28 Mar 2016

"Different River, Different Man" | Why the Investment Clock is a Dangerous Myth

Adam Geha

28 Mar 2016

positioner

“We live in a world where everything is always in a state of flux.” Thus spoke an ancient Greek philosopher called Heraclitus, circa 500 BC.

It’s an astonishingly modern thought for an ancient philosopher – and also utterly forgettable.

But thoughts, like humans, long for immortality. And Heraclitus understood that to greatly honour a thought, you’re obliged to express it memorably. And so in his very next line, he duly obliges:

“No man ever steps in the same river twice – for it’s not the same river and he’s not the same man.”
 
And with that Heraclitus photographed his great thought into immortality, capturing it in an image that is at once obvious and obscure.

The river bed, the water level, the water flow and even the water itself are constantly changing and so is the man crossing it. To the naked eye, they may appear unchanged but the river is different, and so is the man. The epiphany for me was this: when we speak of “doing the same deal again” or “being in the same position in the cycle”, these are only convenient turns of phrase. In truth nothing ever repeats … ever.

Which brings me to the famed and much esteemed “investment clock”. This is the notion, first peddled in the 1930’s but still popular today, that cycles follow a predictable pattern. There are many variations, but the main theme goes something like this:

(1) share prices fall then (2) commodity prices fall then (3) unemployment rises then (4) real estate prices fall prompting (5) a fall in interest rates, which in turn causes (6) share prices to rise then (7) commodity prices to rise and (8) unemployment to decline which in turn leads to (9) rising real estate prices and (10) higher interest rates – which, surprise, surprise brings you back to (1) a fall in share prices.

It’s all very predictable and very reassuring (just like a clock) … and it’s also very wrong and very dangerous.

Take the latest world-wide recession caused by the credit crisis. Shares plummeted by 40%, then commodity prices fell by 30% while official interest rates fell to almost zero then … commodity prices rebounded by 80%. Hey?! What happened to the clock, you ask?  The simple answer is that the clock broke down (for the umpteenth time), this time because the Chinese government stimulated domestic demand, which in turn accelerated demand for resources.

Of course there is always a very good reason why the clock failed to work on any particular occasion. The problem is that it breaks down or reverses direction so often that it is a clock more likely to mislead than to lead. But isn’t the investment clock highly prescient on some occasions? Perhaps, but as the proverb goes: even a broken clock is right twice a day.

The unmarketable truth is that no two cycles are the same, for there are too many dynamic variables at play for a clock to function properly.

This is why at EG we spend no time trying to predict the timing or cause of the next correction or crash. We leave this arcane science to followers of Nostradamus (who on all accounts wasn’t all that successful at it either). “Leading indicators” it turns out are all too often lagging indicators, in anything other than a classic (endogenous) economic cycle.

Instead, through our PRISMS software we track Systematic Risk (timing risk) through what the investment literature calls a “Vulnerability Index”.

Leading Indicators try to forecast the likelihood and timing of a correction; whereas a Vulnerability Index only tries to answer the question: “If a correction does occur, how far do asset prices have to fall?” In other words, how vulnerable would you be if a correction occurred?  Figure this one question out successfully (more on that later), ask it regularly, sell when your vulnerability is high, buy when your vulnerability is low… add a couple of cycles and presto: you will be a very, very well-heeled investor.

Nothing ever repeats … ever. Different river, different man. For the astute investor, this is an arresting thought. For the novice, it’s a paralysing one.

So here’s to Heraclitus, he was ahead of his time: about 2,500 years to be precise.