CPD: Debunking conventional wisdom
Grant Samuel Funds Management recently hosted Scott Weiner, managing principal and portfolio manager with fixed income specialists Payden & Rygel. Scott presented to a number of financial advisers around the country and shared a series of insights aimed to debunk some of the conventional wisdom that prevails in the world of economics and investment.
In this article, GSFM shares these insights.
What is conventional wisdom?
Conventional wisdom can be defined as:
“the generally accepted belief, opinion, judgement or prediction about a particular matter.”
(source: Merriam Webster dictionary)
A classic example of a conventional wisdom that prevailed for many years is the shape of the earth…is it round, is it flat? The experience of most people involved in this debate suggested it was flat, hence the conventional wisdom that dominated for so many years. This illustrates the importance of experience – for based on experience, conventional wisdom takes over…but is not always right.
Interestingly, the term conventional wisdom was coined by eminent US economist John Kenneth Galbraith, who wrote, among other tomes, “The Affluent Society”; the term ‘conventional wisdom’ was first used within.
There are two examples of conventional wisdom that prevail in the investment industry in the United States. They are:
- When saving for retirement, investors should increase bonds over time. The rule of thumb is 100 minus the investor’s age; that’s how much an investor should have in equities and, therefore, equity exposure reduces over time. For example, someone who is 55 should have 55% bonds and 45% equities. At age 60, this would increase to 60% bonds and 40% equities.
However, studies using some years of data now show that a ‘U shaped retirement strategy’ is more appropriate. In this scenario, on or near the day of retirement, 80% of investments should be in bonds, with 20% equities. From there, each year the investor’s equity exposure should be built until it reaches 70%. This flies in the face of conventional wisdom.
- Most people believe that stocks and bonds move in opposite directions. Statistics show it’s a coin toss; there’s a 50/50 chance that stocks and bonds move in the same direction or move in opposite directions.
These examples serve to illustrate that there are many forms of conventional wisdom that people hang on to, that are simply not true. The advent of social media, and the ability to spread information far and wide, creates and reinforces conventional wisdom very quickly.
Debunking conventional wisdom
There are seven pieces of conventional wisdom pertaining to economics and investments to be debunked. While some are more recent, others have their roots firmly planted in the past.
#1 Economic cycles are like trees – they don’t grow to the moon
Conventional wisdom suggests that economic cycles must end; this is very important now for the US and where it is in its economic cycle. Post World War two, cycles of expansion and contraction in the US tended to be six years – five years of expansion, followed by one year of contraction.
Many investors worry that with the US now well beyond the average number of months in a post-war expansion, the business cycle will soon end. However, evidence from other countries, illustrated in figure one, suggests that there is no natural limit on how long an expansion can last. Australia hasn’t seen a recession for 25 years…perhaps the US economy is just getting started?
While past experience in the US suggests it is time for a contraction, this is an example where conventional wisdom has been superseded by a new world order.
#2 Want a recession? Have an election! Want to guarantee a recession? Vote Republican!
Republicans are known for being more austere than Democrats; therefore, conventional wisdom says that having a newly elected Republican, coming off the heels of a Democrat, should cause the economy to tank. Add the uncertainty associated with the period of time following a presidential election, and conventional wisdom also points to the increased likelihood of recession.
Payden & Rygel has run the data, starting at 1900 – and as illustrated in figure two, there is no relationship between recessions and elections, regardless of which party is elected.
#3 Economic forecasters don’t like political uncertainty
Conventional wisdom tells us that economic forecasters don’t like uncertainty – and there is plenty of that in the world right now; Brexit, increasing nationalism, increasing populism, and the uncertainties surrounding President Trump and his policies, to name a few. It is feared that the nationalism sweeping through Europe may result in the election of populist governments and cause Eurozone GDP to fall.
Given that backdrop, it would be expected that forecasts would be negative.
While all eyes focus on political events, it’s possible that 2017 holds better news on the economic front. Figure three suggests so; following the marked improvement in monthly measures of economic activity (e.g. PMIs), euro area growth forecasters seem optimistic, politics notwithstanding. Forecasters are not seeing all doom and gloom; they are going against the conventional wisdom of what they should be saying (economic doom and gloom) and instead are forecasting a positive outlook.
#4 The world goes as oil goes – when oil goes down, sell, sell, sell
When oil prices dropped in 2016, conventional wisdom said investors should sell shares because companies would go out of business.
As figure four illustrates, one year can make a significant difference. One year ago, investors worried about China’s devaluation, global deflation, falling oil prices and a US recession. One Wall Street strategy team went so far as to recommend clients “sell everything except high quality bonds.”
One year later, oil prices were up nearly 40%, US stocks up nearly 30% and high yield corporate bonds rallied more than 26% since the lows in February 2016. The high quality bonds?…down 3.4%.
It is interesting that conventional wisdom should suggest that falling oil prices should lead investors to sell…after all, shouldn’t lower oil prices be better for businesses? If a small number of oil businesses go under because of low prices, that sorts out supply issues and prices will self-correct.
Conventional wisdom doesn’t always tell the story behind the story.
#5 We’re days away from a big short – the housing bubble is back.
House prices along many parts of coastal US have reached, or surpassed, the price at which they peaked before the GFC; therefore, conventional wisdom tells us that the US is poised for another crash in the housing market.
The GFC bubble was caused by leverage, shoddy lending standards and spec homes – none of these things exist anymore. Loans are high quality and it’s hard to get a mortgage.
There has been an increase in house prices because since the GFC, there’s a shortage of housing. In fact, the inventory of existing homes in the United States is at its lowest level in over 15 years. This measure, which excludes the inventory of newly built homes, suggests two related things. First, after years of sluggish new home construction, would-be buyers today have little choice but to pick through the few existing properties that are on the market. Second, even as new home construction has rebounded from its nadir, the supply/demand imbalance suggests that the recent price gains in the US single-family housing market may continue for some time.
In today’s terms, houses are relatively affordable and rising prices are not a harbinger of disaster.
#6 Let’s make America great again by making stuff again
Conventional wisdom points to the fact that the US has exported so many jobs overseas, that if many of those manufacturing jobs can be repatriated back to the US, more jobs will be generated and this will help make America great again.
Since 2000, manufacturing jobs (as a percent of employment) have fallen nearly 50% in the US. Over this same time period, manufacturing as a percent of GDP, has fallen only 20%.
In other words, boosting manufacturing does not necessarily lead to job creation. In fact, technology – such as computers, robots and 3-D printers – have made US manufacturing highly efficient and productive, and therefore less labour intensive. Bringing manufacturing “back” might not generate jobs.
There are many industries in the US that were large – such as textiles, furniture, jewellery making – that have been offloaded to regions of cheap labour; this is what President Trump wants to lure back to US shores. He may well be successful – because of technology, manufacturers are now able to compete with cheapest labour in the world. For example, in furniture manufacturing, robots can make custom built furniture, work around the clock without breaks and demands for overtime, and make custom built pieces faster and better!
While manufacturing jobs may now be imported back into US, the employment profile of new hires will be quite different from the days of old…there will be fewer factory workers and more high tech people to run the machines, fix the machines, calibrate the machines. Where a factory once employed 200 people, manufacturing of the future may employ just ten percent of that number.
When looking at conventional wisdom, one has to remember – what might have worked in the past won’t necessarily work today.
#7 High yield spreads are too tight, it’s time to sell
Conventional wisdom says that the absolute level of high yield spreads is a harbinger of deterioration of high yield prices – or in other words, credit spreads widening.
Payden and Rygel studied 20 years’ worth of data from the high yield corporate bond market (figure five) and found the following:
- The yellow shaded area is where high yield spreads are positioned approximately 50 percent of the time; most often, spreads are between 400 and 500 basis points
- The events people worry most about – spreads at +800 basis points – are exceedingly rare; in fact, since 1997, high yield spreads have been above 800 basis points only 7% of all days.
Just because spreads are tight, or are getting tight, does not mean that prices will increase. The absolute level of high yield has no correlation to direction of total returns of that asset class. Conventional wisdom – reversion to the mean does not follow for this asset class and bonds in general.
Conventional wisdom can be right, it can be right for the wrong reasons, and it can be wrong for the right reasons. It often:
- is influenced by experience
- can be influenced by the way things have worked in the past.
Conventional wisdom often relies on the concept of ‘reversion to the mean’ – instead it requires a deeper study of the underlying causes of the phenomena, rather than a reliance on top line information.
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