Absolute Return Partners: Pie in the Sky?
“The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith
And now for something completely different. You have just started to read the first January Absolute Return Letter. Since late 2003, when it was first published, it has been circulated 10 times a year, usually during the first week of the month with the exception of early January and early August. The latter is obvious, given how many people are away on holiday at that time of year, but we have decided that early January is a good time for a letter despite our skepticism on the wealth of January publications giving a ‘view’ on the coming year.
The aim is to make our January letter an annual statement of sorts – but do not expect it to turn into an archetypal annual forecasting exercise, of which there are so many. This will be a little different and, hopefully, value-added.
It has always baffled me how the financial industry, and financial newspapers in general, in January appear to be hell-bent on forecasting this or that. The amount of forecasts predicting where the FTSE or the S&P will end up in the year ahead is mind-boggling, and quite frankly a little silly. As if anyone knows! My top prize this year for utter silliness goes to this one.
Even worse, the amount of macro-economic forecasts is tedious to say the least. I made the point last month that the link between economic growth and stock prices is pretty much non-existent – at least in the short term. If you don’t recall the chart I used to make my case, here it is again (chart 1).
To exemplify how bad forecasting often is, and just how careful one needs to be if relying on forecasts to construct one’s portfolio, take a look at chart 2 below. As the oil price collapse got more and more pronounced during 2014, analysts didn’t change their future price expectations one iota.
The 3-month and 12-month forecasts were more or less the same premium over the spot price – the starting point (the spot price) just got lower and lower. As Gavyn Davies says, predicting oil prices (or anything else for that matter) can be a mug’s game.
Absolute Return Partners: Our investment style
Having said that, not all forecasting is a waste of time. We make forecasts (!) and have an acceptable track record, but we have some strict rules that we follow which I will get back to in a minute. First some evidence of our record. In March 2004, when the oil price was in the mid-30s, I wrote:
“Oil is essential to everything we do. And because oil is critical to our economy, changing oil prices can have dramatic impact on financial markets. In this month’s newsletter, we will focus on the longer-term outlook for oil prices (we don’t pretend to know what will happen in the short term). Let’s jump to the conclusion right away. We believe we will see $100 per barrel oil prices within 10 years.”
We obviously got the timing terribly wrong. The projected spike in oil prices happened a lot faster than we thought was feasible at the time.
In July 2009 I wrote:
“For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation.”
In truth, we were almost alone with that view back in 2009, which can be a terribly lonely feeling, such was the conviction that QE would end up with (hyper) inflation, but we were sufficiently convinced that we called the letter Make Sure You Get This One Right.
A few months earlier – in March 2009 – we had predicted that the aftermath of the financial crisis would be much harder on Europe that on the U.S. (the letter was called Europe on the Ropes). The reality as we enter 2015? All three predictions have been massive winners.
I don’t mention these examples just to blow my own trumpet. The important point in this context, and providing the framework to those rules I mentioned, is that they all have one particular – and very important – feature in common. The reasons behind all these forecasts are structural in nature – not technical or cyclical.
When putting money to work, I am the first to admit that I am pretty lousy at short term investing. The only consolation is, and please don’t be offended, I think most people are. It is no big challenge to make short term profits in a bull market, because the rising tide will lift all boats. It is a great deal more difficult to generate a positive return over the short term when the beta is zero or negative.
I distinguish between three time horizons when investing:
1. Very short term (mostly technical factors)
2. Short to medium term (mostly cyclical factors)
3. Long term (mostly structural factors)
When I speak of technical factors, I am not referring to all those wonderful charts that people create to support their bull or bear case. That sort of technical analysis doesn’t work for our style of investing and I don’t pay any attention. The biggest technical factor for me is the contrarian indicator. If the entire world is negative on asset x, I see it as a major positive. My logic is simple. The vast majority of people are smart enough to position themselves accordingly before they go public with a view. So, when the entire world is already negative, where is the selling pressure going to come from?
This logic unnerves me somewhat as far as my long-standing view on inflation v. deflation is concerned. As already mentioned, when I first went public on the subject in 2009, I belonged to a tiny minority. That is no longer the case. At least as far as the Eurozone is concerned, an ever-growing majority now expects deflationary or near deflationary conditions, which explains why 5-year German notes now offer negative returns and the German 10-year bund now trades around 0.5%.
If you are based in Italy or Greece, and you worry about the risks associated with deflation (which we all now realise are significant after having watched events in Japan over the last couple of decades), and you don’t want to be exposed to currency risk, what do you do? You don’t buy Greek or Italian government bonds. No, you buy German bunds. Using ‘my’ contrarian approach, German interest rates may not have much further to fall (as if they could). Deflationary expectations are now too well entrenched for my comfort.
See full PDF below.