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The surprising thing about surprises

11th May, 2020

Published in the Sunday Times on May 17th 2020
Four out of every three people struggle with fractions, goes the old joke about innumeracy. Judging by the nonsense that gets reported, most of us could do with a refresher course in number skills.

A BBC online article from 2018 — fretting that a currency had lost 180 per cent of its value, raises an eyebrow. But the one that takes the proverbial biscuit is surely the failure of the third pounder hamburger to tempt consumers away from McDonalds’ smaller quarter pounder. Focus groups later confirmed that it floundered on the failure to recognise that the “3” in one third is larger than “4” in one quarter.

So you can imagine the eye roll that greeted a recent article about US oil prices plunging by over 100%. After rolling my eyes back, it was clear this wasn’t a hamburger-like mistake.

Oil prices decline by over 100%

So, oil prices can actually fall below zero. Granted it happened only briefly, but nevertheless remains on the record. There’s another cherished notion about financial markets torn asunder.

If we’ve learned anything in the last few months, it should be that assumptions you have about the future can be upended overnight. It was true in January, and it’ll be true again in the future. Things change. As Daniel Kahneman says, “The correct lesson to learn from surprises is that the world is surprising.”

In a world where fundamental assumptions about the future are so fragile, we should think about the future and our ability to divine it with a great deal of humility.

How to think about the future as far as investment decisions are concerned

Likely uppermost in investors’ minds today are questions like: When will the lockdowns end? What will happen in the travel and hospitality industry? When will there be a vaccine? What sectors should do well out of the crisis?

These are all legitimate questions, the accurate answers to which would no doubt arm one with a valuable edge in deciding how to deploy capital.

We often look to financial markets for clues as to what the future holds. After all, markets are an exceptionally good discounting mechanism. We are however getting some mixed signals from stock markets at the moment.

Newsflow about the next six months looks quite dire. The International Monetary Fund, which expects global Gross Domestic Product to decline by 3% this year, observed that the magnitude and speed of collapse in activity is “unlike anything experienced in our lifetimes.”

The impact on companies will inevitably be severe. This souring of the corporate mood has been accompanied, bizarrely, by a mini-boom in stocks.

The rally in markets since March

The S&P 500 is up over 25% from its March 23rd low (in Euro) and is in positive territory year-over-year (as at May 4th). And it’s the technology sector that has been leading the charge.

The stocks that matter most to index returns tend to be well-capitalised secular growers that seem particularly well adapted to operating in the current environment. On main street, newsflow may seem pretty dire, but to get a sense of this we need to look beyond megacaps.

Here we see a more nuanced story about Covid-19 impact on financial markets. Rallies in megacap firms are masking a much more tepid recovery in the market at large. The equally weighted version of the S&P 500 (where each stock is equally weighted, rather than weighted by market capitalisation) remains over 10% below its year ago level (as at May 4th in Euro), despite a strong recovery from its lows. This provides a broader representation of corporate America.

The concentration at the top of the S&P500 index has never been so extreme. The largest five companies, all from the tech sector, now represent 22% of the index. The S&P 5 as they are now being referred to, easily eclipse the previous peak in concentration back in 2000.

Trees don’t grow to the sky

The market cap of the largest stocks in the S&P500 have grown at roughly three times the rate of the broader index in the last six years. According to Michael Batnick, If these divergent growth rates were to continue, in 7 years these 5 stocks would represent half of the index in terms of market capitalisation. For reasons that are obvious, i.e. trees don’t grow to the sky, this cannot go on indefinitely.

Betting against this winner-takes-all trend has been career hari kari for many a fund manager. There aren’t any immutable laws in finance. Things are subject to constant change as we are only too aware. But as Michael Batnick points out, there’s an iron law of pizza which applies equally well to stock markets; the slices of the pie cannot be bigger than the pie itself.

Lessons for investors

There are a few lessons in this for investors. Predicting the winners in all of this is subject to a high degree of error. Notwithstanding the dispersion of valuation that currently exists that arguably creates great opportunity for skilled stock pickers, its simplest to play this in a diversified fund or Exchange Traded Fund.

Opportunity is usually best where the outlook is worst. We have to look beyond mainstream stock market indices to find those conditions.

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