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MESSAGE FROM CAM

George Herman
Chief Investment Officer

 

In April, our discussion was about the difference between panic and awareness and included a look at financial risk. Today’s message is about and the ‘wisdom of crowds’ and the acceptance or rejection of the economic reality.

The Coronavirus pandemic (CV19) brought the world to a sudden stop during the first quarter of 2020, with social immobilisation wreaking havoc in the global economy. Never before, not even during times of war, did both supply and demand stop entirely, simultaneously, and globally. CV19 saw the world fall into an immediate, synchronised recession, shedding jobs at the fastest pace ever. Markets reacted to the economic shock and dropped into a bear market, also at the fastest pace ever.

The financial crisis of 2008 and the subsequent efforts to resuscitate the global economy is the only playbook the world has to attempt another economic rescue mission. So, it was no surprise that major central banks stepped up and delivered monetary support via interest rate cuts and quantitative stimulus. Again, at a rate never seen before. It was also expected that governments would expand fiscal expenditure sharply to fight the pandemic and support their respective economies. What happened next, was truly astounding.

But let’s step back a moment for context. During the latter part of February 2020, the global financial markets started to get a sense of what the CV19 pandemic might mean for the global economy. It could literally cause the global economy to fall off a cliff! Global economic output was about to seize up entirely, as social immobilisation brought the entire world to a standstill. It became clear that fundamental economic data was facing the most severe setback in history. Quarterly GDP figures for the United States (US) could be down by as much as 35%. The country’s jobless claims sky-rocketed as more than 20 million people were laid off. Whatever economic data-series existed, got absolutely squashed and reduced to insignificance by the enormity of the developing crisis. So as markets crashed during the meltdown in March, the world entered a period where no fundamental economic data was available or any comparative economic analysis possible.

The US Federal Reserve (the Fed) quickly responded to the market meltdown, not only with enormous monetary stimulus, but more importantly, with moral support. The language central bankers use is often more important than the actual measures implemented. In this instance Chairman of the Fed, Mr Jerome Powell, threw the ‘kitchen sink’ at the situation unleashing every measure available in his arsenal; including fiscal reflation and quantitative easing, just fancy terms for DEBT. The reality is that the measures used to attempt an economic rescue had to be funded by new debt. The FED created more new debt in the last quarter, than it had in the preceding 30 years! It seems to have worked though, for now.

Without any form of credible and comparable economic data, the financial markets decided to cling to Powell’s coat tails like a toddler to a mother’s dress. All rational discussion and analysis were immediately drowned out by the single retort, “Don’t fight the Fed”. Any attempt to analyse the true economic impact or to draw any rational inference to the financial markets due to the historic economic calamity taking place on the ground, was muted by the simplistic statement, “We have to look through this”.

Another phrase that caught on was, “Markets are discounting mechanisms of the future”. It became a popular explanation for why equity markets jumped more than 40% in the fastest rebound ever. It soon became apparent that any attempt to include economic analysis in any discussion around financial markets would be deemed heresy by a crowd blindly following their central bankers. Markets were now being washed along by a surge of liquidity, funded by debt. The financial market ‘crowd’ had suddenly grown in number as every person on the planet with an internet connection was now a stock market wizard, armed with the knowledge that the economy isn’t the market, and that stocks will always go up.

This one-track-minded narrative took me back to James Surowiecki’s 2004 book, The Wisdom of Crowds. In his book Surowiecki argues why often the decisions taken by crowds, even with imperfect information, is often superior to the decisions taken by any informed individual. The current market-crowd is comfortable with this idea, as it takes markets into record valuation levels amidst a global recession.

Reading Surowiecki’s entire book, however, brings the reader to the five elements that Surowiecki states are required to form a wise crowd. Three conditions lead to a wise crowd: diversity, independence and decentralization. Such a crowd would then make wise decisions if two more conditions are met: disagreement and contest. Finally, it is noted by the author that too much communication would render the group, as a whole, less intelligent. However, the current market-crowd isn’t diverse or independent, there’s no disagreement or contestation whatsoever and there’s a deluge of communication reinforcing and regurgitating the same narrative, “Reality doesn’t matter”.

The Economist magazine recently devoted their front page to this current anomaly, referring to it as the divide between Wall Street and Main Street. The financial markets represented by Wall Street consider the GDP contraction brought about by CV19 as merely temporary and hence look beyond it into the future. The real economy, Main Street, still has to deal with the developing impact of the virus, which includes job losses, insolvencies, credit losses and much uncertainty. Clearly they’re looking at the same thing, but seeing it differently!

At Citadel our investment philosophy is firmly rooted in the fact that the actual economy drives the financial markets and not the other way round. We acknowledge that the future is uncertain, with constantly changing facts, rather than a mere extrapolation of the past. The assumption that economic output will automatically revert to pre-COVID levels is based on an erroneous deduction from a mathematical fact. When GDP figures experience a massive decline, it is a mathematical certainty that they will bounce back the next period. This is because these numbers are period-on-period comparisons, not cumulative long-term achievements.

Looking at the cumulative progression of economic output that experiences a sharp non-cyclical reduction, highlights just how much pain is impacted by an economic shock. The economy needs to recover to a growth trajectory that is even faster than the original rate, if it is to recover the output lost. The reality is that CV19 and social distancing expunges capacity from an economy and try as you like, economic output cannot reach pre-COVID levels easily.

Add to that the uncertainty of consumer behaviour in a post-COVID world, whether a vaccine can be found and distributed globally, and the political ramifications of de-globalisation, and we argue that we face a much more uncertain world than we did when we entered 2020.

The next pillar of our investment philosophy is that valuations matter. Assets achieve record valuations during periods conducive to growth when they have few limitations on capacity. This, however, is not possible during a recession, especially when the end cannot be predicted. Our final investment pillar is that diversification is crucial in an investment solution which is able to withstand volatility and achieve its long term objectives. The current market narrative that the Fed will protect markets from declining and one could thus buy anything and everything, is not diversification.

We find ourselves at one of those crucial junctures where reflecting on our philosophy and trusting our well-sculpted process, places us at odds with the mass hysteria of bull markets. This is the time we ring the bell of sanity and ask the difficult question: Doesn’t reality matter? We believe that economic reality does matter, and always will matter, and that Wall Street and Main Street will once again be two routes to the same destination.

I hope you enjoy this edition of the Citation.