Is Everything That Didn’t Work Worthless?
For reasons best known to themselves and their (not very robust) consciences, America’s central bankers concluded that the best way to drag the US economy out of the Financial Crisis was to make rich people richer and poor people poorer. They therefore adopted policies—QE1, QE2, QE3—that drove up the prices of assets mainly held by the wealthy (especially stocks) and drove interest rates down, crushing savers, the elderly, pensioners, defined benefit participants, etc.
Writing in the Financial Times, John Authers described the result as “a soul-destroying decade stuck in the paradigm of reliance on financial engineering and low interest rates.”
But never mind the moral repugnance of these actions, and never mind that they did nothing for the US economy. What we’re interested in today is the effect of Fed policies on the investment management industry and, therefore, on the health of investors’ portfolios looking forward.
For seven long years, the Fed offered investors the so-called “Bernanke put,” essentially guaranteeing that stock prices would never fall far, would always recover, and would virtually always go up. If you were an investment manager who did anything but operate a capitalization-weighted index fund, you looked stupid for eight years. Worse, America is now full of investors who think investment success requires nothing more than a knowledge of Vanguard’s URL.
I’m not going to go through every possible investment style and strategy, identifying why each had no chance of success in a rigged market. But I will talk about two kinds of investing that didn’t work for many years but that will be crucial for investors going forward: value investing and hedge funds.
Over virtually every longer period of time, value investing has added value and beaten, among other styles, growth investing, usually by a substantial amount. And there’s no secret about why: value investing is the quintessential behavioral finance free lunch. Over and over again something like this pattern occurs in the financial markets:
1. Savvy investors spot X, an interesting stock or sector, and begin buying.
2. Less savvy investors notice what’s going on and join in the fun, buying more X.
3. Eventually, dumb investors pile in, creating a mini-bubble in X, which soon pops.
4. The savvy investors get out with a profit, the less savvy investors get out at breakeven and the dumb money takes a huge bath, having bought X when it was already way too pricey.
5. With the price of X having now fallen far below its intrinsic value, value investors start buying.
6. Eventually, savvy investors spot X, making value investors a lot of money, and the cycle begins all over again.
This might be a free lunch, but it’s a lunch that’s only available to a few extraordinary investors. Value investing requires, in the first place, a degree of patience not generally vouchsafed to ordinary mortals. Day-after-day, month-after-month, quarter-after-quarter, year-after-year you have to watch as really, really bad investors brag about how much they made that day/month/quarter/year. You avoid your country club, you stop playing golf, you dodge your boss. Meetings with your investors are excruciating.
Then, finally, the mini-bubble bursts and it’s time for you to buy. Except now the proverbial blood is in the streets. Not only do you have to wade into the ice-cold waters alone, but you have to do it while everyone else is already way up on the shore, running the other way and shouting, “Tsunami! Tsunami!”
It’s because value investing is so hard that it’s so valuable. But when an entire stock market has been rigged by central bankers who won’t allow prices to fall—because that would make rich people poorer—how can value investing work? The short answer is that it can’t, no matter how patient the value investor is, no matter how steely his or her buying discipline might be.
As a result, very few value investors are still in business. Some have literally closed up shop, some have sold out to (mostly much-inferior) firms, and most of the rest have sold out in a more important sense: managers who used to be value investors are now GARP investors: growth-at-a-reasonable-price. In other words, they are willing to pay up for stocks they would formerly have avoided.
It’s understandable that managers would succumb to business exigencies, but unfortunately it means that they can no longer be trusted to execute a value strategy. Thus, we have the worst of both worlds: most investors have given up on value strategies and the ones who haven’t can’t find untainted value investors.
And the timing could hardly be worse. After a long seven or so years of value underperformance, we are just entering a prolonged period of value outperformance. That period began as soon as the Fed announced that it was thinking of raising rates and it has accelerated in 2016. During the post-Trump rally, for example (the most powerful in US Presidential-election history), when you would most expect that growth, speculative, and volatile stocks would outperform, value clobbered growth.
For investors who aren’t irretrievably addicted to cap-weighted index funds, it’s worth the trouble to search out the few remaining value investors. For those investors who lack the skill to do so, fundamentally weighted index strategies are probably the best option.
[By the way, as I was drafting part 2 of this series of posts and went off to do some fact-checking, I realized that I had borrowed several ideas from an interview of Ted Seides by Patrick O’Shaughnessy. If you don’t know Ted, he trained under David Swensen at Yale and then spent years seeding new hedge funds as president of Protégé Partners, a firm founded by Jeff Tarrant. Ted was one of the first to point an accusing finger at the Platinum hedge funds, whose partners were recently arrested and charged with operating a “Ponzi-esque” scheme. The interview with Ted is an hour long but it’s well worth listening to:
Next up: Is Everything that Didn’t Work Worthless? Part II