Hari Seldon was a genius. He developed mathematical models that accurately predicted changes in mass behaviour. Unfortunately, Seldon was merely a creation of the sci-fi writer Isaac Asimov. Otherwise, his algorithms would tell us when the next market crash would occur.
Real-world prophets are increasingly convinced US equities are in a bubble. That would mean a crash is likely. A common definition is a one-day drop of 10 per cent or more in a key index.
This prospect is alarming for equity investors, however indirect their exposure to the US. Lacking Seldon’s prophetic powers, pundits are unable to say when the crash will happen.
Crashes are both intriguing and annoying for students of behavioural finance, the subject of these columns. Collective panic triggers them. That reinforces our presumption that psychology drives market moves. But understanding human biases — even with help from such authorities as John Maynard Keynes, Charlie Munger and Hyman Minsky — does not give us the Seldon-like prescience needed to sell high and buy low.
We can however control our own biases, such as aversion to losses, to weather crashes in good shape.
Bears believe US earnings-based valuations are too high relative to other markets. They envisage a rout cooked up within the financial system. This might follow a spell of inflation inspired by Trumpian economic policies that raised asset prices further.
That scenario would be more convincing if US private debt was higher. But some other exuberance indicators, notably the bitcoin price, are on a tear. Moreover, it is some years since we had a crash without an external trigger, namely a pandemic.
It is probable bullishness has begun to lose its hold on reality within the hive mind of the US financial industry and the customers it serves.
Let us unpack our three experts. Keynes, England’s best-known economist, believed “spontaneous optimism” drove many activities, investment included. Unquantifiable “animal spirits” mattered more to markets than earnings-based valuations, which he saw as mere conventions. Take that, CFA Institute!
Minsky, a shy US economist, elaborated on Keynes to theorise that capitalist economies move from stable to unstable conditions driven by speculative leverage. Eventually, confidence collapses. The term “Minsky Moment” describes that reversal.
For his part, Munger, Warren Buffett’s late sidekick at Berkshire Hathaway, came up with the term “febezzle”. This loosely encapsulates illusory wealth created by market bubbles, a portion of which is extracted by the financial industry for doing nothing useful.
No member of the trio had anything nice to say about financial professionals. They typically cop the blame for crashes.
I try not to judge. Most financial natives are just fallible humans, like me, you and the young man in the limerick who realised he was “a being that moves in predestinate grooves”.
In finance, those grooves are incentives encouraging everyone to nudge prices upwards. Remuneration in the sector is mostly funded from percentage charges on assets dealt in or advised on. Pay formulas can be complex, incorporating deferrals and clawbacks. But, in general, yearly pay tends to rise with asset prices.
Intermediaries therefore receive upfront a percentage of the supposed net present value of the assets they specialise in. Long-term investors have to wait to get their own percentage, via the recurring cash flows on which that net present value is theoretically based.
It is easy for intermediaries to convince themselves that cash flows will be a lot higher in far-off year five than in year one — and pass on the good news to clients. Analysts rate most stocks a “buy”, including many mediocre ones. M&A bankers evangelise takeovers to their clients, despite the poor outcomes of many larger transactions.
Professionals inclined to bombard fund managers with “sell” notes or warn would-be acquirers against overpayment face a big disincentive: getting the sack. Most investors relish rising prices too.
Moreover, it is almost impossible to predict a crash correctly. And a successful forecast may be dismissed as a lucky guess.
So everything is awesome — until suddenly it isn’t. Ben Kumar, head of equity strategy at wealth manager 7IM, prefers “flocking” to “herding” as the mot juste to describe groupthink during bubbles and crashes. He says: “The market is like a flock of birds: everyone is seeking to move with the group, but no one knows where the group will go next.”
His analogy is with a murmuration of starlings, a cloud of birds that flexes and flows to avoid danger. These are fun to watch. The chances of the birds suddenly dropping to roost rises as time elapses. Predicting the moment accurately is impossible.
So what is a private investor to do? Here is how I think about it. This is not investment advice.
If I was in an accumulation phase, I would go on feeding money steadily into a diversified range of investments. This would reduce damage that my timing errors might otherwise wreak. I would stay invested, in any event.
I would rebalance my portfolio, to reduce its susceptibility to falls in markets that have risen steeply. My aim would be to contain risk, not reap more gains (read Stuart Kirk’s column for a smart contrary view).
When drawing on my funds, I would do so gradually too. This would protect me from timing errors on the way out. Gradualism also extends the period over which compounding equity returns recoup losses made during crashes.
And what was the other thing? Oh yes. I would not panic. If there is a crash, everyone else will be doing that. You and I can spare ourselves the bother.
Jonathan Guthrie is a writer, adviser and former head of Lex; [email protected]
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