Market View - September 2012

The sun finally shone during August and Great Britain basked in its most successful Olympics since the event was first hosted by London in 1908, winning a total of sixty five medals including an incredible twenty nine golds, and its looks like there will be quite a few more British medals in the Paralympics which commenced at the end of the month!

Thankfully the sun was shining also on global equity markets as the cyclical bull market which has been in place since March 2009 (when the S&P 500 in the US hit its post Lehman low of 676) continued to progress helped along recently by the expectation of further quantitative easing measures from the Federal reserve System in Washington DC, although the announcement many had expected from the Jackson Hole conference did not materialise, so now all eyes switch to the FOMC meeting later this month! From an intermediate perspective, the S&P 500 end August close of 1406.5 was 107.9% above the March 2009 closing low and 10.1% below the nominal all-time high of October 2007.

During August global equities as measured by the MSCI World index rose 2.29%, and the index is now up 8.17% since January 1st, 2012, while the JP Morgan Global Bond Index has risen 2.12% since the start of the year. Most regional equity indices rose in August with the S&P500 climbing 1.98% (up 11.85% year to date), while the FTSE 100 climbed 1.35% ( up 2.50% YTD), the FTSE Eurotop 100 climbed 1.50% ( up 6.29% YTD), the Nikkei 225 in Japan  climbed 1.67% ( up 4.55% YTD), the MSCI in India climbed 1.01% ( up 13.00% YTD), while the Hang Seng in Hong Kong fell 1.59% ( but is up 5.69%. YTD) and the Shanghai Composite in China also fell 2.67% (and is also down almost 7% YTD)!

The economic backdrop continues to prove a concern to markets with the eurozone crisis seemingly just on hold for the moment (with much expected from the European Central Bank council meeting on September 6th), China increasingly looking like it is experiencing a hard landing after all, and US housing and employment data stubbornly lacklustre. The latter was borne out by recent research showing that the total student debt in the US now exceeds $900 billion compared to just $500 Billion five years ago, while unemployment in the 16-24 year old section of the workforce is running at more than 16% compared to a little over 8% for the economy as a whole, and of course the picture is little better (or in some cases much worse) here in the UK and Western Europe!

Back in March we touched upon an important piece of research being conducted by respected journalist and economist John Kay on behalf of the British government. Effectively in June 2011, Vince Cable the Business Secretary commissioned the Kay report to find out how well the UK stock market is achieving its dual objectives of enhancing the performance of UK companies, while also enabling savers to benefit from the activity of these businesses through ownership of shares either directly or indirectly through pension and other investment plans.

The report titled “The Kay Review of UK equity Markets and Long-Term Decision Making” disappointingly concludes “that short-termism is a problem in UK equity markets, and that the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain”. Most of the proposals for reform are extremely sensible and already practised by the majority of investment firms with whom we have relationships.

Some of the more interesting recommendations which probably are not currently the norm across our industry include “ improve the quality of engagement by investors with companies, emphasising and broadening the existing concept of stewardship” and “ increase incentives to such engagement by encouraging asset managers to hold more concentrated portfolios judged on the basis of long term-absolute performance”. Another recommendation that seems to make total sense is to reduce the pressures for short-term decision making that arise from excessively frequent reporting of financial and investment performance (including quarterly reporting by companies) and from excessive reliance on particular metrics and models for measuring performance, assessing risk and valuing assets.

When addressing the problem of short-termism, many older investors will doubtless agree with the review’s findings that in more recent times, “public equity markets encourage exit (the sale of shares) over voice (the exchange of views with the company) as a means of engagement replacing the concerned investor with the anonymous trader”. To a large extent of course and as the Kay Review observes, this has been due to the evolution of the structure of shareholding in UK equities leading to “increased fragmentation, driven by the diminishing share of large UK insurance  companies and pension funds and by the globalisation of financial markets which has led to increased foreign shareholding”.

The review also points the finger at the (arguably) erroneous belief by the market generally in the efficient market hypothesis, suggesting “that the theory represents a poor basis for either regulation or investment” and consequently ”may drive damaging short term decisions by investors, aggravated by well – documented biases such as excessive optimism, loss aversion and anchoring.” The report observes that Asset Managers have in modern times become the dominant shareholders and that unfortunately “the appointment and monitoring of active asset managers is too often based on short term relative performance. The shorter timescale for judging asset manager performance, and the slower market prices are to respond to changes in the fundamental value of the company’s securities, the greater the incentive for the asset manager to focus on the behaviour of other market participants rather than understanding the underlying value of the business.”

Arguing that ultimately competition between asset managers is a zero sum game and that they undermine their objectives of delivering good long term returns through what appears to be the short term focused strategies of most of them, Kay suggests that regulatory policy in future must address these issues and “focus on the establishment of market structures which provide appropriate incentives, rather than the fruitless attempt to control behaviour in the face of inappropriate commercial incentives”. In its executive summary the Kay review makes no less than 17 recommendations to resolve the current investor investee disconnect, including those referred to above and most make perfect sense , while some such as “regulators should avoid the implicit or explicit prescription of a specific model in valuation or risk assessment and instead encourage the exercise of informed judgment” are arguably inherently obvious.

It is perhaps purely coincidental that a recent book from Simon Lack, a former JP Morgan executive titled “The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True” arguably reaffirms the folly of short termism in investing (since most hedge fund managers and strategies tend to be short term traders) when it claims “if all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good”. As we have always suggested, it pays to have a reliable long term investment strategy at the core of your portfolio, supplemented by tactical asset allocation decisions where and when appropriate!