The Ulysses Pact: Market Commentary from CBIS Chief Investment Officer Frank Haines
Investment discipline is the best defense against the financial song of the sirens.
In the investment world, financial advisors are now suggesting that clients sign such a pact to bind themselves to stay the course of their long-term investment strategy, and not make an ill-timed decision in the grip of emotion provoked by market uncertainty and volatility. This is an admirable goal, as investors can often be their own worst enemies by abandoning discipline when overcome by short-term fears. However, such pacts may prove more difficult to enforce in real life than in Homer’s heroic tale.
Interest in restraining the adverse impulses that mark human behavior is understandable given recent market conditions. So far in 2012, global markets rallied strongly during the first quarter, then fell just as powerfully in the second as the outlook for global GDP growth weakened, the chaotic and grindingly unresolved EU debt situation took another turn for the worse, and investors’ suffered faltering confidence in the ability of governments to energize stalling economies through a new round of fiscal stimulus and monetary ease. Governments have appeared inept, at best, managing what seems to be a deteriorating situation, and investors are perplexed at how to prudently respond to resulting market risks. It is difficult enough to make confident decisions in the face of financial uncertainty. The challenge is made nearly impossible when political uncertainty, and its inherent indeterminacy, becomes a key factor that shapes market outcomes. The markets await each government announcement or intervention with bated breath, then jump in volatile fashion up or down, with the volatility in price often bearing no reasonable relationship to changes in underlying value.
EU Crisis Stumbles On
In early February, we noted the series of events in the European Union (EU) during the first half of 2012 that might lead to a clarification by mid-year of the path forward for the region. Following news of Greece’s debt restructuring and rating agency downgrades in March, the best indication of an emerging viable solution to the EU debt crisis would be the restoration of investor confidence and trust in the bonds of other debt-burdened peripheral governments. In early June, that confidence is still lacking, and the risks to the exchange value of the euro and very survival of the eurozone in its current form are rising. Spain’s sovereign debt yield has once again approached 7%, a level many economists view as preventing the nation from viably selling new debt in the public bond markets. A further disquieting trend is the growing retail deposit flight from banks in Greece and Spain — driven by residents’ fear of devaluation through forced conversion into new drachmas or pesetas — coupled with institutions relocating cash to the safer havens of Germany, Switzerland, the UK and U.S.
There will surely be more developments by the end of June. The Greek election on June 17th will determine whether the austere terms of the current bailout program will prevail or whether a more radical government (led by Syriza) will overturn them and force a possible Greek exit from the euro. A summit of European leaders beginning June 28th may provide some guidance on whether Germany will accommodate demands by other EU nations for stronger European Central Bank (ECB) support of the currency block’s fiscally weak governments and even the possibility of supporting them through bond issues backed by the eurozone as a whole. Absent meaningful steps such as these, the EU situation is likely to deteriorate with increasing speed. Disintermediation (bank withdrawals) and debt boycotts by public market investors —whether of sovereign debt or bank issuance — may force a sudden denouement to this sad saga.
Tuning Out the Financial Siren Song
A good piece of advice I received long ago was that in frustrating situations it is far better to reflect a bit than react immediately. With all of the market’s current uncertainty, CBIS participants should do the same. When volatility is high and investors’ emotions raw, it’s essential to have a long-term policy in place and adhere to it, rebalancing as opportunities permit. The economic backdrop remains deflationary due to waning economic growth, excess capacity on a global scale, and high unemployment in many developed-market nations. As low as bond yields currently are, it is entirely reasonable to believe that they will remain low for a sustained period, and that bonds will continue to serve as a valuable haven from equity volatility and weakness.
In the event of further stock market weakness — which seems probable should economic conditions in the U.S. and Europe weaken more than anticipated and dim the outlook for corporate earnings — the value scale will gradually shift to favor equities as the superior asset class from both an income and long-term total return perspective. Ultimately, inflation will be the most likely government solution for reducing the burden of excessive developed market debt, and that will further reinforce the advantage of equities relative to bonds. Wary investors, however, will have adequate time to react to a shift from deflation to inflation. And in the interim, the worst mistakes they can make are to withdraw from the markets in frustration over volatility or seek to cleverly time shifts among assets. The latter is difficult enough to do when based on analysis of financial factors such as valuations, earnings trends or interest rate spreads. Given the current degree of political uncertainty and the unpredictable nature of future government interventions, it is simply too costly for all but the most experienced and skilled professional investors.
Perhaps an implicit Ulysses pact is in order for investment committees. The caffeinated daily rush of financial news creates a siren song that’s hard to ignore. Placing wax in one’s ears to block it out, or tying oneself to one’s desk to avoid a compulsive, ill-advised trade, are gestures too extreme to be viable. But committee members may wish to bind themselves to the conviction that it’s generally best to focus on long-term goals and not be shaken by short-term events. One defense may be to simply tune out the daily noise and read a good book instead -- the Odyssey and its saga of Ulysses even. It will reveal more about the human psyche — and therefore the nature of markets and investing — than anything on CNBC.
Please contact your CBIS Investment Adviser if you would like to discuss these issues in more detail.