‘Macro’ trends rule financial behavior

People absorb information about macroeconomic themes every day without realizing they are doing so. Newspapers and websites — financial and non-financial alike — are filled with stories about the overarching macro trends un-folding all over the world. If asked generally, most people probably would say that they know little about macro, but if questioned about the state of the housing market or the influence of China, most would likely come off as fairly well-informed. The same goes for in-vestors — the majority claim that they are stock pickers who focus solely on bottom-up company analysis. In reality, they often are choosing these stocks based on bigger-picture trends guiding the entire industry. The influence of macro extends far beyond what most people realize.

Question: If macro is so ubiquitous, then what exactly is it?

Answer: It is the force(s) that dictate how the world unfolds around us.

Macro permeates day-to-day life. The cult of homeownership in the United States was rooted in political and monetary policies handed down from Washington, D.C. Ultimately, this was embraced by the population at large, and fueled the expansion and bursting of the housing bubble. Americans’ adjustment to the new reality of less available credit is reshaping spending patterns and lifestyles. This is just one of many unfolding macro trends that is important to markets. The aging of the enormous baby boom generation is a force that will impact health care in this country for the next 30 years. The emergence of a new consumer class in China will change the balance of trade and economic power around the world. The technology revolution is giving a voice, and power, to people in far corners of the world who until now were largely silent. The accelerating pace of globalization is changing the face of trade, information flow, market movements and even culture. The analogy of a butterfly flapping its wings felt halfway across the world is truer than ever for global markets.

The investment implications of these market-moving trends do not exist in a vacuum. Each of them impacts the analysis in some way. In many cases, the implications of one theme lead directly into another, especially with respect to policy action taken. Take, for example, the sustained cycle of easy monetary policy following the bursting of the technology bubble in 2000. Federal Reserve Chairman Alan Greenspan lowered interest rates repeatedly as the markets corrected from the heights of the late 1990s. Following the technology meltdown were the 9/11 terrorist attacks and a series of corporate-accounting scandals, such as Enron [Corp.] and Tyco [International Ltd.], that kept the markets on shaky ground. The solution in each case was lower interest rates.

The rock-bottom interest rates that helped pull the economy out of the doldrums after the crises of the early 2000s laid the groundwork for a massive expansion of credit. Easy access to credit helped fuel the housing boom of the 2000s and the subsequent bubble that rocked the latter years of the decade. Although the federal funds rate was increased in 2004 and 2005, the damage was done and the economy is still sorting through the rubble. The extremely easy policy that Mr. Greenspan’s successor, Ben S. Bernanke, put in place in the years following the bursting of the credit bubble fueled the massive run-up in commodities prices. Only time will tell what the exact nature of the next bubble will be, but certainly it will come. Without a doubt, macro matters for investors.

EXPLAINS EQUITY RETURNS

Ignoring macro is like ignoring the seasons when trying to predict the weather. Any December day in New York City is likely to be a cold one. The “macro” backdrop dictates wearing a coat instead of shorts. The “stock-specific” issues determine whether that coat should be a winter parka or a lighter jacket. It’s possible to decide incorrectly on the choice of coat, but regardless, one is usually better off wearing a coat than shorts in December in New York City.

Macro trends influence everything that happens in the markets, but the extent of its sway probably is a surprise even to those who embrace these trends. Investors who actively harness the powerful influence of macro and use it to their advantage can set themselves apart from the pack.

Investors often have a difficult time explaining the performance of their stock picks. This is largely because they underestimate the influence that macroeconomic forces have on individual stocks. They search for a connection between returns and earnings or management strength, but the truth is that an overmost stock performance is explained by forces that go beyond the income and cash flow statements. In fact, the data show that historically, 71% of equity returns could be explained by macro trends. This means that all of the time stock pickers spend poring over balance sheets and talking with company management gives them only a third-better chance that the stock they choose will perform well. How many investment managers would willingly admit that they are investing blindly with respect to two-thirds of the factors driving their portfolio’s return?

One of the prevailing trends over the past several years has been the heightened influence of top-down analysis and a renewed focus on macro. While some stock pickers may have been fortunate enough to pick winners that outperformed their benchmark indexes, most stocks’ relative performance trends have been whipsawed by the macro-induced market peaks and troughs. Since late 2008, the percentage of equity returns explained by macro forces has risen steadily and reached a record high 90% by the end of 2010. Getting the “big picture” right has become a necessity for top performance results.

Policy moves meant to prop up the economy in the aftermath of the technology bubble actually laid the groundwork for the next bubble. This pattern is not unique, and in fact has repeated itself many times in financial market history. Conditions must be ripe for a particular asset to develop into a bubble, but it takes much more than that. Usually, it requires easy monetary policy for the bubble to form and a policy-tightening cycle for the bubble to burst. The reason for this is that after a series of interest rate increases, the accommodative conditions that set the bubble in motion in the first place have dried up. As that bubble deflates, the central bank steps in again with more liquidity to temper the economic slowdown. This once again sets the stage for the beginning of another speculative mania.

It’s hard to imagine in the immediate aftermath of a bubble meltdown that investors would get wrapped up in another would-be mania so soon, and history shows that bubbles do change investors’ future behavior. The lessons learned in the technology bubble that popped in 2000 still affect the way people invest today. The huge multiples paid by investors in the 1990s have led to a preference for companies with lower valuations. Equity market multiples, in general, have been in decline since the 2000 peak as the excesses work themselves out. Several years after the housing bubble peak, the residential real estate market is still sluggish. Most people are deleveraging their personal balance sheets and have altered their use of debt, choosing to use debit cards instead of credit cards. Lessons learned even as far back as the Asian currency crisis in the late 1990s still are being played out. Most of the Asian countries that stumbled from excessive debt during that period weathered the latest credit crisis better than most countries because they were less leveraged. The mistakes of the past can have a big impact on market trends.

Yet history also shows that there have been dozens of bubbles going back at least to the Dutch Tulip Mania in the 1600s. The study of human nature sheds some light on why investors fall for a new bubble each time around. One of the 2002 Nobel laureates in economics, Vernon Smith, has attempted to address the study of why markets work the way they do through his research in experimental economics. Mr. Smith and his colleagues have produced significant work centered on laboratory-induced stock market bubbles. In the experiments, Mr. Smith and his team look for patterns that emerge from participants’ trading activities and draw conclusions about investors’ financial market behavior. During a series of 1988 experiments, his team of researchers made some interesting discoveries about how prior experience affects the severity of bubbles and crashes.

Testing simulated 22 market environments. Price bubbles formed and subsequently crashed on 14 of those occasions. Participants’ behavior did differ, however, based on their experience with trading. When inexperienced traders were involved, the price bubbles tended to be much more dramatic. Stock prices rose far above fundamental values and then crashed back to fundamentals late in the stock’s lifetime. As participant experience grew, the results changed. More-seasoned traders did not avoid bubbles altogether, but the severity did decline. Mr. Smith and his team concluded that experience was the only way to avoid falling into the bubble trap. The laboratory results showed that by the third go-around, market participants recognized their past mistakes and moved the market toward a more fundamentally grounded pricing structure.

While this seems like encouraging news for the elimination of future bubbles, real life does not tend to play out exactly in this fashion. New participants are entering the financial markets all the time, introducing inexperienced traders who have not yet learned the lessons of bubbles. Also, the time lag between real-life bubbles weeds out the number of people who can gain enough experience to learn from their previous errors in judgment. Unfortunately, what qualifies as “experience” in the laboratory-created markets takes longer to acquire than the life span of the typical Wall Street career. The “good news” is that speculative manias tend to follow a predictable path, and it’s possible for astute investors to recognize the patterns. Distinguished and experienced investors such as Jeremy Grantham have built very successful careers on identifying and profiting from these macro patterns.

Bubbles are the natural outgrowth of extremely stimulative policies enacted in the wake of an economic slowdown, and these conditions usually hold regardless of whether the bubble forms in commodities, real estate or equities — or during the 1600s or the 1900s. The rapid succession of recent bubbles — Asian currencies, technology, and credit and housing — is the byproduct of a series of recessions brought upon by the collapse of the previous speculative mania. Given the increasing frequency of bubbles in the past several decades, it is more important than ever for investors to understand the macro forces at work.

Ideally, an investor would avoid buying into a market when prices and fundamentals are out of sync, but unfortunately, that is not always an option. Shunning the highflying technology sector in the mid-1990s would have led an investor to underperform the benchmark drastically as the sector grew to more than 30% of the S&P 500 by market capitalization. Instead of fleeing a bubble, market participants must have a framework to understand how it developed, its typical life cycle and, most importantly, how it will eventually burst.

The pre-bubble environment typically is characterized by an easing of credit conditions and the general availability of easy money. Money supply typically builds and then begins to contract prior to the peak of an asset bubble. Flush with liquidity, this backdrop sets the stage for economic growth and, eventually, speculative excesses.

At first, the asset-class-specific excesses are not apparent. A booming economy fueled by easy credit causes nearly all asset prices to rise as most of the population enjoys increasing wealth. The birth of the Tulip Mania in 1630s Netherlands was a typical example. The Dutch Republic was experiencing a golden age of high incomes and commercial supremacy, and optimism led to an extremely consumer-oriented nation. At first, the tulip was just a way to brighten the landscape and decorate small gardens, but it quickly became a sought-after status symbol. Tulips became a sign of wealth and luxury.

The ability to consume and invest more eventually feeds on itself and leads to speculation, as “keeping up with the Jones” becomes a way of life. In the modern economy, house prices are a good proxy for this phenomenon. Homes are typically the largest investment people make and, as everyone now knows, are particularly vulnerable to asset price inflation.

In Holland, the Tulip Mania was ripe for speculation since the colors of the flowers were not known until the tulip actually bloomed. Since any bulb could become a Semper Augustus, the most valuable strain, trading in these bulbs became highly profitable. As word spread around Europe and attracted more participants, the Tulip Mania was born.

The euphoria of success causes investors to increase their propensity for risk taking, much as a gambler winning at blackjack may up his bets with every hand. The media begins to chime in with talk of a “new paradigm,” and investing in the asset du jour becomes cocktail party fodder. In Holland, the popular frenzy launched a futures market for tulips. The average Dutch person who was unable to participate in the stock market of the day was able to wager on tulip bulbs, leading to an escalation of the mania. This social reinforcement builds a false sense of security and creates a feedback loop, sending asset prices spiraling upward well beyond intrinsic value.

At this point, pricing pressures accelerate, typically beginning with raw materials such as commodities. Several years into the tulip bubble, the value of some bulbs would nearly double in little more than a week. Capital rushed into the market, and amateur “investors” ponied up all that they had. Volume reached all-time highs, with bulbs changing hands up to 10 times per day.

In time, higher prices begin to filter through the greater economy as wage pressures accelerate and lead to higher overall inflation. This forces central bankers to intervene in order to maintain price stability. Eventually, the removal of cheap capital squashes speculation. The Tulip Mania ended with an internal “liquidity” crisis. Spring was fast approaching, and thus the impending delivery of the bulbs, so rumors began to spread that there were no more buyers. Tulips became un-sellable and a spiral of defaults occurred.

The Federal Reserve’s attempt to control an overheating economy usually goes to extremes in the modern day, as well. Not only do policymakers create enough economic drag to break the back of speculative excesses, but almost every Fed tightening cycle has concluded with an economic crisis.

As borrowing costs increase, the economy slows and investors re-price risk. This generally leads to investors’ abandoning the inflated asset classes, causing prices to fall dramatically. The feedback loop that elevated prices to such lofty levels operates on the downside, as well. In most cases, stock prices and earnings growth have already begun their declines by the time the recession officially begins. In fact, stocks have peaked on average about nine months before the start of a major slowdown.

THEMATIC BUBBLES

The post-bubble environment generally depends on how deeply the bubble has penetrated the economy. Thematic bubbles, which occur when a particular asset theme becomes popular and crowd mentality promotes ownership of the group, do not usually leave a massive mark on the economy. The thematic popularity of bowling stocks in the 1960s was just a blip. The Tulip Mania became Tulip Phobia, causing most of the common varieties to never recover their values, but no general economic crisis ensued. Life-changing bubbles, which are often based on new and transformative technologies or infrastructures that change the face of the business, tend to be farther-reaching and historically have led to massive overinvestment and subsequent economic declines. In the aftermath, with the economy in the throes of recession and anemic growth, policymakers typically begin increasing liquidity to jump-start credit creation. This reigniting of credit is typically the link that ties serial bubbles together.

Excerpted from “The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground” by François Trahan and Katherine Krantz (John Wiley & Sons Inc., 2011).

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