Your investment outlook vs the consensus one

IT'S a good idea from time to time to pause and assess how similar your investment outlook is to the consensus of chief economists and other assorted forecasters. The beginning of the year is a perfect time to do this, as the flood of reports titled "Outlook for Next Year" usually give a good overview of what the aggregate market is thinking.

One of our constant themes is that when an investment consensus becomes very entrenched, to the point where it is almost taken as a self-evident truth, it will likely mark a major turning point. When your views are the same as the consensus, it is good to carefully re-analyse your reasoning for holding that view.

Last year broke a number of crowd-consensus trades which we covered, from bitcoin/crypto mania at the very beginning of the year to cannabis stocks in the second half. Finally, in the fourth quarter, the consensus that tech stocks and US equities will continue to outperform because of their higher growth rates was dispelled, with investors now questioning the sustainability of growth and margins in companies such as Apple.

It is important to note that the consensus is not always wrong. While calling a top is more art than science, identifying a wrong consensus is much easier when we are in the midst of a mania and everybody from your cousin to the taxi driver and the shoeshine boy all want to get in on the latest 'sure thing". Crypto-mania a year ago fit this to a tee, where a restaurant manager I knew well wanted to put all his savings into bitcoin, and a very rich investor expressed admiration (and maybe some envy) at his niece, who had turned US$10,000 into US$100,000 in crypto-currencies. Even some (formerly) smart hedge fund managers who really should have known better got caught up in it, leaving their jobs to set up a crypto fund, right at the peak of the market.

This year's outlook has no manias in sight. The biggest consensus seen from every commentary is that the world's economies are all at the late stage of the cycle. I confess to having held this exact same view for over a year as well, meaning that I should step back and closely examine the potential flaws in the reasoning that leads to this conclusion.

Unlikely scenarios

Late-cycle slowdowns lead to an equity bear market, either a shallow one (-20 per cent on average) or a deep one (-35 per cent on average). It is true that the current expansion has gone on for a long time. Valuations in the US are expensive on some metrics, especially the cyclically adjusted P/E and P/Sales. A much shorter economic slow-down, and a re-acceleration of global growth would be a surprise that would take every economist projection off-guard. Possible candidates to avert the expected slow-down, all of which admittedly look unlikely at this point, would be:

All of the above look like wishful thinking. But as we have seen time and time again, unexpected events can and do happen, especially political ones in recent years. And widely-held consensus investment views almost never turn out to be correct.

This late-cycle view naturally leads to a more cautious view on equity markets for this year, especially after the recent volatility. There are plenty of reasons to be cautious: the US-China trade war, quantitative tightening by Central Banks, and a possible impeachment of the US President.

Deeper analysis

A deeper analysis of stock market situations similar to our current position from the past paints a different picture. Quarters where US stocks had falls of -15 per cent or more are relatively rare. Post-World War II, in 100 per cent of such cases, markets were higher two quarters later. Even on a shorter time-frame, just one quarter after the negative performance, markets were higher in 85 per cent of cases. The pre-World War II period had negative performance over a few consecutive quarters only during the Great Depression in the 1930s.

The message would appear to be that in the absence of a very sharp contraction in economic activity, where much of the population loses their jobs and many businesses go bankrupt, the market tendency is to recoup its losses quite quickly.

The second consensus, though less prevalent than the first, is that Emerging Market (EM) equities are the place to be for this year. This is backed by historical data, where the EM sector is about as cheap as it has ever gotten relative to US equities. The MSCI Emerging Market index is actually -3 per cent in the last five years (vs S&P500 +36 per cent before dividends). Even worse, over the last 11 years with the starting point before the Great Financial crisis, EM is -22 per cent vs +70 per cent for the S&P500. I was at a bank's 2019 outlook conference this week, where the audience was polled on their opinion of the bank's outlook. Out of all the bank calls, the bullish EM call received the lowest agreement from the audience, so clearly investors are not convinced. Reversion to the mean is a very strong tendency in financial markets, and EM equities are well overdue for one.

As always, investors who are sitting in cash fretting about the return of volatility can use history as a guide. The 2017 period of low volatility was the real abnormality, while the higher volatility experienced last year is not unusual when viewing financial markets on a longer-term basis.