Saturday, school holiday, and the sun is shining

I love chatting with taxi drivers. These philosophers of the road are an interesting source of wisdom, knowledge and – occasionally – casual racism. No matter where I go in the world, I tend to strike up conversations with cab drivers to learn something about the local culture or the current political climate. 

Recently, my wife and I took a taxi in London to the opera and our driver greeted us with the words: “Today is one of the most dangerous days to drive”. In disbelief, I looked out the window to check if I was dreaming but it was still the glorious London summer day I remembered from ten seconds ago. I asked the driver, why he thought that this day was so dangerous for drivers? He said that today was a Saturday and the sun was shining. The only thing, in his opinion, that could make it worse was if it was the first day of a school holiday. According to him, this is when traffic accidents increase, in particular accidents that involve pedestrians and cyclists.

I thought that rush hour on a day with heavy rain or snow would have been the most dangerous time to drive in the city, but he explained that in busy traffic with rain or snow, people naturally are aware that the conditions are treacherous and are more alert. On a sunny day with little traffic we tend to let our guard down and easily get distracted by the beautiful nature or the people around us. This is particularly the case for daydreaming pedestrians who walk into the road, and potentially into a car with an equally distracted driver. Accidents happen not because the environment is dangerous but because people don’t pay attention to risk.

And in investing, it seems as if the same thing is true. In the first six months of 2019, the MSCI World Index was up 15.6% in US Dollars, the MSCI Emerging Market Index was up 9.2%, the Bloomberg Barclays US Aggregate Bond Index was up 6.1%, emerging market bonds were up 9.4%, the Bloomberg Commodity Index was up 5.1% and the HFRX Global Hedge Fund Index was up 4.1%. I could go on but you get the picture. Practically every asset class has registered strong gains in the first half of 2019, even the long-suffering ones like commodities and emerging markets. If you were running a fund and you would sell everything today and invest it in the money market, I am sure none of your investors would complain about the performance at the end of the year. It is clearly Saturday and the sun is shining.

As investors, this is the time when we have to fight complacency. Of course, we should enjoy the day and the great performance of our investments, but we also need to be aware that other investors might lower their guard and this, in turn, might create an accident in financial markets. The year 2019 has seen economic growth in the US and around the world slow down (not dramatically, but a little bit) and tensions between the US and China and Iran, respectively, increase. Nevertheless, more and more investors seem to think that the current bull market will go on as the central banks will support the market with interest rate cuts and the current cyclical slowdown seems to be so shallow that we might never have a decent recession ever again. But my take on the current situation is that i) central banks are cutting interest rates because they are afraid of a much more pronounced economic slowdown than the one we have experienced so far and ii) every recession starts with a little slowdown. And every time we see some people argue that this time there won’t be a recession.

I cannot forecast recessions and I don’t know if the current slowdown will end up in a recession, but as more people enjoy the Saturday sun I think it is wise to prepare for the possibility of some pedestrian walking in front of a car or of a sudden thunderstorm.

Today, investors have many tools to prepare themselves for such situations. One possibility would be to sell risky assets or to hedge the downside risk with options and other derivatives. The advantage of these actions is that if markets crash, the portfolio is fully protected. But metaphorically speaking selling all risky assets is like staying at home and shutting the windows and blinds. And buying put options or other derivatives to hedge against downside risks is like walking in the sunshine with an umbrella: it might give you some shade but you still look silly. And most importantly, you are missing out on the nice weather, which in a city like London is rare enough anyway.

Short of staying at home or wearing rain gear, there are other tools investors have at their disposal to reduce risks. If you want to enjoy a hot summer day, one thing to do is to sit outside in the shade. You still get to enjoy the sunshine, but it isn’t quite as hot and you don’t risk a sunburn. In investment terms the equivalent action would be to shift from cyclical to defensive stocks such as health care and food stocks, utilities or regulated infrastructure stocks. This way, you still enjoy the upside of the stock market, but if markets turn you have some protection. 

Similarly, one could enjoy the day wearing sunscreen. Sunscreen protects you against UV radiation that can cause skin cancer but lets the warm infrared radiation through. This is like having a stop loss on your risky assets in place that is 10% or so out of the money. You get to fully enjoy the good times but the stop losses can protect you against the worst drawdowns if the bull market turns into a bear market.

And finally, while most people let their guard down on a sunny day on the weekend, investors should be particularly vigilant now. Other people will make mistakes that may impact you. A sudden change in market sentiment may trigger a significant sell-off as many investors run for the exit at the same time. Alert investors may observe such signals of a pending mood swing ahead of time and mentally prepare themselves for the possibility of a sudden drop in markets.

The risk of paying close attention to markets today is that greed might take a hold of us and we might start to get enthralled with the great performance of our investments today. Behavioural finance tells us that is all too easy to get swept away in the positive emotions that strong performance triggers. Thus, it is important to focus on the things that might go wrong in the future instead of the things that have gone right in the past. 

I usually remind myself of the story told by Abraham Lincoln in 1859:

“It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride! How consoling in the depths of affliction!”

Performance of different asset classes in the first half of 2019

Source: Bloomberg.