11 Jul It’s all in the price
Image by Gellinger on Pixabay
I recently attended an event which addressed the vitally important subject of the suitability of the advice that advisers give to their clients. One speaker particularly got my attention.
A macro economist with wide experience in the private and public sectors and latterly in academia, he has been building an interactive forecasting tool to allow people to model the impact of various possible macro-economic shocks on the global economy. While tools of this type are not new, they have hitherto been available only to institutions with large budgets and his laudable intention is to make it available via a website to a much wider audience. Such shocks (since, by definition, a shock is unexpected) might be in a number of forms and a 15-minute discussion among the audience of around 50 practitioners managed to come up with a respectably long (if somewhat worrying) list of possible scenarios.
The ability to model the impact on a portfolio of, for example, a 60% increase in the oil price over the next three years is interesting and no doubt reflects considerable effort on the part of the people building the tool but given that we are dealing with the inherently uncertain future, who is to know whether a 60% increase is a reasonable scenario? What if it is 30%, or 90% or 160%? What if it happens tomorrow or in six and a half years? What if it then stays at that level rather than reverting to current price? All of these scenarios can be modelled and the results will vary but, even assuming that the constants inherent in the formulae are correct, the variables are numerous. As more and more components are added to the formula in pursuit of ‘accuracy’, the range of potential outcomes grows exponentially. And there is still no guarantee that any of them will be correct. Even if one of them is, how will we be able to separate it from the noise of all the others?
The events which should worry us are those which are not widely anticipated (or even considered) and therefore not already reflected in market prices. Unfortunately we may have no idea of what those are and when they might occur (for example, what if an earthquake precipitated the collapse into the Atlantic of the western part of Gran Canaria, resulting in a tsunami which then devastated much of the eastern coast of North America?). How would anyone accurately model the economic impact of that when there is no historical basis on which to do so?
One of the slides that the economist showed was the results of a survey of a group of long term investors as to what they thought were the dozen or so biggest risks in the global economy. Top of the list was a slowdown in China’s economic growth. Down at the bottom was an oil price shock – seen by the participants as a risk but not a massive one. Interestingly, the speaker pointed to the latter as the biggest risk in the 1970s but I wonder whether, in September 1973, that was really in people’s minds as such a big risk. The event which sparked the spike in oil prices was the 1973 Arab-Israeli war, which started with a surprise attack on Israel by Egypt and Syria. Despite its highly-rated intelligence agency Mossad, even Israel was taken by surprise by the actions of its neighbours and yet its very survival depended on not losing such a conflict by having enough warning to mobilise its citizen forces in time. If Mossad failed to spot the signs, what chance did the economists (who had far less at stake) have?
In any case, even if we are able to forecast accurately the events, markets do not always react to them in the way we might expect, whether that be in terms of the magnitude of the movement or even its direction. In September 2015 the French government’s credit rating was adjusted downwards by credit rating agency Moody’s from Aa1 to Aa2, which one might expect would result in a sell-off of French sovereign debt as it had now apparently become riskier. In fact the price actually went up following the announcement, because investors had long been expecting the downgrade and so it already reflected that expectation. The official announcement lagged the market’s reaction.
Of course it is quite easy to look back on historic events and identify what the risk was but that doesn’t really help us much when trying to predict the future. Yet as investors, arguably we don’t actually need to do that.
If those long term investors really think that a Chinese slowdown is currently the biggest risk, it is reasonable to expect that this will feature in their decision-making process when determining how to structure their portfolios. In such circumstances, it is unlikely that they would be loading up on Chinese shares or those of overseas businesses which they anticipate would be negatively impacted by such an event. Instead they would be looking to reduce their exposure to that perceived risk and reallocating to what they see as assets offering a higher expected return. Such actions are what investors do constantly and if enough want to sell something, the price goes down until someone is willing to buy it because they perceive that their own expected return on it is now sufficiently attractive.
That is how publicly traded markets work and so the prices of assets continually reflect the level at which buyers and sellers are prepared to trade them. Consequently, the aggregate expectations of all market participants are always reflected in the prices of quoted assets (in these days of electronic data transfer, almost instantaneously around the world). Only the flow of news about unexpected events causes these to be adjusted either up or down. There is obviously no certainty that the collective view of the market will reflect some intrinsic measure of the value of the traded assets but it does reflect at what price investors are willing to own them at any point in time.
The benefit of investing in publicly traded assets is that the range of potential investors who can influence their prices is truly diverse and with a range of different objectives, perceptions and biases. While none of them needs be correct individually, the collective impact of all those participants taking a view on the relative attractions of owning any particular asset is such that at any one time, its price will move to a level at which someone is willing to buy and someone else to sell. Neither of them may be happy that the price is ‘correct’ but it is at least reasonable.
So next time you are agonising over whether the price you are quoted for something, whether as a buyer or seller, is correct, ask yourself if you are prepared to accept it. If you are, then it’s reasonable for you on that day. If not, you always have the option to wait until the other party comes round to your way of thinking. They might, or then again, they might not but you can always reassess your decision based on what you know then.