Odd Lots - What Happens When Markets As We Know Them Cease to Exist

Episode Date: April 13, 2017

What if you woke up tomorrow and found the U.S. stock market was closed for good? That happened to investors in the Russian market after the communist revolution in 1917, leading to huge losses for people who had put their money in what was then one of the major economic and political powers in the world. The Russian example was brought up last month by Ray Dalio, founder of Bridgewater Associates, who sounded the alarm over the rise of populism and its impact on markets. In this edition of the Odd Lots podcast, we pick up the theme with Simon Hinrichsen, assistant portfolio manager at First State Investments, and guest co-host Sid Verma of Bloomberg News. We discuss how investors can prepare for the very worst. Along the way, we ask whether the dominant forces in markets today -- powerful countries, institutions and investment theories, such as the relationship between bonds and stocks -- can survive forever.See omnystudio.com/listener for privacy information.

Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, lists and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk Vanguard Marketing Corporation distributor. Thanks for listening to Odd Lots. Follow the show on Amazon

Music for more future episodes or just ask Alexa play the podcast, All Thoughts on Amazon Music. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. My normal co-host, Joe Wisenthal, is away this episode.

But don't worry, I've found the perfect replacement. It is Bloomberg reporter, Sid Verma. Hi there. So, Sid, you're filling in for Joe today. That means that we get to talk about whatever we want, basically, right? Definitely. I mean, yeah, let's be postmodern, talk about anything. All right.

So speaking of postmodernism, I have a complaint, and it's a grievance of mine, which is, you know, whenever people tell you that you should pursue your dreams? Are you talking about the positivity industrial complex that run America. We're in the same page. I wasn't quite talking about that. But, you know, like, if you want to be an actress, you should try to be an actress. That's like the classic one. Or if you want to be an astronaut, you should try to be an astronaut. And then you always hear these big success stories from all these people, right? Of course, it's awful. There's a word for it, though, right? I believe in managing expectations. So I wish that I

fail. And then if I succeed, I'm pleasantly surprised. Okay, but the fact that we focus on all these celebrities who have succeeded in life and they're sort of our base standard, there's a concept that we use for that and it's called survivorship bias, right? And that's basically the mistake we make that by concentrating on the people or things that survived some certain process or situation, that that's kind of like the norm, right? Just because they did it, they're there. Of course, yeah. Losers don't matter. That's how the whole world is framed. Winners write history is also a classic example. Okay, so believe it or not, that concept can also be applied to the markets. Yeah, I guess create a destruction of capitalism is another way of putting it.

I'm trying to be really alpha male here. And I'm going to ask Simon, why does it matter? You know, survival of the fittest, destruction of capitalism. Why is this a problem? That's what I'm going to be doing. Well, you just give away our guest. We have the perfect person here with us to talk about survivorship bias. It's Simon Henrickson. He works on the multi-asset team of first state investments,

and he has authored a fantastic paper all about this topic. Awesome. Should we bring him on? Definitely. You already gazumped me. I scooped you. Okay. All right, Simon, thank you so much for joining us today.

Thank you for having me. So I use that example about us focusing on successful celebrities as the sort of baseline norm. Do you think that's the right way of looking at survivorship bias? I think it's a pretty good way of looking at it. In finance, you often hear things like equities are going to do better in the long run. And there are certain managers and fund managers who are celebrated for their ability to beat the market. it. Well, oftentimes what we miss are these really, really big events that either destroy whole markets or, as you say, sometimes people are just lucky. So if we look at equities over

the long term, well, what people often mean is that the US or the UK's equity markets or developed markets have done really well. But what they don't necessarily mean are all the countries that didn't make it. Now, if we talk about fund managers, well, well, you know, you know, imagine that you have a hundred people where you gave them money and each had to try to beat the market. Inevitably, at some point, you're going to have someone who's going to look like a genius, but someone is always going to end up looking like that. It's just chance.

And it's really important not to conflate luck with ability, but it's also really important to be able to distinguish are we actually falling for the survivorship bias in when we look at investments, and does that mean that you have massive concentration risk in your portfolio? Right. So when you looked at survivorship bias in the markets, where did you find the biggest or the best example of this? You mentioned equities just then, so I guess that's an obvious one. Well, it is, but if we look back, some of the really interesting event, especially through history, has actually been where you had catastrophic events. So my favor is probably back in 1917, where we had a revolution, Lenin took over from the Tsarist.

And when World War I began, the markets closed. Then if we look back over the last 50 years before they actually closed, Russian equity markets did remarkably well. And they actually produced pretty good returns. World War I happened. Equity markets shut. Everyone thought that, okay, when markets open, we're going to go back to the way they were.

They opened up 20% up. You had two months of trading before the Russian Revolution where the communist expropriated all equity holders. So it actually went to zero. I can imagine the investment bank reports at that time where you have, by Russia, we believe that the Communist Revolution will deliver stability, etc. Do you think that's a problem about institutional memory? We forget all this. Financial market participants are basically forced to be. have unrealistic assumptions based on data that's effectively massaged?

I think it is because remember at any point in time, nobody actually knows what happens. So if you have a, let's say we know a probability of something happens, and let's say it's 70-30. If you bet on the 70 and it actually comes out, you're going to look pretty smart, but it doesn't mean that it was a good idea not to protect against the last 30%. So just because something happened doesn't mean that you, were an idiot for thinking the opposite. The problem is if you say things like equities will always outperform over the long run, you end up having some things like Russia in your portfolio if you don't know how to correct for that. I hate to use these terms, but how would you

distinguish this concept from tail risk in Black Swan event? Because I think a lot of people are obviously very accustomed to those terms and they were bandied around during the financial crisis, but how is this conceptually different? I would actually say that this is a proper terror risk, a proper catastrophic event which we don't know could happen. So if we go back to our old friend Donald Rumsfeld and the known knowns and unknown unknowns, if we look forward, this is an unknown unknown, something where we look backwards in terms of Russia, we knew that happened.

But if you remember, you need to correct for these type of things. So say that you analyze a portfolio of world equity markets. If you don't correct for all the constituencies that fall out, all the companies that go bankrupt, you're going to have a concentrated portfolio of all the really great companies. This would be like if you knew that invest your money with Berkshire Hathaway 40 years ago, of course you would do it. But at the time, nobody really knew this was a good idea. But I do think that survivorship buy is actually a proper-tale risk event.

And it's something where it's very hard to protect against going forward, but if you don't know what to look for in the past. So this is one of the areas where economic history is really, really important, but it's also important to have very long time series. Yeah, so I think that's an important point. And I really like the Russia example, because if you think about it, you know, if you were a European investor in the early 1900s, Russia was one of the great powers. So why wouldn't you invest in that market? And the idea that the market was going to close down at some point was, as you put it, a complete unknown unknown. But realistically, how do you protect yourself against that? Is it just about having a wide variety of assets in your portfolio?

It's about having a lot of different risk drivers and making sure that when you look at your portfolio, that you don't just look over a short horizon. but you also look at what can actually happen. So say the idea of having what has been very popular over the last 40 years, having a portfolio which is 60% equities and 40% bonds. Now, this has been a uniquely optimized portfolio over the last 40 years, and market conditions have been great because one, you started from a valuation point where equities were really cheap and bonds were really cheap. So you wrote the cycle.

You also had the added benefit of having negative correlation between the two. So when equity fell, equities fell, which would be 87, you had the dot-com bubble, you had the great financial crisis. You actually saw bonds doing really well. That has not been the case historically. So if you go back and take England, and England is one of the good examples because we actually have great data going back almost 500 years, because the Bank of England is good at collecting data. Then for 350 out of the last 400 years, you actually saw a positive correlation between bonds and equities. So all the times of, say, wars, both actually behaved like risk assets and they were not good offsets.

That's something that's hard for people to get if all you've lived through like me were the last 20 years of time where it was conventional wisdom that bonds and equities are good offsets. Put knowledge to work and grow your business with CIT. From transportation to healthcare to manufacturing, CIT offers commercial lending, leasing and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. Obviously, in the emerging market space, if you fall out of benchmark indices, if you don't have what the rating agencies want you to have, if they look at it.

at institutional strengths and so forth. So if you look at all those indices, a lot of those sovereigns are those with strong institutions. And so you forget that actually there are a lot of reasons why strong corporate structures matter for equities that actually matters to have a rule of law. And it seems like institutional memory just to hark back on my point because it seems to be forgotten by a lot of investors. So I guess it's just really hard to kind of correct that impression because on day-to-day trading, you could go mad if you have to revisit every single prior that you have. So I think that's a very good point because what we've had in terms of survivorship bias here is that the countries that have done very well have in general

been the countries that have had strong institutions. There's a whole strand of literature in the economic history body where the overarching theme is that institutions really matter and I tend to make fun of them a little bit because it seems a little bit simplified and well, duh, because obviously they do, but they actually do. And this is obviously pretty important as we look forward in terms of countries where we now have big institutional changes. So think about Trump. Is this just something that's going to happen and he's going to disappear in four years? It might be. It also might be that the institutions have dramatically changed and this is a structural break. the fact that Brexit is going to happen, a structural break for the Eurozone, which as far as we

can remember back has moved forward in terms of integration. If this is a break, then are we starting to having to look back to history where European countries weren't trying to help each other, but we're actually in conflict? And that's the sort of thing where it's very important to know history. It's very important to know that if you don't take these things into account when you build a portfolio, Oftentimes, you end up with concentration risk. And it's not enough just to say, well, U.S. equities have outperformed basically everything else over the last 100 years. Well, yes, they have because they were the best, most democratic, best well-functioning

country that has been there. So you end up having to look at a variety of things. And one of the things, if you go from backward, looking, forward-looking, is, well, these type of things, rule of law, it really matters. especially when you look at EM, we know that it matters for equity returns, for bond returns. And should we think about this where we live now? I mean, if you look at Venezuela, it's everyone knows that you're going to have to take expropriation risk, that they're actually not going to pay you back, or they might not just expropriate some of the assets in the country.

Well, it's not really something that people who've done developed markets only think about. And one of the things that worries me is that the people who are really, really worried about, what has happened over the last year. Are people who tend to do emerging markets or history? Yeah, so that reminds me, but we did see at least one rating agency talking about developed countries exhibiting more emerging market risks, right? Sid, I seem to remember you writing a story about that. Yeah, I mean, it was an interesting statement from S&P stating the fact that institutional strength has been one of the biggest anchors for high sovereign ratings amongst developed markets along with strong capital markets, etc.

But now they say the strength of institutions and the rule of law is now under question because of this rise in populism. I think your point earlier kind of really struck home to me because it seems that emerging market investors get much more concerned about developed market risk than vice versa. And it seems like, yeah, that's part of that point. The survivorship bias seems to be extremely important. If you have that perspective, then you understand the historic anchors for capital market performance.

And I think it's important to say that I don't know what's going to happen, but I know which risks are important to look for. So it might be that the next 100 years are going to see amazing U.S. equities returns. But the situation is different. And just because something happened over the last 100 years doesn't mean that it's going to continue because, as we know, U.S. were the hegemon and they actually won, whereas if we are in a situation where we've seen lots of these things happen over time. So another one of my favorites is back in the French Revolution when the Jacobians came in

and they expropriate a lot of church land. You have other episodes in the 20th century in Shanghai, 1949. The communist expropriated all of the equities as well. And you do see these types of event. But what strikes me is the fact that just looking at some of the data, US assets have outperformed in real terms, nominal terms, risk-adjusted returns for the last 100 years. So this is American exceptionalism in capitalism.

And how dare you question American exceptionalism would be the naysayers to your narrative. Which is fair. But what I would say is try and wind back 100 years. who were going to be the world hedgeman at the time. And then if you look at returns for Germany versus the UK versus Soviet Union, you end up with a discrepancy that is so big that it's actually hard to measure because there can only be one winner. And over the last 100 years, German bonds, you would have returned basically nothing

in real terms, whereas you've had really good performance in the US. So the thing is, I'm not actually going to. questioning what has happened and the conventional wisdom as it were over the last 100 years. Just saying that it's very important to look at these big episodes, whether it's going to be political revolutions or hyperinflation, currency mismanagement, or potentially wars. Look at those, see what did capital markets do in those type of situations and how does that actually affect the portfolio? And this is not something that is likely to happen, but it's a useful exercise.

for your mind to say, well, let's assume that the world is not going to be like it was over the last 10 years. What actually happens? And do we have too much risk into one scenario? It's kind of like a gloomy scenario, though, isn't it? Because if you're taking a really, really long historical time frame of the world, then you're almost ignoring whatever progress you might claim to happen. made over the past, you know, 50 years or 100 years. It's almost mean reversion to what the middle ages.

I don't know. Absolutely. If you read someone like Pickety, you would actually say that the last 50 years were the anomaly and that over time we've generally seen that it is the high earners who take most of the money home and you have massive inequality. Now, I'm not a massive fan of his theories, but his data is really good. And if you go back and see through history, we actually have had it very well over the last 100 years. I mean, I find this framework really useful, not just for thinking about big global macro events and big terror risks,

but just on a simple concept of unrealistic assumptions. I mean, you've got pension funds that are targeting high inflation adjusted returns. And they're complaining that they can't fulfill these return targets. but it's not just because government bond yields are low, it's because it's all based on benchmarks that only cover the winners, and the losers always consigned to the dustbin of history, effectively. And if we make it a little bit more tangible, a lot of people have said that global financial crisis looked a lot like the Great Depression.

I think that's a fair comparison. If you go back and look at asset returns, let's assume that the UK and the US are actually, the template going forward. Bond returns were really bad in 1950s. You came from really, really low yield and they rose, which meant that equities did very, very well, but bonds didn't. We live in a world where we've been used to double-digit bond returns. And at these levels, it's just not possible. Now, I don't think we're going to necessarily see bond yields that are going to be double-digit anytime soon, but just the return assumptions from, say, pension

funds, as you said, to it. a little bit hard to imagine those actually coming to fruit. Do you have any sympathy for people who mount the classic argument that this time is different? You know, like secular stagnation, will change bond returns or alter portfolio balance, any sympathy at all for that? No, I'm a historian, economic historian by education. And most things have actually happened before. At any point in time, you usually had people saying this time is different. sometimes it's true, mostly those can be found in terms of technological progress. In terms of political cycles, economic cycles, things have a tendency to repeat themselves.

And when people say that this time is different, well, this time is actually not that different. You had the Great Depression, which was a pretty good way of looking at the global financial crisis. Bond yields did more or less what we would expect them to do. And you have so many countries in the world that it's not unlikely that we're going to see hyperinflation going forward. It's not unlikely that we're going to see revolution. We have wars all over. So I have sympathy that things are not going to be the exact same. And you need to be very careful how you actually look at history and use it as a guide.

But in terms of things are great and we are now in the most peaceful time, as one author put it when he says, that we haven't seen a big war in since the Second World War, I think that's misunderstanding what has actually driven history. And if we want to tie this back to survivorship bias, one thing that I haven't mentioned is that the most dangerous thing is that all the things in history, which we can't measure. So oftentimes the thing that really drives survivorship bias are either records that are lost, people who have died or people have disappeared,

or we'll use to say that history is written by the winners. This is very, very true. There is not really any way to measure whether a conquering country back 300 years expropriated some assets and never told anyone about it. Now, we have a lot of these stories, but I'm sure there are many more

simply because nobody is really left to tell them. And if nobody documented them, well, even if they did, try tell your friend a story and then see when that story comes back to you from another friend how much has changed. It's changed quite a bit, usually. Well, should we leave it on that? I feel like we go into a dark place when Joe isn't around.

Yeah, I'm actually too scared to ask a follow-up question to Simon because I'm worried about the world ending. We can leave things, but it's probably going to be okay. It's just important to be, like, knowledgeable about these risks. And I'm not saying that we're going to see a world extinction event. but through the good of managing expectations

history has told us that managing expectation is not the worst thing you can do okay

Simon Hinriksen from first state investments thank you so much for joining us

so Sid have I scared you away from the Odd Lots podcast

forever yeah maybe I'm pretty I think this is a useful framework to think

about the end of the world stroke terrorist risk, stroke, equity market, stroke, mutual fund performance. And I was very skeptical when I heard of the concept because, as I said at the, you know, the outset, I wanted to be really alpha about it and say, why do losers matter?

This is what makes capitalism great. But yeah, you realize that history really does matter and it really flatters the winners. It does make you think about core concepts in investing, such as, you know, if you're sat in a developed market, you're probably mostly buying developed market assets. And should that be the case? And if you really want to catch on to the next big thing, it might not be the current big thing, right? Yeah. And that totally can change. But if you look at the data over the long haul, it will massage and airbrush out all those lessons. And I thought that Simon's point that we don't really know what happened. We don't know which sovereign expropriated what assets. We don't know which companies have failed because a lot of the

data when you look at it over the long haul doesn't provide those lessons. And I feel like institutional memory about the importance of governance and structure and so forth is it falls by the wayside. So yeah, it's a really great framework actually. I'm going to think about this much more. Yeah. And maybe there's like a holy grail historical document somewhere that would turn our entire viewpoint of markets and finance on its head, but it's hidden away in, you know, like some ancient temple. Or you saying that yields don't move inversely to prices and bond markets. I think we're going to go and have to search for that ancient text. All right, let's leave it there. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And you can follow me on

Twitter at underscore Sid Fermer. And you can follow Simon Hinnrickson. at Simon H underscore D.K. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work.

The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gura. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Refini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off.

And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to provide prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on

Bloomberg Television, radio, and wherever you get your podcasts. What separates good leaders from transformational ones. I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to Leading By Example, executives making an impact on the IHeart Radio app, Apple Podcast, or wherever you get your podcasts.