Inside Investment: In truth, nobody knows


Andrew Capon
Published on:

The pretence of knowledge is the curse of the financial world, especially when we live in such uncertain times. There are very few certainties left.

In early 2008 I achieved my 15 minutes of fame. A research report I had written was quoted on Bremner, Bird and Fortune, a successful satirical TV programme in the UK. In response to the credit crunch, I had suggested that investors did not know whether to, “buy on the rumour, sell the news, do the opposite, or do neither, depending on which way the wind is blowing.” Thankfully my research notes had limited distribution, very few people made the connection and the satirists, one now sadly dead, did not cite me by name.

Watch it on YouTube. It is hilarious. 

I kept my job, but received endless emails and the mockery of the trading floor. The point is that analysts, fund managers, and financial commentators, are supposed to be experts. They get relatively inflated salaries based on what they are supposed to know. They are relied upon for their judgment. 

 If you believe in fundamentals you have
to be fundamentally mental

The truth though can be different. In 2000 at the Extel lunch at the Guildhall in the City of London, the consensus prediction was that the FTSE100 would reach 7,200 by the next time the best brains in the City sat down to celebrate their collective wisdom in 2001. In spite of new highs, and 15 years on, we are still not there.

Who knew what would unfold in 2008? My view was that markets were heading into massive dislocation. I said so here. I said so in my research reports. But a sure way to lose friends and alienate people is to be a Cassandra, even though her prediction of a bloodied winding sheet was right. At a conference in Boston in April that year I was sat on a table of sniggering experts responsible for overseeing hundreds of billions of dollars of investors’ capital as Nouriel Roubini told the audience we were heading into financial Armageddon. Bear Stearns had already gone, but the sunnily sanguine thought surely that was as bad as it could get.

They were wrong. Roubini was right then, but that does not mean his views are any more valid now than anyone else’s. This column has made some good predictions: that 2008 would be very bad; that equity markets would rise in 2009; that the eurozone would not break up in 2011; and a few bad ones, like gold being a good bet in 2013, though as a hedge against huge uncertainty there is no reason to give up on that quite yet. But the only real insight has been a basic one: mean reversion. The business of forecasting has never been easy and thanks to policymakers has got a whole lot more difficult.

Essential complexity

In his Nobel prize lecture, The Pretence of Knowledge, the Austrian economist Friedrich von Hayek, talks about the essential complexity of economics and the financial system. Finance has tried to impose order on chaos. We have gone from things that are relatively easy to understand such as price-to-book, price-earnings ratios, and earnings per share, to CAPM (the Capital Asset Pricing Model), Modern Portfolio Theory, the Efficient Market Hypothesis and, joy of joys, Generalised Auto Regressive Heteroscedasticty to try to explain finance. We used an untested model (Gaussian copula) to value asset-backed securities. That did not work out well because normal distributions are presumed, as they are in most finance theory.

Hayek notes that in the 16th century Spanish philosophers decided that the pretium mathematicum, the ‘right’ price, depended on so many variables, that it could only be known to God. 

Financial gurus may have assumed his mantle but hubris is never a good look. That is particularly true now because if you believe in fundamentals you have to be fundamentally mental. You cannot buy a German government bond out to eight years maturity with a positive yield, the European Central Bank is buying the entire net issuance of eurozone bonds and more than half of all global government bonds in circulation offer investors 1% or less. Whither the bond vigilantes?

All asset prices and all asset classes are being driven by central banks. There is no yield anywhere because of a desperate last ditch attempt to generate inflation and growth. There was once a concept called the zero bound, but the Riksbank and the Swiss National Bank have other ideas. The next steps are price level targeting, taxes on wealth, and debt monetization.

You could jump on some clear recent trends such as the strong dollar in an attempt to generate reliable returns. But there are $11.5 trillion of reserves held by central banks, mostly in emerging markets, that may think this is a selling opportunity. 

In the comedy sketch John Fortune asks: “and this is the kind of rigorous analysis that companies in the City pay ample bonuses for?” Sadly that part was not true. Shrugging your shoulders and saying ‘who knows?’ is not acceptable in this trade. But this is a 2008 moment. Humility seems sensible, so does cash and contrarian trades such as emerging market debt. Central bank manipulated asset classes make no sense at all.