News Archive

It is often said that the financial markets are driven by logic over the long-term but by human emotion in the short-term. Indeed to quote Benjamin Graham, considered to be the grandfather of value investing, “the owner of equity stocks should regard them first and foremost as conferring part ownership of a business... the stock owner should not be too concerned with erratic fluctuations in stock prices, since in the short-term the stock market behaves like a voting machine, but in the long-term it acts like a weighing machine.”

Graham believed that long-term value would be reflected in share prices. But fear and greed can push prices to extremes, in either direction, in the short term. Short-term fluctuations are driven by supply and demand, all acting on a tide of human emotion.

A study of financial market history suggests that prices do tend to move in long-term trends, more commonly referred to as bull and bear markets. Trends can easily be identified; we can draw straight lines from trough to peak. But markets do not rise or fall in straight lines. When prices become detached from their fair value and shares are over-bought or oversold markets move to pull them back into line. This process is referred to as mean reversion.

Markets are in essence a pendulum, swinging backwards and forwards at varying speeds but in the end reverting back to the centre.

Investors must first establish where their mean lies before they can calculate reversion. Share prices may look cheap relative to their mean over the last decade but expensive compared to that of the last fifty years. In MultiManager investing, this type of analysis is particularly useful in the evaluation of one asset class over another, as in bonds versus equities.

Where are we?

The equity markets have been trending upwards over the last eight months, a dramatic turnaround from the steep declines experienced last year. This trend has been driven primarily by the unprecedented efforts of governments and central banks to reflate the economy and fight deflation. This has involved extremely low interest rates and a massive amount of quantitative easing. In the short-term this “shock treatment” has been constructive for asset prices; however, there is a fear that these policies may be destructive down the line. Already there is talk of the next bubble being created in a similar fashion to the “Dot Com,” Housing and Credit bubbles of the last decade.
There is no sign that either of the two central banks at the heart of the global credit crisis, those of the US and UK, are considering monetary tightening. Indeed Ben Bernanke, Chairman of the US Federal Reserve and counterpart to Mervin King, Governor of the Bank of England, has studied and lectured on the mistakes made during the Great Depression of the 1930’s and by the Japanese in the 1990’s. His belief is that on both occasions the authorities were too slow to supply liquidity to markets and too quick to end those efforts. This suggests that he is hardly likely to start tightening policy after just a single quarter of growth; especially whist unemployment continues to rise.

For now, an environment of low interest rates and low inflation will continue to support equities after a year that has seen asset classes like corporate bonds delivering equity like returns with a fraction of the volatility. However, be aware that equities have rallied 50% from their lows and currently look ahead of themselves as measured by short term daily moving averages. So expect to occasionally see, as we witnessed in October, short-term mean reversions.

Whilst no longer at bargain prices, equities are not far from fair value in terms of historical price to earnings ratios.

Speaking to the non-professional investor, Benjamin Graham warned against trying “to make ‘business profits’ out of securities... unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.” That is to say, if you are actually a retailer, police officer, or nurse, you should not worry about the daily, monthly, and even yearly ups and downs caused by an exuberant market… that’s your fund manager’s job.

John Husselbee
Fund Manager, City Financial MultiManager Range