Market View - June 2012

Volatility and fear returned with a vengeance to global equity and commodity markets in May as the eurozone debt crisis threatened to run out of control with politicians and policy makers seemingly out of ideas!

Many commentators now believe there are just two options remaining in Europe, namely the total breakup of the eurozone, (and incredibly possibly precipitated by Germany deciding to leave first), or Europe moving politically and fiscally to a model more akin to the United States which would enable Eurobonds to be issued for the first time. Global equity markets became a sea of red last month as the MSCI World index fell almost 7%, which included the S&P 500 in the US falling 6%, the FTSE Eurotop down 7%, the FTSE 100 in the UK falling 7.50%, and the Hang Seng in Hong Kong and the MSCI Emerging Markets indices both falling more than 11%! The Shanghai Composite in China was the only major equity market to almost buck the trend as it fell less than 1% and is still up almost 8% Year to date in 2012, while global equities as measured by the MSCI World are up just 2.39%.

There were however glimmers of hope economically as The Economist newspaper published a special fourteen page report on China (Pedalling Prosperity) which was on the whole encouragingly positive and suggests that despite a recent slowdown, the world’s second biggest economy is more resilient than its critics think! That is not to say that there are not many things wrong with the Chinese economy as the report acknowledges, but most of these will not become problematic until much later and on balance the next decade should be manageable before the country’s personal savings rates starts falling as its demographics deteriorate.

The Economist dismisses pessimistic comparisons of China with Japan’s decline since 1991 saying “Japan did not blow up until its income per head was 120% of America’s (at market exchange rates). If China’s income per head were to reach that level, its economy would be five times as big as the US”.

With the fallout from the credit crunch continuing to play havoc in the Eurozone and in global markets several years after the Lehman shock, it is interesting to read the wise words of James Montier of GMO taken from his recent white paper titled “The Flaws of Finance”, when he says “Give a monkey a value at risk (VaR) or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands”. He examines the role played by “bad models, bad behaviour, bad policies (which is really just bad behaviour on the part of central banks and regulators) and bad incentives” in creating the global financial crisis, and arguably his white paper should be required study for all practitioners, regulatory authorities and the Chief Executives of any banking and financial institutions dealing with money!

Perhaps unsurprisingly, most of James’ observations involve simply applying common sense when using models like CAPM which in theory all too often look foolproof, but inevitably when it comes to real life have shortcomings. He reminds us of CAPM’s shortcomings historically from the saga of Long-Term Capital Management, and is equally scathing of value at risk modelling suggesting that “Using VaR is like buying a car with an airbag that is guaranteed to fail just when you need it, or relying upon body armour that you know keeps out 95% of bullets. VaR cuts off the very part of the distribution of returns that we should be worried about, the tails”.

Montier also refers to the human tendency to be blinded both by science and by supposed “experts”, as well as alarmingly being vulnerable to a behaviour known as anchoring which can make even irrelevant numbers powerful inputs into our decision making. He quotes the evidence he has gathered from testing over six hundred professional fund managers of how this worrying trait can erroneously impact our judgement. James suggests that “anything requiring advanced mathematics should be treated with extreme suspicion when it comes to financial applications”.

Benjamin Graham forewarned us of this a long time ago when saying “Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw from them...whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment”

James Montier’s paper concludes with a manifesto for change that includes a recommendation that all involved in the theory and practice of finance would do well to memorise “The Modeler’s Hippocratic Oath” (written by Emanuel Derman and Paul Wilmott), which says:-

I will remember that I didn’t make the world and it doesn’t satisfy my equations.

Though I will use models to boldly estimate value, I will not be overly impressed by mathematics.

I will never sacrifice reality for elegance without explaining why I have done so.

Nor will I give people who use my model false comfort about its accuracy. Instead I will make explicit its assumptions and oversights.

I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

We have no doubt that the financial markets and the global economy would be much more profitable and less volatile if everyone adhered to this oath!