How investing works in the dollar driven world
US stock markets are expensive. Does technology justify this or are we due a crash? It's time to take The Sniff Test.
Three decades ago I worked at Schroders, a leading money manager. My proudest moment was becoming secretary to the large stock committee, where I assumed the finest minds would teach me how to beat the market. Instead most of my minutes documented the firm’s position relative to the competition.
I learned quickly that three things matter to money managers. The first is marketing because launching new funds is the fastest way to grow. This requires investment returns to be consistently above average, but not enough to stand out and appear to be taking excessive risks. The third concern is staying out of regulatory trouble.
These are the rules of pension fund management and how to make an above average living from investing other people’s money. They are not the rules for becoming a billionaire, although there’s an exception when your firm grows as big as Blackrock. The consequence for pension owners is a steady flow of average returns that won’t beat the market.
You cannot buy a stock market index
When we say the stock market we mean an index of the largest publicly traded companies in that country. The most familiar US index is the S&P 500 and the UK has the FTSE 100. The letters refer to the company calculating the index and the numbers reflect roughly how many stocks are in it.
You cannot buy an index as it a measure of what a group of companies are theoretically worth. You can buy all the companies in the index, or a fund to do it for you and you pay fees to do either. Consequently, your investment lags the value of the index by the amount of the fees.
Index constituents change. There is survivor bias in stock market returns that measure the performance of winners and not the companies that fall away. You keep shuffling your portfolio to match the list of constituents, which adds to trading costs and makes it harder to beat the market. Hence academic theory says why bother.
The Efficient Market Theory
The theory of efficient markets says all information that can be known about a company is known and therefore reflected in its stock price. You cannot gain an informational advantage and hence you shouldn’t bother. The best investing advice is to buy a low-cost fund that matches the index and wait. Markets generally rise due to economic growth and inflation, and the stock market is the best way for ordinary investors to benefit from this.
While it’s true that public knowledge is widely available, it is not the case that everyone interprets it the same way. We buy companies anticipating what they will be worth in future, most likely when we retire. My views on future economic growth, inflation and interest rates are not the same as yours and we therefore value companies differently.
Economists call this being irrational but it is a fact of life. I value my family home at a higher price than the developer who wants to modernise it. This is called the Endowment Effect, which is the higher price we put on things we own. This effect means that when house prices fall the volume of housing transactions drops even more, because owners refuse to sell until prices recover.
In financial markets the same bias is called the Sunk Cost Fallacy. Shares in companies have less practical use than houses, but we cling onto them when prices fall because we don’t like losses. The biggest reason to hire a professional money manager is that they are trained to be emotionally detached.
We don’t need modern psychological terms to understand this. The saying that a bird in the hand is worth two in the bush encapsulates much the same thing. An object is worth more when I own it than when I don’t and the efficient market theory doesn’t hold.
The investment advantages of speed, size and knowledge
A second reason to hire a money manager is because it’s their full time job. Professional investors have an edge in markets due to speed, size and knowledge. Four out of five amateur investors underperform the market over 10 years according the CFA Institute.
The speed advantage to professionals is due to technological advances. High Frequency Traders pay large sums to co-locate servers next to stock markets and for the latest communications technology. A micro-second quicker is enough to make large returns if you bet enough.
There is controversy around this type of trading, especially in the US where the largest firms pay people to trade with them. Robin Hood and Charles Schwab offer commission-free trading of shares because they sell your trades to the likes of Citadel. Trading firms argue they make markets more efficient and that explains why everyone wins. The cynics point out that if you don’t know who is paying for something then inevitably it’s you.
Again there is ancient wisdom to explain this. He who pays the piper calls the tune is as true today as ever.
Superior stock market knowledge is also about technology. The ability to spot patterns in large volumes of data and predict how regularly they recur is the mark of successful hedge funds and their billionaire owners. To win you must trust the machines to do things that aren’t intuitive and mathematicians are best at this.
In this world you make trades that have a positive expected outcome, even if it’s as small as 51% to 49%. If you make enough trades you earn a fortune. But there is another skill that is even more valuable.
The top money managers understand how to size trades. In an interview with RealVision, Dmitry Balyasny of the eponymous hedge fund explains that while colleagues are often better at picking winners, his edge is knowing how to size bets. The adage that you ride your winners and cut your losses should be that you increase winners and cut losses.
Diversification is for the masses
If you lack time and resources to follow markets closely you are advised to diversify. Spreading your bets means you catch most trends and are not exposed to unforeseen disasters.
Diversifying means keeping your options open. You either do this by buying an index fund for average returns, or by paying a manager who may invest in anything, but you hope selects a few winners. If you limit the investing options, for example by using sustainability criteria, then you acknowledge that investment returns are not your primary aim.
A 2022 Morningstar report showed that a quarter of US funds beat the market over 10 years and less than 9% did over 20 years. A follow-up noted that only 1% of funds had outperformed holding Apple since 2000. There are around 7,400 US mutual funds so good luck finding future winners.
That doesn’t stop people trying and as hope springs eternal, so does a new generation of value investors.
The Emotional appeal of value investing
Warren Buffett is the people’s investing champion and someone who argues against diversification. Buffett buys businesses he understands, where he believes in management and there is a moat around the business. This means a premium product that is hard to copy.
Buffett spawns thousands of copycats, both amateur and professional, who are labelled value investors. This refers to the idea that you can spot the long-term value of a business and wait for everyone else to catch up. For most this is a losing trade.
Buffett’s initial advantage was that he used other people’s money to invest. Noting that insurance companies sat on cash to pay future claims, he bought one that provided a float for him to invest. A well-run general insurance company always has spare funds, allowing Buffett to make long-term investments.
As his wealth grew Buffett used the size of his cash pile to make outstanding returns. In every crash he provides rescue finance on favourable terms to him, such as when he invested in Goldman Sachs after the 2008 crisis. Nowadays he buys whole businesses and takes them private. The myriad of copycats use techniques that are over 50 years old and lack the clout that delivers Buffett the big bucks.
Understanding that Buffett is unique and the need to market yourself as different, even if your results are standard, money managers adopt a hybrid approach to investing.
Why the world buys America
The US has around 4% of the world’s population and accounts for a quarter of the world's economy. Its stock market is over 40% of world-wide public companies and home to 39 of the largest 100 firms.
Last week I noted that economic growth is a result of population expansion and productive investment. The US is immensely successful making productive investments and the central role of the dollar in the world economy is both a cause and a benefit. The US borrows money to buy goods in dollars which are recycled into US financial markets and in turn used to make investments worldwide. Over 40% of the profits of large US companies come from abroad.
This flow of funds through financial markets makes America rich. Rich people invest more and a virtuous circle occurs. Money from the rest of the world is sucked in by rising prices.
US markets have risen 6.9% a year this century assuming you reinvested the dividends from companies. The increase is around 5% if you spent the income. It’s hard to make big returns from investing if you need the income to live.
The US return is more than 50% better than European markets. The US economy grew faster than Europe, but by 37.5%, which means stock markets do more than simply reflect economies. As corporate profits rose around two and a half times on both continents, US companies have become progressively more expensive relative to the rest of the world. Why?
The exceptionalism of American technology
A big issue with value investing is that it relies on mean reversion. This assumes a trend rate of growth and valuation around which stocks fluctuate. You sell expensive ones and buy cheap while waiting for the trend to reassert itself. It’s hard, as Keynes noted:
Markets can remain irrational longer than you can remain solvent
Value investing is about discounting the future. Like the efficient market theory it purports to disprove, this relies on people sharing a view about what the future looks like. You use current market values to make assumptions about what happens next and hope everyone else does the same. If they did then the value stocks wouldn’t be cheap because everyone spots the same opportunity. Hence, like Keynes, most value investors are waiting for a train that never comes.
Technology stocks in the US are up over 800% this century. There is massive survivor bias in these statistics, but as noted an investment in Apple beat most professional investors. You don’t need to fish for small fry. As professional investors cannot differentiate themselves by buying Apple they do look for small company opportunities, but these are harder to persuade others to buy. You only make money investing if lots of people buy after you do.
This reinforces the idea that index funds are best for the average investor, as well as being cheaper because you are not paying a money manager for their skills. It also supports the view of an exponential cycle of American technology that marks it out from the rest of the world.
Of the 17 companies that have grown to be valued at over $100 billion since 1990, 11 are in the US, 6 in China and none in Europe. The EU Commission recently published the biggest risks to its security, and advanced semiconductors, artificial intelligence, quantum technologies and biotechnologies topped the list. If your gut reaction is to see technology as more risk than reward you get left behind.
The coming crash and how it’s avoided
Technology companies are the biggest beneficiaries of the money created since the Financial Crisis. This is justified by having better prospects than other companies and investors valuing that future at higher prices due to low interest rates. According to finance theory this will reverse as interest rates rise, but it hasn’t yet.
The exponential growth theory says that technology outcomes keep doubling and hence comfortably outrun the drag factor of rising rates. It highlights the technologies the EU fears as the reason why growth keeps accelerating. If the cycle of money printing unfolds as suggested last week, then ever more money will flow into US technology shares.
If you believe in cycles then all good things come to an end. The problem is that it takes much longer to happen than you think, because of the time between your understanding and everyone else’s. In the investing world, professionals learn to ride the cycle till the bitter end and not miss out on any upside.
The smart guys at Schroders knew you don’t lose doing what everyone else does.