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November 2017

Investment insights

The eye only sees

Tom Stevenson, Investment Director 
 
Perhaps the most unhelpful of the psychological flaws we are prone to as investors is confirmation bias. Our desire to seek out information which reinforces our existing beliefs and to reject anything which undermines our prejudices is powerful and dangerous. 
 
As Warren Buffett said: ‘what the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.’
 
We all do it, in all areas of our lives. Climate change, homeopathy, the stock market, Brexit - we all mistake the desire to be right (the commendable search for truth) with the desire to have been right, which is often simply the pride that comes before a fall. We cling onto our beliefs because to entertain the opposing argument is cognitively painful.
 
Investors are particularly vulnerable to mental shortcuts. They are easy and require little energy. This is pretty much essential in an activity like investment in which the amount of information that could be relevant to our decisions is infinite. We obviously have to be selective in the ideas we use; but we don’t have to, and shouldn’t, prioritise the data which simply allows us to come to the conclusions we want to reach.
 
If this were the extent of confirmation bias’s corrosive influence on our decision-making it would be bad enough. But in fact our desire to stick to our prejudices is even more powerful. Studies have shown that presenting counter factual evidence to a person can actually reinforce their beliefs. They will emerge not only unshaken by doubt but even more convinced by their version of reality and, in some cases, even more evangelical about convincing others of their point of view.
 
As an investor, one of the things I try to do is to read things that challenge my world view. Even better is to try to make the case for something I don’t really believe. So, having spent the past few months shoring up my mental defences against the ongoing bull market, I have this week gone out in search of reasons to be cheerful. My default view is ‘glass half empty’; I’m looking for why it might actually be half full.
 
This is the context in which I read the most recent of Goldman Sachs’s excellent Top of Mind series of reports. The latest has an interview with Steve Einhorn, a former head of research at Goldman and now at New York adviser Omega. He thinks the equity bull market has months if not years still to run - perfect fodder for a reluctant bull.
 
Einhorn’s main assertion is that this economic cycle really is different. Having expanded for 101 months now, the US economic upswing is way longer than the 60 months average upturn in the post-war era. It is the second longest rally to date and could well end up being the longest. But long in the tooth does not mean past its sell-by.
 
The list of reasons to expect the economy to continue growing is long. Despite historically low unemployment, wage growth is tepid. At the end of the cycle it would be overheating. Economic output remains below its long-run potential and is rising; typically, ahead of a recession it is above potential and falling. Leading economic indicators usually warn of problems ahead in the months leading up to a recession but today they are pointing in the opposite direction.
 
Ahead of a downturn, the Fed Funds interest rate is usually above the neutral rate at which it neither stimulates nor depresses the economy but today it is half as high. The bond yield curve points down in the late stage of the economic cycle, suggesting fears about future growth; today it is still positive. Yes, this is a long economic cycle, but it has also been a notably subdued one. GDP growth has been well below average in the past eight years. Inflation is unusually muted. 
 
The link between this prolonged economic cycle and the equity market is, of course, the Federal Reserve. The subdued recovery has demanded an exceptional response and the central bank has delivered extraordinary stimulus and near zero interest rates and it remains accommodating. This matters because, as the old adage says, bull markets do not die of old age, they are murdered by the Fed. Supportive monetary policy is one of the key reasons to expect the party to continue.
 
Einhorn identifies five bear market signals that are a prerequisite for a prolonged downturn in share prices as opposed to a short-term correction (which we may well see). None of the five, he believes, are ringing alarm bells today.
 
First, there is no wage inflation. The kind of earnings increases that would prompt a response from the Fed will probably not be evident before the end of 2019 or 2020. This means the second bear signal, a hostile Fed, is also unlikely for at least a couple of years even if, as expected, Janet Yellen is replaced. Third, recession is unlikely before 2020. Fourth, sentiment remains subdued. Finally, valuations are not demanding in an environment of persistently low bond yields.
 
So, there we are. Despite the cognitive dissonance, even we temperamental bears can make the case for sticking with the market. The eye sees only what the mind is prepared to comprehend so it’s worth opening up to the possibility that we might be wrong.
 
 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets.

This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. 

This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading it from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

 

© 2017 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.

 

This website is intended to provide general information only and has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information and consider the relevant Product Disclosure Statement for any product named on this website before making an investment decision.

© 2017 FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340.
Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL limited.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia"). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International. Prior to making an investment decision retail investors should seek advice from their financial adviser. Please remember past performance is not a guide to the future. Investors should also obtain and consider the Product Disclosure Statements ("PDS") for the fund mentioned in this document. The PDS is available on www.fidelity.com.au or can be obtained by contacting Fidelity Australia on 1800 119 270. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider such matters before acting on the information contained in this document. This document may include general commentary on market activity, industry or sector trends or other broad based economic or political conditions which should not be construed as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be construed as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity funds is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. References to ($) are in Australian dollars unless stated otherwise. © 2017 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International, and the Fidelity International logo and F symbol are trademarks of FIL Limited.