history, but people seldom associate the roaring 20s that preceded it with what had been a major bull market. Bull markets represent wonderful money-making opportunities if we equip ourselves with the tools necessary to benefit from them.
One of David Fuller?s maxims since the 1960s has been that ?financial markets are man-made resources for us to harvest when the timing is right?. Major bull markets represent times when a notable theme animates the investment crowd to such an extent that prices form rhythmic moves ideal for a trend-running investor. While we can become enamoured with any market we successfully interact with it is worth remembering that financial instruments only exist because of us. They depend on our participation and while they reflect real world phenomenon, how they perform is dictated by people, their perceptions and actions.
Investing is therefore a two-step process. On the one hand we need to equip ourselves with an appreciation of macro-economic conditions and fundamental value metrics. On the other we need to understand that how the investment crowd perceives this information will evolve over time, and this will affect how we can profit from the market.
As we approach the subject of how to identify major bull market before they become celebrated by the media, the best way to profit from them, and the best time to exit before moving on to the next opportunity, we must first recognise that all bull markets have similar characteristics.
Themes and Fundamental Value
Human beings are social animals and we thrive on stories. In psychological terms, we use stories to help us make sense of the world, to transmit ideas and to relate complex data to our individual experience. Therefore, when we are presented with an investment idea, it is more accessible if it comes packaged in a story that is easy to understand. For exactly the same reason politicians deliver stump speeches and are pleaded with by their handlers to ?stay on message?. An investment theme is therefore a complex idea based on facts that have been distilled down to a compelling message.
Given the right circumstances an investment theme can go on to form a major bull market and might even end in a mania phase where prices accelerate higher. The most successful investment themes promise to change the world. For example, the building of railroads in Europe and the USA allowed the transport of goods and services like never before. Railroads opened up huge new areas for cultivation because the time needed to bring products to market grew shorter. Leaps in technology created products and efficiencies that changed the way people lived their lives.
Japan?s revival following World War II was nothing short of an economic miracle which was predicated on a collaborative and highly efficient management structure. The rest of the world went on to imitate this structure over the following decades. This represents another example of how productivity gains created value.
The swift pace of microchip development, the evolution of the internet and mobile phones among many other technological advances have created productivity gains where none were previously thought possible. All the promises about how technology would change the way we lived came true. And the pace of innovation continues. In the meantime, however, the prices of related instruments have moved both up and down a great deal as perception of the sector?s potential varies.
Gold completed a lengthy bear market in 2002 following more than 20 years when it went from being the ultimate store of wealth to being considered, in Keynes? old phrase, a ?barbaric relic?. Following the dotcom bust in 2000, central bank money printing took off. Mines were forced to shutter production because of low prices. At the same time demand, particularly in Asia, began to trend higher. The stage was set for a major revival. All of these points are encapsulated in the typical beginning to any bullish story on the yellow metal: ?Gold is the only real money ? ?.
All of these themes formed massive bull markets that have or will eventually end. There have, of course, been myriad other investment themes that have not persisted for nearly as long or had the wherewithal to change our lives in a truly meaningful way. In some cases it was because while the reasons to invest were compelling, the market was just not big enough to absorb the weight of money thrown at it. This is often particularly true of small, illiquid frontier markets or individual small cap shares.
It is not enough to have a good story. Any competent marketer can come up with an alluring sales pitch. For an investment theme to acquire the adherents necessary to spur a major bull market there must be fundamental value.
Value investors such as Benjamin Graham employed a method of discounting cash flows in order to come up with a fundamental value for a share then compared it to market traded prices in order to decide whether it was cheap or expensive. Warren Buffett has taken the premise further by, as he puts it, ?finding an outstanding company at a sensible price?. Deep value investing has been demonstrated to produce positive returns on a long-term (as in anything from three to 20-year) basis. However, because it ignores a timing component it is prone to underperformance until the wider market comes to share the investor?s perception of value.
Value investors not only represent a major demographic within the investment community but their actions help to dictate at what point markets bottom out. They will often be early in buying during the typically lengthy base formations that precede more consistent uptrends and will often be too early in selling as bullish sentiment intensifies in the latter stages of major advances which are often characterised by upward acceleration in prices. Therefore, while value investing is a laudable endeavour, it should form a component in one?s research rather than the basis for when to buy and sell.
When Sir John Templeton spoke of the best time to buy being ?the point of maximum pessimism?, he was referring to an emotional cue rather than a fundamental value.
When we think about our reasons for participating in the financial markets it is to make money. Doesn?t it therefore make sense to consider the nature of money when our ultimate goal is to get as much of it as we can?
Capitalist economic systems are set up to ensure that liquidity flows to assets with the most productive potential. These can be considered the assets with the best potential yield and/or potential for capital appreciation. When an asset class is considered to represent value and have a compelling theme it will inevitably begin to attract investor interest. Just how much money it attracts will be dependent on how much money is available for investment at that time.
When central banks ease the terms at which they are willing to make money available they follow three distinct policies. They lower the price at which money can be borrowed by cutting short-term interest rates. This simultaneously creates an incentive for those holding cash to spend or invest. They can increase the supply of money which helps to grease the wheels of commerce by ensuring availability of money for borrowers and increases the threat of inflation for savers. They can change the terms under which they are willing to lend by altering the regulatory framework. This increases the market for credit by making it available to more participants.
Any of these measures can be considered positive outcomes from a liquidity perspective. When all three are employed we can conclude that the money lent out by central banks will find its way into financial assets and will be multiplied as speculators take on leverage.
An important consideration is that while central banks have in the past and will again debase their currencies or neglect the interests of savers or, at the other extreme, impose austerity or actively curtail the flow of liquidity to a favoured asset, our opinion of these actions is irrelevant from an investment perspective. We might be angry, disgruntled, bemused, encouraged, happy or even delighted by central bank actions but that does not affect the influence of liquidity provision on asset prices. David Fuller has long said that ?we need to adopt the humility to accept the reality provided by the market? and to resist the temptation to tell the market what to do.
When central banks begin to withdraw the proverbial punchbowl, credit becomes more expensive, less available and the conditions for access become stricter. As this process matures, it acts as a leading indicator for the next significant pivot in prices. Sentiment among the bulls trails this change in liquidity conditions but as David Fuller has long said ?central banks raising short-term interest rates have killed off more bull markets than all other factors combined?. Just as easy liquidity conditions are required to fuel a new bull market, as liquidity tightens it inevitably puts pressure on margins, speculators and other leveraged investors. In turn this alters the rhythm of the dominance of demand over supply upon which a bull market depends.
Central banks are in the unique position that they can create new money. However, there is still a large quantity of investable capital and this moves gradually from one asset class to another over time as perceptions of value evolve. During a major crash leverage is squeezed out of the system and investors flee to other assets vowing never to return. However as prices fall, value returns and, while it will take time, the fundamentals of the instrument readjust. When a compelling new demand story eventually develops, all those people with cash in another instrument represent potential investors who could be convinced to buy back into the original asset.
US Stock Market Allocations Stocks Indexstalstox
The Bloomberg US Stock Market Allocations Stocks Index offers a wonderful example of how trauma in one asset class affects the perceptions of how it will perform in future and therefore the decisions of investors in how they will allocate their assets. This chart depicts an average of the suggested allocation to equities among Wall Street strategists.
The index hit a peak near 72% in 2001; a year after one of the longest bull markets in history had ended. While the S&P Index spent the subsequent 13 years in a broad range, the perception of upside potential for equities continued to deteriorate so that by late 2012 the suggested allocation to equities was only 42%. A contrarian would look at this data and immediately conclude that just as it was incorrect to be overly bullish about expectations when prices had peaked it is most likely incorrect to adopt an overly bearish perspective about upside potential because prices have been rangebound for so long.
Above all else, this index exemplifies the tendency of investors to move with the latest fad. Their actions have a material impact on the flow of money in and out of various asset classes as perceptions gradually change. The nimble investor is best served by anticipating rather than following these movements.
Governance Is Everything
To say that governance is everything may be something of an exaggeration but it does serve to highlight the fact that declining standards of governance are often a component of an inflating investment mania. Improving standards of governance are often a motivating factor that encourages investors to support a nascent bull market.
It would be inappropriate to speak of governance in absolute terms because there is no numeric way to measure this phenomenon. Instead we consider whether governance is improving or deteriorating. By removing an absolute comparison between countries, companies or regulatory systems and instead examining each individual asset class on its individual merits we put ourselves in a much stronger position to answer the question ?Are things getting better or worse??.
When we address the prospects for an individual economy we look at fiscal policy, monetary policy, the regulatory framework, rule of law, minority shareholder protections and property rights. In making an appraisal we resist the temptation to compare the situation to other more highly developed or less-developed countries or indeed our home country. The more important question is whether the situation is improving and whether it is likely to continue to improve.
This is important for one simple reason. Improving standards of governance remove barriers to development and ease the way for productivity gains which create value. When a country?s standards of governance improve it can have a material impact on the prospects for its bonds, currency and domestic stock market.
When a company that has been run for the benefit of its management rather than shareholders, or has been taking on more risk to enhance short-term earnings rather than focusing on creating long-term value, or expanding too quickly despite a saturated market, or paying record high prices to takeover questionable assets, we can conclude that governance has deteriorated. When managements change, the health of the balance sheet is prioritised, and the creation of value for shareholders is put ahead of short-term gains, we can conclude that governance is improving. This can have a material impact on pricing and sentiment towards a company.
If we concentrate on the trajectory of governance we can avoid complacency or self-satisfaction that a company or country?s progress is ?good enough?. The simple truth is that governance can never be good enough. If value is to continue to be created there is always room for improvement. In fact, when governments or corporate boards engage in the hubris that they are perfect and have nothing to improve on we can conclude that standards of governance are more likely to deteriorate than improve.
The determination of value can be a subjective practice because a market that we consider cheap can become cheaper. We might become enthralled with the story used to convey a bullish message. We might incorrectly consider that standards of governance are on an upward trajectory. To one extent or another these are subjective opinions. Price on the other hand is definite and can be regarded as a reality check. If price action does not support our hypothesis, we need to reassess.
An instrument?s price tells us a great deal about how the competing forces of supply and demand are arranged. It tells us whether the trend of investment has been to support higher prices or to wait for lower prices. It allows us to sense the rhythm of the market and to observe how perceptions gradually change from disbelief to acceptance then euphoria and back again.
We need to have an appreciation of the fundamental basis for the market but once we understand the bull or bear case, the constituent arguments do not change all that often. Price changes a lot. The vacillation of the investment crowd and how it reacts to different stimuli will determine whether we make or lose money regardless of whether we have got the fundamental call on the market correct. For this reason alone I can say with absolute certainty that I never make an investment or trading decision without looking at a chart of price action first.
There would not be a financial market without human beings. Human beings are social animals and we thrive in groups. Price history gives us a graphic representation not of fundamental data but of how investors perceived it and reacted to it. A picture paints a thousand words.
David Fuller has long advised that investors should strive to ?view the market in the manner of a naturalist?. We should attempt to view the investment herd as if we were looking in from the outside. If we are to profit from the market we need to participate. This eventually requires that we subject ourselves to the same allure of crowd psychology as everyone else. Put simply, as soon as we take a position our objectivity is compromised. Therefore in order to decipher what the price action is telling us we need to approach the market from a dispassionate perspective and employ a disciplined approach.
Just as with art, the tastes of buyers will differ considerably but those who interpret the works on display focus on facts such as composition, use of light and shade, texture and history. When we interpret price action on a chart we cannot simply rely on our gut feeling but must adopt an analytical process. We ask whether the market is trending or ranging, consistent or inconsistent. We identify what the consistency characteristics are. Once armed with this information we have a formula for monitoring the rhythm of the market. When this changes it signals that the interaction of supply and demand that has animated investor appetites has changed. We must then reassess our investment strategy.
No one method can be relied upon to frame our analysis of and participation in markets. A holistic approach where we are sensitive to fundamental considerations, aware of the effect on prices of liquidity, cognisant of the trajectory of governance and where we adopt a dispassionate interpretation of price action puts us in the strongest possible position to profit from financial markets.
When all four of these factors fall into place, when a major theme is developing and value is accruing, when liquidity is becoming more available, when the trajectory of governance is turning upwards and when the pattern of price action dictates that an asset is under accumulation, then we are presented with a high probability candidate for a trend running strategy that can persist for a number of years and possibly even decades.
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