"Monsters are real, and ghosts are real too. They live inside us and sometimes they win."
Stephen King
October witnessed some extraordinary market volatility. Most of this was to the downside, but some exceptional upside volatility was experienced too. For instance, Tuesday of last week saw the Dow Jones Industrial Average finish the day up 889 points; this 11 percent move represents the second-best daily point gain ever. The Standard and Poor’s 500 Index (S&P500) gained an equivalent 11 percent on the day. To put these figures into context, the increases in these two closely-watched equity indices represent a one-day capital gain of just over US$1.5 trillion, an amount that is equal to about two-thirds of the balance sheet write downs recorded by banks, insurers and other financial services firms since the middle of 2007. The following day equity markets that trade in earlier time zones than US markets played catch up. Tokyo, for instance, put on about eight percent on the day, and South African equities leapt more than twelve percent in two days.
However, these big on-the-day increases have not done much to relieve panicked investors from the 45 percent decline recorded by global equities over the year to date. Nor could these one-day price jumps mask the fact that October saw the S&P500 fall to its lowest level since March 2003. At the same time, Japan’s Nikkei Index reached its lowest level in 23 years and, in the past 12 months, the former glamour markets of Brazil, Russia, India and China have recorded declines of between 40 percent and 70 percent in US$ terms. Collectively, these statistics reinforce the widely accepted view that October 2008’s equity market crash is a once-in-a-generation phenomenon, perversely having occurring on the twenty-first birthday of the October 1987 crash, when ‘black Monday’ saw the Dow Jones Industrial Average fall 22 percent on the day. Perhaps the only real difference for index watchers this time round was that it took five days in the second week of October to see the same index slide a massive 18 percent.
It is against this backdrop of extreme price volatility that market participants collectively have reached the conclusion that equities, without question or qualification, should be sold. The reasoning is simple: the only direction that equity prices can go in the foreseeable future is down.
Yet, this conclusion has a number of theoretical flaws and practical pitfalls. First, the result ignores the fact that equities represent the best performing asset class over time. For instance, the equivalent of R100 put into equities in 1900 would have been worth R108 000 in real terms by 2008. The same R100 in government bonds would be worth R221 or, if held as cash, would be worth R191 today. In other words, of the major asset classes, over the course of the past century equities have delivered 900 times what the next best asset class has generated. Consequently, for those wishing to capture long-run benefits from owning equities it means that there will come a time that they need to take a decision to buy back into the asset class if they follow the panicked herds’ decision to sell. In short, selling to avoid further equity price declines and buying back in later to redevelop exposure means that investors must practice market timing.
However, and second, whilst market timing has tremendous emotional and intellectual appeal, there is no empirical or anecdotal evidence from South Africa or elsewhere that suggests people have skill in market timing. More often than not decisions to sell or buy at the right time boil down to luck. To make this point more sharply, if anything, the right time to sell equities was mid-2007 and not at todays levels after a 45 percent decline in price. Indeed, now is the time to be buying.
Nonetheless, it is the overwhelming power of human psychology that encourages us to react to these sharp price falls by running with the herd for the exit. Yet, if we are able to identify these psychological influences we equip ourselves to be better investors. On this front, there are at least two psychological errors or biases that will have promoted the panicked herd’s stampeding.
First, in the heat of the moment, we lose perspective. Instead of being remembered as the best-performing asset class, equities quickly have come to be the most feared asset class. In the fullness of time this perspective will change, at which point the myopic herd will stampede back in to equity markets. Successful investors will move ahead of the herd. Recall the case of Sir John Templeton, one of the most successful investors of the twentieth century. Sir John made a fortune by buying 100 shares of each company trading for less than US$1 a share at the end of the Great Depression in 1939; within four years he had made many times the money back. In any event, as the chart below from Factset shows, the world’s largest equity market has more stocks trading on a single digit price-earnings ratio than at any other time since the crash of 1987. From this, the top performing asset class, equities, must be considered cheap.
Figure 1: Percentage of Stocks in the S&P500 on Price-Earnings Ratio of Less Than Ten
Source: FactSet
Equally, it is noteworthy that in the case of the Johannesburg Securities Exchange, 77 percent of resource counters, 58 percent of financial stocks and 75 percent of industrial companies trade on price-earnings ratios of less than 10. As further evidence of deep value, one-third of resource and industrial counters offer dividend yields in excess of 5 percent, whilst more than two-thirds of financial companies offer dividend yields greater than 5 percent.
Second, people convince themselves that their view of the world is a reliable view – a result that is due to human overconfidence. Examples of overconfidence abound. For instance, empirical research reveals that about 80 percent of people consider themselves to be better-than-average drivers. This, of course, is a mathematical impossibility. Similarly, a survey conducted by Duke University shows that chief executives consistently think that their company will do materially better than the economy, and that their company will outperform competitors. In turn, these perverse levels of confidence leave little room for reflection and contemplation. Instead, bold, incorrect decisions go unchallenged.
By recognising the long-run potential of equities and the practical difficulties of market timing and adding to this acknowledgement of psychological errors or biases, successful investors equip themselves to cope with the emotionally intense task of surviving a market crash. In so doing, this group will achieve investment results instead of results that are the random consequence of overconfidence, knee jerking and wild speculation born out of myopia. Warren Buffett sums it up best in noting that the time to be fearful is when others are greedy, and the time to be greedy is when others are fearful. With more than 55 percent of US equities trading on price-earnings ratios of less than 10 times, and the South African market trading on a trailing price-earnings ratio of less than ten, it’s time to be greedy.
Posts
