Predictions, Forecasting and Experience
My daily monitoring of market news and headlines is throwing out a couple of signals that remind me a little of the complacency that existed in financial markets pre-crisis.
A steady stream of articles articulate how the credit or corporate bond markets are absorbing new supply or issuance by the bucket load and in the higher risk tranches. The hunt for yield is once again overshadowing the obvious question of whether yields adequately compensate investors for the inherent credit risk that exists in the market.
I also noted an interesting snippet in the FT the other week suggesting that a private equity group is seeking to publically list a business called Countrywide- a real estate company in the UK. The reason this stands out for me is that Countrywide is a company who came to market with a new high yield bond deal right at the peak of the high yield boom in 2007. The deal proved to be great timing for the private equity holders who basically levered up a housing related business and extracted their equity capital just before the US housing market imploded. Management and equity owners suggested at the new issue roadshow that this business was ‘recession-proof’ because real estate agents make money for selling houses regardless of whether the prices are rising or falling. It was a good example of the danger of placing much reliance on management forecasts given the inherent bias that exists. Suffice to say bond holders did not fare very well through that bond deal. The private equity partners (not entirely the same ownership structure) are now seeking to offload their equity stake via a public listing on the London Stock Exchange. The private equity partners have agreed not to offload any of their stake until six months have lapsed. Excuse the scepticism but I hazard a guess they are not seeking to exit the business because they think the prospect for the next few years is attractive and they want to share the upside. The successful timing of these deals is not predicated on being able to predict the future but rather sticking to a strategy and utilising the demand within the market to achieve their desired outcomes.
Finally, I see that last week Goldman Sachs and Morgan Stanley, two of the largest American investment firms, upgraded their forecasts for where the S&P 500 will end 2013. They have upgraded their return expectations by about 12% from previous forecasts and it’s worth noting the S&P 500 is already up about 17% year-to-date and trading at multi-year highs again. I wonder if this is more of a capitulation rather than a conviction forecast.
Not all forecasting and analysis is mired by hidden agendas and misaligned stakeholder interests however. The accuracy of forecasting, even by well intentioned and experienced professionals, can be wholly misleading as the following anecdote illustrates.
While thinking back to the Countrywide bond deal all those years ago I was reminded of the time in early 2007 when I had to do a presentation on the greatest risks facing bond investors. My firm had an incredibly intelligent economist who covered the US economy for us. He was hugely experienced and, in my opinion, well balanced in his process. I went to him and asked about some of the warning signs I should cover in my outlook segment. When we got to the topic of housing and house prices in the US, we were able to relatively quickly dispel this as an area for major concern as far as any negative impact on the economy was concerned. In short, he said, we need not worry about sub-prime lending which was already receiving lots of attention (somewhat like the unsecured lending is doing today in South Africa). I will never forget the logic of his explanation and analysis which I think useful to outline here again to illustrate just how wrong the professionals can be.
Subprime Mortgages were at the very low end of the lending spectrum or riskiest form of mortgage lending. It was the largest growing area as everyone wanted to join in on the boom in house prices and lever their ability to create wealth. But subprime lending accounted for only 10% of the entire mortgage lending market. Since home loans or mortgages are by definition backed by the physical asset or property, even if home owners in this higher risk category did start to default on their loans then the recovery rate would be somewhere around the 50% mark. If I remember correctly he mentioned that housing contributed about 7% to the US economy so even under the worst case scenario – a complete collapse of the sub-prime mortgage market – the impact on US GDP would be around -0.35%*. With trend US GDP growth of about 3% at that stage, this was hardly a major concern.
Fast forward a few months and we now know that the subprime scenario played out in a very different fashion. Through all sorts of financial innovations (read leverage) and the support of rating agencies ascribing AAA credit ratings to what we now understand was toxic debt, we landed up with significantly far wider reaching costs and consequences of the subprime collapse. In fact it resulted in the near failure of the financial system as we know it with high profile casualties like Lehman Brothers, Bear Stearns, and the bail-outs of AIG and General Motors to name but a few.
To the best of my knowledge, no one has a crystal ball that enhances their ability to predict the future. Despite this fact, you rarely pick up a newspaper, trade magazine or analyst report that does not attempt to in some way forecast the level of GDP growth, index returns or asset prices over a relatively short time horizon. This is not the fault of the financial services industry alone – I can say from firsthand experience that fund managers are constantly asked to predict returns for their asset class and are often measured on quarterly, if not monthly, performance statistics by the very people who employ them to manage their investments for the ‘long-term’.
History can however be useful to provide guidance (but not guarantees) on what the future may hold. If over the last 100 years real returns from equity markets have outperformed cash investments then one could reasonably expect them to continue to do so over the long term. That is not to say they will necessarily do so over the next 12 to 36 months though. Similarly, if a company has produced steady earnings growth and dividends payouts over the last 10 years, barring any major industry changes or loss of competitive advantage, we could reasonably expect them to continue to deliver.
Understanding the difference between predicting the future and using past experience to guide your future actions can be very helpful indeed. There is no room for complacency and we should monitor markets for signs of history repeating itself. The purpose is not to make a prediction but merely to prepare ourselves for the possibility of a short-term shift in momentum and to ensure that we do not try and adjust our long term strategy as a result of short-term shocks. You need to be sure that you are happy with your investment strategy on an ongoing basis.
If rebalancing is required as a result of the strong run up in equity markets, now is the time to adjust portfolio positions and not after a 20% or more correction!
*Workings of an overly simplistic but nonetheless enlightening example
Lets say GDP is represented by a nice round $100.
So the mortgage market accounted for 7% of GDP or $7.
And we said subprime only accounted for 10% of the mortgage market so $0.70 of GDP.
If the entire subprime market defaulted and we recovered 50% on foreclosure sales then we would only suffer a loss of $0.35 or 0.35% of GDP.
Please note this write-up does not constitute advice. Contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future.