On wishful thinking

“The stupid neither forgive nor forget; the naïve forgive and forget; the wise forgive but do not forget.” - Thomas Szasz.

Hussman Funds’ John Hussman, in “A Who’s Who of Awful Times to Invest”, points to the following market corrections:

December 1961: followed by a 28% market loss over 6 months

January 1973: followed by a 48% market loss over 20 months

August 1987: followed by a 34% market loss over 3 months

July 1998: followed by an 18% market loss over 3 months

July 1999: followed by a 12% market loss over 3 months

December 1999: followed by a 9% market loss over 2 months

March 2000: followed by a 49% market loss over 30 months.

What conditions do these periods share ? Hussman finds four congruent characteristics:

1) A price / peak earnings multiple above 18 times;

2) A four-year high in the S&P 500 (on a weekly closing basis);

3) The S&P 500 at 8% or more above its 52-week moving average;

4) Rising Treasury and corporate bond yields.

(As Hussman suggests, depending on how one defines trends in interest rates, one can also include two periods: October 1963 and May 1996, which were both followed by 7-10% corrections.)

And as Hussman points out, one more date completes the list: July 2007. This is not, in itself, a market call - merely an observation about market statistics. Readers can and should draw their own conclusions. But given the recent losses incurred by a number of overleveraged and poorly risk-managed collective vehicles masquerading as hedge funds, and given the extent - both in duration and percentage returns from their trough - of equity market rallies, a degree of expectations management is surely in order.

Egregious fee extraction is, of course, not restricted to so-called hedge funds. There are plenty of traditional funds charging unjustifiably high fees for substandard performance. If future market returns are likely to disappoint by comparison with the recent past (and the two-decade rally in both debt markets and equity markets which was recently reversed in the former strongly suggests that they might), then the imposition of any fees whatsoever is likely to hinder portfolio returns. Alistair Blair, writing for Investors Chronicle, recently addressed the impact of fees on traditional fund performance, in damning style. Referring to the malign influence of fees and commissions upon retail investment products, he offered the following solution:

“consumers simply cannot grasp the fact that the man sitting in front of them and the people behind him are being paid via a long-term and hugely expensive levy on the returns from their savings.. here’s a suggestion.. Investment products should be required to be sold with a warning comparing the total impact of fees over 20 years with the impact of fees on the least expensive indexed product on the market. I believe this slot is currently occupied by the Fidelity Moneybuilder UK Index Fund, which has an annual management charge of 0.1% and total expenses of 0.3%. The warning would run like this:

1) This product aims to deliver you a greater return than you would obtain by buying the Fidelity Moneybuilder Index Fund directly. It will need to do so because our costs are much higher. Very few people understand the effect of fees - even apparently small ones - on investment returns, SO PLEASE READ THE FOLLOWING CAREFULLY.

2) If you invest £5,000 in the Fidelity Moneybuilder Index and it achieves 7% growth a year for 20 years, your £5,000 will grow to £18,000. If you invest in our product and it achieves 7% growth a year for 20 years, the effect of our higher fees will be that you will end up with only £12,000.

3) But we aim to do better. In fact, even to match the Fidelity Moneybuilder, we’ll have to outperform the index by an average of 2.4% every year for 20 years.

4) In the FSA database of 15,000 funds offered to the public over the past 20 years, only 10 funds have achieved this kind of performance. We aim to be the 11th.”

Of course, not everyone wants index performance, hence the existence of hedge funds. But the bifurcation of the investment industry between low-cost tracker products - for example, exchange traded funds - and high-cost broadly market neutral structures - true hedge funds worthy of the name - leaves an uncomfortable no man’s land in the middle replete with mongrel structures of dubious merit: funds which would track the market were it not for those “active” management fees so which are now predestined to disappoint.

It is in the nature of markets to frustrate the largest number of people at the worst possible time. It is in the nature of secular bull markets that they draw in the hitherto resistant just prior to topping out (the fault, dear investor, is not in our stars, but in ourselves). Again, this is not to make a sweeping judgment call on equity market valuations, which in many cases don’t seem particularly extreme. But it is to respect the deterioration in the fundamentals for fixed income markets (the reduced anticipated take-up of international sovereign funds for Treasury risk; the sharp rise in basic foodstuff prices; the sharp rise in oil and the global competition for natural resources; the recent break in a two-decade trend of lower interest rates; the possible contagion from subprime) and the probably inevitable gravitational pull to be exerted on stocks from cheaper government debt. Equities have been bizarrely complacent during the recent upheavals in credit markets, and the ongoing worsening macro factors cited above. Citigroup’s Chuck Prince may still be dancing, but some of us are edging, not that subtly, towards the door.