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Mar 6, 2020

Year-end Blockbusters

by John DeGoey

John de GoeyCape Fear

Did you ever see the 1961 classic movie “Cape Fear” with Robert Mitchum and Gregory Peck? How about the Martin Scorsese re-make in 1991 with Mitchum, Robert Di Niro and Juliette Lewis? It’s a revenge film and a cautionary tale about taking ownership for your professional responsibility and the potential consequences that come from being less than diligent when performing your job. There, a jilted former client takes revenge on his lawyer. Cape Fear might just make for a contemporary metaphor for what some advisors are doing now… a passable, but not entirely complete and diligent job.

By now, most people are aware of the alarm bells that have been ringing since early 2019 regarding the American stock market. We had a few minor yield curve inversions in the spring of 2019 and earlier in the year, the bull market hit a new all-time high for the length of a bull market—a record that has been re-set and extended daily thereafter. The federal reserve board cut interest rates three times in the second half of 2019 even though Gross Domestic Product (GDP) growth was strong, and unemployment was low. On these metrics alone, many believe there is cause for concern.

I’d like to take a moment to discuss the Cyclically Adjusted Price-Earnings (CAPE) ratio. Popularized by Nobel laureate Robert Shiller of Yale, and generally referred to using his name (i.e. the “CAPE Shiller index”), this is something that, in my view, ought to be sending shivers up your spine. I fear CAPE.

Going back to the days of Graham and Dodd, there has been a considered opinion that a simple price/ earnings calculation can be misleading because of market swings causing the ratio to be misleadingly high or low depending on where we are in the cycle. A few decades ago, Robert Shiller and John Campbell decided that it would be useful to develop a new metric to measure the valuations of capital markets. The variations on the tried and true existing methodology were twofold:

i)  take the average earnings over the past ten years (as opposed to merely the most recent numbers); and

ii) adjust them for inflation.

Taken together, these CAPE variations cause the new valuation benchmark to be more stable—and, some say, representative.

Let’s begin by reviewing what CAPE is and is not. Should we be worried? Relatively few people are familiar with CAPE. As with traditional P/E ratios, the CAPE ratio usually falls somewhere in the mid-to-high teens. Based on historical numbers, a fair reading might be something like 17, with anything up to the low 20s being considered “fair” and no real cause for concern. Since very late 2018, however, the CAPE on the S&P 500 has been hovering around, and often, above 30. The only time it was materially higher than that was immediately prior to the bubble at the turn of the millennium. Before that, the highest reading came in 1929 just before the great depression, when the reading was also around 30. According to Shiller, CAPE is a useful and highly reliable indicator of future medium-term returns, say for the subsequent ten years. When CAPE is high, returns for the next decade or so are low, and vice versa. Most people, Shiller included, do not suggest CAPE can be used as a reliable indicator of when a market will peak and head downward. In short, it IS a reliable predictor of future medium-term returns, but it IS NOT a reliable predictor of when markets will tumble (i.e. revert to the mean).

In my 2019 book, STANDUP to the Financial Services Industry, I show that many advisors offer bad advice because they are unwittingly unaware of evidence that demonstrates how wrong they are. I go on to say that part of the reason the problem has persisted for as long as it has is industry-wide groupthink. No one would ever want to admit to a deficiency of self-awareness or critical thought, yet it seems many advisors do what their peers do simply because their peers do it and they want to fit in.

The Big Short

I recently re-watched “The Big Short”, having both read the Michael Lewis book and seen the Adam McKay movie when they first came out. The movie makes it abundantly clear that part of why the run-up in housing prices was so acute over a decade ago was that the financial services industry was engaging in a form of willful blindness where people who “should have known better” and “should have seen the signs” simply failed in their obligations to protect their clients’ interests. Many advisors I speak with these days remain of the opinion that markets are not priced in a way that should cause alarm. Aside from insisting that they are “watching closely”, the sense I get is that few of them are making changes to their clients’ portfolios in light of the evidence that markets are really quite expensive.

There’s a scene in the movie where Christian Bale’s character (Dr. Michael Burry) realizes that, although he wants to short the housing market, he can’t—because there’s literally no mechanism to do it—and no one had ever thought to do it (or at least wanted to do it) before. I’m doing something eerily similar for the beginning of 2020. Like many financial advisors, I’m not options licensed. Furthermore, since most clients would not be comfortable using options and since the use of options would be incompatible with their risk profile, I needed to find another way to try to manage risk (and ideally, to profit) if markets fell. I investigated using some inverse Exchange-Traded Funds (ETFs) offered by Horizons, but these are deemed to be unsuitable for buy and hold investors. According to regulators, the only people who should be using inverse ETFs are day traders, not strategic asset allocators. In the end, I did what Bale’s character did—I approached a major bank (in this case, National Bank) to build some products for me—one that offered a form of inverse exposure to the S&P 500 and another that provided inverse exposure to the TSX. In December of 2019, I laid the final groundwork for making two of the most “out of the box” trades of my career.

The problem with traditional “short” positions is that they may be directionally correct, but the trades (contracts) might expire before the drop occurs. The inverse ETFs have the added problem of daily re-sets, which, to keep things relatively basic, can cause investors to lose money simply due to the vagaries of day to day volatility. What I needed was a compliant and medium-risk product that anyone and everyone could use (judiciously, of course) in order to provide a hedge against a significant downturn.

I got the good folks at National Bank (based in Montreal, the home of Canada’s options exchange) to come up with a pair (one American, one Canadian) of 2-year inverse notes that:

  • Are totally liquid.
  • Carry no MER (i.e. lower client costs overall).
  • Offer 40% participation on the downside (i.e. clients make up to 40% if the benchmark drops 40% or more).
  • Offer 10% participation on the upside (i.e. client lose no more than 10% if the benchmark rises by 10% or more).

We moved a little over one third of our clients’ equity exposure into these notes (slightly more went into the U.S. note, since the U.S. CAPE is a fair bit higher than Canada’s) in the first week of January. We would have done this sooner, but markets were strong in 2019 and we didn’t want to trigger capital gains in Q4 if they could be deferred by an additional year simply by waiting until the first week of 2020. As part of a larger re-balancing, the move to inverse notes was implemented in early January.

The net effect is that smaller clients are now about 40% inverse and 60% traditional long, while larger clients are about 1/6 traditional alternative; 1/3 inverse and ½ traditional long on their equity positions. Basically, the strategic decision was made that we would “play defence” for up to two years.

While no one knows when (or even if) the bear will rear its head, most people are of the opinion that it’ll happen before the end of 2021. To our mind, the risk of a significant pullback far outweighs the risk of not being able to fully participate in future growth.

Of critical importance is that emphatic position that we are not engaging in market timing. If we were trying to time markets (as if anyone could do that with confidence) and were of the forecasted opinion that markets would categorically drop in the next two years, the appropriate thing would be to put all our clients’ assets into inverse products. Instead, we asked that the products be designed with an asymmetrical risk / return tradeoff (i.e. risk losing a bit if markets drop, but critically being able to make a fair bit of money if markets drop precipitously). I personally believe almost every portfolio on earth to be lower two years from now compared to where it is today. I just:

  • Don’t know anything for sure.
  • Don’t know when it’ll happen (if it happens).
  • Don’t know how deep it’ll be.
  • Don’t know how long it’ll last.

In short (get it?), rather than positioning this as a strategic forecast which, if taken to an extreme, would almost certainly make me look foolish, I would portray this as a prudent tactical adjustment to deal with a clear and prolonged valuation risk that has already persisted for over a year and that is unlikely to end well in the coming quarters.

As I write this, it is the middle of December and both the S&P 500 and TSX are hovering near all-time highs. The TSX is just under 17,000; the S&P 500 is just over 3,000. I’m putting an alternative narrative forward for your consideration and I promise to be accountable in the coming couple of years.

Silence of the Lambs

Why do so few advisors make recommendations that break from conventional wisdom or consensus viewpoints? My own view is that it has a lot to do with peer pressure. John Maynard Keynes once quipped (I’m paraphrasing here) that it was “better for one’s reputation to be conventionally wrong than unconventionally right”. Upton Sinclair said: “It is hard for a man to understand something when his salary depends on his not understanding it”. Mark Twain has been credited (and this is delicious, because there’s no hard proof that he actually said it), that: “It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so”. There are plenty of explanations for human behaviour and many are simple homespun truisms that aren’t particularly deep.

My impression, after spending more than a quarter century as an advisor, is that some advisors are highly prone to the behavioural bias of herding. Once a consensus is reached, it seems difficult for them to come up with a counter-narrative to the prevailing opinion. Ultimately, these advisors become docile purveyors of the dominant groupthink viewpoint who say nothing to oppose the consensus view.

For people who have an interest in behavioural economics, you might want to bone up on the term “motivated reasoning”. Sometimes we believe things simply because we want them to be true. The financial services industry has a vested interest in keeping people invested in long-only investment opinions.

Sometimes, after something happens that we should have seen coming occurs, we use something called a “Narrative Fallacy” to tell the story of what we did in order to suggest there was a reason for a certain course of action, even if we never went on record to express any concern (or sometimes, any awareness) of the things that is concerning or the actions that might be taken. The bottom line is that I suspect many advisors tell their clients to “stay the course” because:

  • That’s what their colleagues are doing.
  • That’s what their firms often prefer them to do.
  • That’s what their product suppliers want them to do.

Sometimes, it’s just easier to go with the flow. A final term that you might want to look up is from Leon Festinger in the field of social psychology. That term is “cognitive dissonance”. Cognitive dissonance is when we have conflicting information that is difficult for us to reconcile. The example I often give is a physician who smokes. There are a few ways people can cope, but one of the most common is to simply minimize (and potentially even ignore) the lack of congruency.

Advisors have a mandate to help their clients navigate both rough and not-so-rough financial markets through many cycles in the context of Prospect Theory – decision-making in a world where there are very few unambiguously right (or even “best”) decisions and where everything is about shades of grey and balances of probabilities with asymmetrical outcomes. The cognitive dissonance comes in when advisors are pressed to explain why they didn’t take prudent, measured steps to mitigate the consequences of severe market moves that, while they couldn’t be anticipated with certainty, certainly could have been anticipated on a balance of probabilities basis. No one wants to admit they’re part of the problem. When speaking with advisors in late 2019, many of them insisted that they thought markets would stay strong until at least 2021. They may be right, and I may be wrong, but I wonder how many of them honestly believed it and how many were just trying to fit in.

John J. De Goey, CIM, CFP, FELLOW OF FPSC™ is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. His advisory website is: