Beware of the Writing on The Wall – Part 4 - The Aftermath

2018-09-12T15:31:18+00:00

By Mike Fortunato, CIM®, FCSI®

image:https://econompicdata.blogspot.com/2010/08/housing-greed-fear-bottom-cycle.html

In the previous two instalments of this article I described how the rollercoaster ride investors experienced (as the market peaked in 2007 and subsequently nosedived in 2008) was foreshadowed by posters displayed in several bank branches throughout Ontario, where I worked as a teller at the time. Ironically, the investment products promoted in both posters were ill-timed for many investors to take advantage of their benefits:

First, equity mutual fund posters arrived in the late summer of 2007. Although the funds had terrific past performance, they were doomed to experience substantial declines as the market eventually collapsed a few months after their posters went on display.
Then, in the middle of 2008, as the market continued to crumble, GIC posters were displayed, which were too late to protect many investors from losses that occurred earlier in the year. Also, investing in GICs in late 2008 came with a huge opportunity cost by tying up investor’s funds (at extremely low yields) just a few months before the market was destined to being its multi-year rebound.

In this last instalment I’ll describe how investors were thrown one final loop-de-loop in this rollercoaster ride, that again involved yet another untimely poster (as the market was beginning its recovery in 2009).

Before I lift the curtain on the final act of this real-life drama, I want to give you some background about my disposition, at the time this was unfolding. A few years before joining the bank I had begun studying economics and wealth management as a hobby. I was particularly interested in the concepts of investor psychology and the field Behavioural Finance. At the time, I was actually more concerned with trying to become an investor verses trying to find a career in the finance industry. I spent much of my spare time consuming the financial news, reading books about investing, and testing various strategies in the markets. I continued studying while at work too, as I made it a habit to learn from every customer I spoke with. By viewing each customer interaction through the lens of Behavioural Finance I was able to gain huge insights about the micro-economic forces that assemble to form the macro-economic phenomenon commonly referred to as “the mind of the market”. I had certainly been in the right place and the right time in history to be studying investor psychology. First, I witnessed how flashy historical returns, displayed in our equity mutual fund’s poster, played on the emotion of greed and enticed many investors to go ‘all-in’ near the top of the market. Then, as the market reversed, many investors panicked as their losses accumulated and were allured to the promise of “guaranteed principal” advertised in our GIC poster. Falling victim to the emotion of fear, those that sold out near the bottom of the bear-market, to move into GICs, were also guaranteed to exacerbate their losses with an extra-long recovery due to the low yield of these ‘safe’ investments.

As 2008 was ending and 2009 was beginning, I recall reflecting on the last 18 months since becoming a bank teller in the summer of 2007. It was quite a ride. At that time many investors were still too terrified to invest in stocks because the market still hadn’t shown any signs of letting up from its one-year plunge. Looking back now in hindsight, however, it is clear that this was the best time to start investing in equities again, as the markets have been steadily rising for almost 10 years since bottoming in the early spring of 2009. I could understand investor’s fear however, to invest in stocks again, as their portfolios had been devastated the prior year. It was during this emotional time that the final poster in this saga appeared on the display wall at my branch mid-2009. It was advertising one of our bank’s bond mutual funds. Although it didn’t boast returns as strong the equity fund poster from 2007, it did showcase a mix of high-single-digit (5-year) & double-digit (3-year & 1-year) historical returns. This new bond fund poster must have shined like an oasis to many of our investors given that the other mainstream alternatives at the time were: near-zero-percent yielding GICs and a stock market that had fallen approximately 50%. In light of all the turmoil they had recently experienced in the stock market, I wasn’t surprised that about half of our clients viewed this new poster more like a mirage instead of an oasis. But those that weren’t skeptical actually viewed this bond fund as a better alternative than GICs to claw back all the losses they had experienced.

Historically, it is rare for a bond fund of that nature to have returns as high as the past returns showcased in our poster. Leaving aside the skill of the portfolio management team (which I’m sure was great), there were two main reasons why our bond fund had such a strong 1-year, 3-year & 5-year historical return:
Interest rates had just been aggressively lowered by central banks who were trying to inject liquidity into the financial system.
Large institutional investors moved funds into government bonds in hopes of finding a stable place to ride out the storm.
Both of these factors placed tremendous buying pressure on the government bond market, which caused bond values (and many bond funds) to increase dramatically. The fact that the 1-year & 3-year return on our bond fund poster was much higher than the 5-year return, also seems to confirm that the catalyst for its strong performance occurred mainly in 2008.

Although this fund had great historical performance, the most important consideration for new investors contemplating whether to invest in the fund or not was: how well it would perform in the future. Ironically, the dynamic between the rolling historical return of this bond fund and the cyclical nature of the bond market is very similar to the dynamic we saw in 2007 between our equity fund poster and the stock market. Sadly, many investors I talked with at the time hadn’t learned any lessons from 2007 and again shallowly focused only on the historical returns in large block print in our bond fund poster. In retrospect, those that were enticed to invest in bond funds like this one, in mid-2009, performed okay, but their return was much closer to the historical norm one might expect from a bond fund (as opposed to the double-digit returns they were hoping for). It’s also important to remember that many of these investors saw this bond fund as their ticket to redemption and hoped it would help restore their portfolios to their former glory. Below is an image to help illustrate why their intuition was incorrect:

The blue line above represents the price of iShares’ S&P/TSX 60 Index ETF (adjusted for dividends & splits). The green line represents the iShares’ Canadian Government Bond Index ETF, and the red line represents iShares’ 20-year US Treasury Bond ETF. The chart starts at the left showing only the TSX 60 ETF. As you can see, TSX 60 ETF starts dropping in the middle of 2008 and falls almost straight down for an entire year. Once the blue line reaches its lowest point in February 2009 I introduce the two bond ETFs to give you a sense of what a recovery would be like had investors either stayed the course and held on to their stocks (in blue) or swapped into bonds (in green & red). It is important to note, that had investors had the intuition to transition into bonds prior to the crash (or held a diversified portfolio) they wouldn’t have experienced such a dramatic loss. But that certainly wouldn’t have been possible for any investor who took their investment cues from posters, as the bond fund poster wasn’t even displayed until 2009.

The period between 2007 and 2010 played a crucial role in developing my understanding of market cycles, investor psychology, risk management and the important of due-diligence. Unfortunately, for many investors, that same period in history represents huge financial losses and emotional pain. It is important to note that similar posters to the ones displayed in my branch were also displayed in our competitors branches as well. I’m also not insinuating that there was any foul play with respect to the odd timing of the posters. We expect companies to want to advertise when their products are performing well. Markets tend to move in cycles, but ironically, the length of those cycles just so happens to approximately the amount of time it takes for many investors to take notice and get on board. This has the effect of pulling the rug out from those that are late to the party.

For almost a decade I’ve been pondering the events I witnessed as a bank teller between 2007 & 2010. I’ve come to the conclusion that: having a lack of financial literacy was what hurt regular investors most. Most people are not taught how to interpret technical and fundamental market data. When it comes to purchasing a consumer item most people find it easy to spot a deal, or a fad, but when it comes to financial products most untrained investors seem to reverse the two. The consequences of having a lack of financial literacy are amplified when emotion is involved. The mood of investors seems to mimic the cyclical nature of markets by oscillating between the emotions of greed and fear. I observed this first hand when so many investors rushed to invest in my branches equity fund at the top of the stock market just because they saw a poster showcasing how great their returns would have been had they invested five years earlier. Many of those same investors panicked in fear and sold out of their stock investments after experiencing dramatic losses, only to trade into GICs that paid almost zero return (but promised a “guarantee of principal”). Finally, some investors then missed out on one of the longest bull-markets in recorded history because they were either on the sidelines stuck in safer GICs or because they were lured into bonds by yet another poster showcasing how great their return would have been had they invested five years earlier.

For most people, investing is deeply connected to their present & future quality of life. That’s why it is almost impossible to completely separate emotion from investing. Having an understanding of financial literacy (or aligning with an advisor who is financially literate) can help investors temper their reactions to highly emotional situations. The other tool all investors should leverage is a solid financial plan. A strong financial plan can help investors to never lose sight of their goals. Its principles aren’t eroded by the cacophony of conflicting market commentary investors are subjected to on a daily basis. Although I’ve been studying markets and investing for about 15 years the most important lessons I’ve learned came from my short time as a bank teller observing how clients reacted to the posters on display during the beginning, middle and end of the 2008 Financial Crisis. Despite still being tempted by my own emotions during periods of market euphoria and hysteria, I’m reminded to stick with my financial plan and beware of the writing on the wall.

Beware of the Writing on The Wall – Part 3 - A Change In Mentality

2018-09-06T18:20:30+00:00

By Mike Fortunato, CIM®, FCSI®

image: https://www.flickr.com/photos/notionscapital/5455358198

Although the indices dipped slightly in the late summer of 2007, both the Canadian & US markets had recovered by October of that same year. During that same period at our branch, our equity mutual fund poster continued to be an attraction for many of our clients. I vividly recall how the double-digit returns on display sparked many conversations that ranged from transactional chit-chat to requests to speak with our advisors. As 2007 was coming to a close, excitement among our clients had reached its peak; little did they know that the rollercoaster ride was just about to begin.

Fast forward less than one year, to the summer of 2008, and the mood had certainly changed. The Canadian market, which showed positive signs in the spring of 2008 was back where it was a year earlier. The US market, on the other hand was doing much worse and was down approximately 15% from the level it was when the equity mutual fund poster first appeared at our branch. The mood of the clients was also beginning to shift. Those that were covetous a few months earlier were now much more cautious. My favourite client, the man who just a few months ago was excited to give me his weekly, bullish market prognostications, was now probing me about when I thought the market would rebound.

By early fall of 2008 things had taking a precipitous turn for the worse. Both the Canadian & US markets were approximately 30% lower than they were the preceding year. Any hope that was remaining at beginning of the summer had now transformed into panic. Much of the losses accumulated in those months in 2008 were concentrated in a few extremely volatile days. This took many investors by surprise and left them holding portfolios with massive unrealized losses. My branch was somewhat of a microcosm of what was happening on a global scale. The same clients, who just a year earlier were so intrigued by our equity fund’s potential return, were now desperately in search for any means to stop the pain.

In an effort to buttress their deflating economies, central banks around the world began aggressively lowering interest rates in their respective jurisdictions. During 2008 alone, the Bank of Canada lowered its key overnight rate almost 3% (from just over 4% all the way down to 1.5%). Although this rate easing would eventually sow the seeds of a slow recovery that would take about four years to materialize, its initial effects were to dramatically distort the fixed income markets throughout Canada. It was during this commotion that our branch eventually removed the equity mutual fund poster that had caustically arrived as the market was reaching its peak, about a year earlier. The new poster that replaced it, however, was no less ironic in its timing and implications; it’s caption read: “Guaranteed Investment Certificate”, and it offered terms that ranged from 1 year to 5 years.

At the time we were still in the middle of a market meltdown, and I can completely understand why banks would choose to remove the equity mutual fund poster that boasted double-digit historical returns. After all, those performance numbers were certainly no longer acculturate, and could easily spark resentment with many investors who were still experiencing the pain from the bear-market that had no end in sight. The idea of a guaranteed investment must have gleamed like a light beacon to the many clients that were watching their portfolios slowly evaporate away. Sometime during the 2008, I recall noticing that the other competitor banks also took similar actions by eventually replacing their equity mutual fund posters with GICs posters. Unfortunately for all investors, due to the dramatic shift in our yield curve, I don’t recall seeing any GIC’s offering more than 1.5% (regardless of the term). That is the nature of any market; when investors rush into a security, the price of that security rises. In this case, investors were rushing into an investment that offered a guarantee of principal. Speculation had taken a back-seat to safety, and that spike in the demand for safety had a tremendous effect on its cost: the cost being the fact that you would earn almost nothing for locking up your money for one to five years.

Beyond earning almost nothing, there was also a huge hidden opportunity cost embedded into those GICs due to the fact that your investment is locked up for the term of the GIC. As I mentioned in part 2 of this article, going back to 1956, the average bear-market in Canada & the USA have historically lasted around 9 to 14 months, and by the time it took both markets to drop about 30% from their 2007 high, an entire year had just about passed. So, on a historical basis, the bear-market that was causing our clients to panic was actually coming close to its end. But as is normal in both bull & bear-markets, most investors and commentators seem to believe that “this time will be different”. Looking back in hindsight, we can see that the bear-market during the 2008 Financial Crisis actually lasted about 11 months in Canada and 16 months in the USA, which was very much in line with the historical averages. So, for an investor motivated by fear, locking into a GIC for a long-term in the latter part of 2008 meant missing out on the recovery that followed.

Below is graph to illustrate my point:

The blue line above represents the price of iShares’ S&P/TSX 60 Index ETF (adjusted for dividends & splits). The movement of that line is analogous to the movement an investor’s portfolio would undergone during the seven-year period between May 2007 – May 2014. As you can see, an investor would have experienced a dramatic loss early during the financial crisis between May 2008 – Feb 2009. The five other coloured lines are the theoretical return an investor would have received had they sold out of the market and immediately invested in a GIC paying 1.5% per year. The green lines represent investors who made that switch in June 2008 & August 2008. They managed to enjoy all the gains of the bull-market while also avoiding all the pain of the initial drop in 2008. Even the best investors rarely display such perfection in timing and foresight. It is important to note that just staying the course and riding the blue line eventually becomes the winning bet near the end of our chart (in May 2014), and shows a massive outperformance had I extended the chart all the way to present day (mid-2018, where GICs are still paying less than 2%). The red lines at the bottom of the graph show a more realistic representation of what a panicking investor might have experienced. After all, the bulk of the losses occurred in the span of just two months just after the summer of 2008. For most inexperienced investors, their capitulation would have probably occurred after that big drop.

As a bank teller during the Financial Crisis I was observing this dynamic play out in real time. The graph above displays blue, green and red lines, but to me, those lines represent actual investors I knew and interacted with on a daily basis. Some held onto their investments and rode out the storm and eventually recovered all their losses, while others threw in the towel at or near the bottom of the market and haven’t invested in equities since. Witnessing the forces of fear and greed in a Behavioural Finance context taught me valuable lessons about investment suitability, and the interaction between an investor’s time horizon and their risk tolerance, that I still leverage to this day. Many of the clients at our branch were lucky that they had relationships with our branches advisors as they were given guidance during the market turmoil. Unfortunately, any investors who took their cues from posters often found themselves invested in good securities, but at the worst possible time.

Beware of the Writing on The Wall – Part 2 - Enter The Crash

2018-08-13T14:47:46+00:00

By Mike Fortunato, CIM®, FCSI®

image: http://theholyfinancier.com/beat-the-herd-mentality/

It was the early summer of 2007; I had just started my new job as a bank teller and had begun building relationships with my branch’s many regular customers. Our diverse customer base contained a wide spectrum of investor profiles whose experience ranged from starter to sophisticated and whose risk appetite ranged from skeptical to speculator. One thing they all had in common however, was that they were complete unaware of the looming Financial Crisis that was just around the corner. During those first few weeks, while settling into my new role, I recall that all the posters on our display wall contained what I would describe as boring advertisements of our various account types and fee structures. One day this all changed when a new poster became the centerpiece of our five-poster spread. I remember this all very clearly because this was the first time any client had ever asked me for more information about one of our posters. And for several weeks after its arrival that poster became the catalyst for many eye-opening conversations between myself and the inquisitive clients who just “had to know more” about it. What was on the poster? It was an advertisement for one our equity mutual funds. I actually don’t even remember the name of the fund. To be honest, however, it wasn’t the mutual fund’s name that had piqued the client’s interest. I’m certain of this because the only part of the poster any client ever inquired about were the three, double-digit, numbers centered on the poster in large, bright, bolded font under the corresponding headings of: “1-Year Return, 3-Year Return & 5-Year Return”.

The information presented on that poster was not an exaggeration. That particular equity mutual fund actually did deliver double-digit, annualized returns to its unit-holders for the past several years. But beyond eliciting a Pavlovian response, that information is of almost no use to an investor who understands the cyclical nature of markets. To be clear, I’m not saying that the bank was attempting to manipulate its customers through Bernaysian persuasion; in fact, anyone with a magnifying glass could clearly see that “past performance wasn’t indicative of future returns”. It is important to note that at the time I also had personal accounts at two other Big Five competitors and often visited their branches to conduct personal business. During those visits I observed that they too were usually displaying posters that advertised the same investment products as my bank. While their poster’s colour scheme was different than ours, the content displayed was usually quite similar.

A major component of my role as a teller was to refer clients who were interested in our products to our branch’s advisors for more information. Needless to say, my referrals really picked up the day we began displaying the past, double-digit returns of that equity mutual fund. Before introducing them to our advisors, our interested clients would often ask me a few cursory questions about the mutual fund and although I wasn’t in a position to answer many of their questions (for regulatory reasons) I did glean some insights into the mindset that they entered the advisor’s office with. As someone who had already been studying Behavioural Finance for the past few years, it was very easy for me to conclude from the nature of their questions that they were operating from a mindset tilted more towards greed verses fear. Of the dozens of clients that were interested, only a handful ever asked me about the risks involved with such an investment, and the vast majority were mostly concerned with seeing proof of the past performance, which was quite easy for our advisors to provide them. The only fear I ever detected came in the form of “fear of missing out” rather than fear of loss. It is important to also remember that, at the time, the market had been in an uptrend for the past several years and one only needed to flip to any financial news TV station to see the anchors proudly boasting that broad market indexes were too showing double-digit historical returns. I’ll never forget my favourite customer; an upbeat older gentleman who would visit our branch on an almost daily basis to give me his stock picks for the week. When I probed him as to why he liked those tickers he would parrot to me the target-price he saw online that morning as if the company was destined to trade at that exact price in the near future. While the mood during this time in history wasn’t quite the “irrational exuberance” that Greenspan had observed a decade earlier it certainly was an exciting time to be in the markets.

It wasn’t a mere coincidence that the arrival of the poster showcasing double-digit, historical returns came just a few weeks prior to the top of the market. This is actually quite normal and has less to do with some secret bank conspiracy and more to do with basic math and market dynamics. You see, markets (like the stock, bond or real estate markets) tend to move in a cyclical fashion. Generally speaking, over very long time periods, markets usually tend to move in a positive direction, however, over the medium & short-term we tend to see prices oscillate between peaks and troughs. Using price data all the way back to 1956, we can see that there were 12 stock market cycles in Canada and 11 the USA (peak to peak including our current bull-market). During that time, the average bull-market lasted 52 months and 48 months respectively while the average bear-market only lasted 9 months and 14 months respectively. But as the two graphs below illustrate, we can see that the duration of the average bull-market has increased significantly in more recent history (from 1980 till present). It would appear that more modern bull-markets tend to last somewhere between five and ten years in both Canada and the USA.

Source: mackenzieinvestments.com Original Source: Bloomberg March 2018

As we can see, the return from equities is far from steady. Over the long-term we can forecast growth, however, that growth is traditionally delivered in waves that last between five and ten years. This is why it is incredibly dangerous to rely on historical growth (especially when measured in 3-year & 5-year rolling periods) to predict where the markets will go in the near-term. Mathematically speaking, if a market rises for five years or more before falling, then that market’s 5-year historical return will be at its highest level precisely at the moment before it is about to crash.

To illustrate this point, I’ve created a theoretical market price series that runs for 40 years. The price of this series (the blue line) starts at $1000 in 1978 and ends at $4448 in 2018. The market follows a simple, random progression where it increases for seven straight years with each year’s increase being randomly generated between 5% and 15%. Then, on each eighth year, the price decreases by a random amount between 30% and 50%. This creates a 40-year market price series (with repeating cyclical periods of eight years) and has an average annualized total growth of about 4%. If we add in a 2% dividend, we have a somewhat realistic model to work with.

On top of this price series I’ve overlaid its rolling 5-year return, rolling 7-year return & rolling 10-year return in orange (in three separate graphs). As you can see, the historical 5-year, 7-year & 10-year return is at or close to its peak precisely as the market, in blue, is about to start falling. There is one other noteworthy observation: according to this chart, the best times to buy this market also happened to be when the rolling 5-year, 7-year & 10-year historical return was at or near its lowest points. In some cases, the rolling, historical return was actually negative even though the market had bottomed and was about to rise for seven consecutive years.

If this artificial price series seems too unrealistic, I’ve also replicated the same experiment using actual prices data from both the S&P 500 between the years of 1990 – 2018 and the S&P TSX60 with price data from 1988 - 2018. Again, we can see that high points in the historic rolling 5-year returns (in orange) correlated well with precipitous drops in the value of the market index. Also, investors who invested when historical returns were low were rewarded for their contrarian courage.

As you can see from the two diagrams above, there is a short window where the market’s rolling historical 5-year return is too high for a bank’s marketing team to ignore, given that their goal is to attract new business through visual advertising. You can’t really blame them either, because most clients would probably ignore any poster that displayed lackluster past returns, even though we have now proven that it might be in their best interest to take that information into consideration. The mathematical relationship between a cyclical market and its rolling 5-year returns, combined with basic phycological facts about human greed & fear offer us a complete model explaining why equities appeared so attractive to so many people at the worst possible time. No conspiracy theories required!

Beware of the Writing on The Wall – Part 1 - The Bull Market Leading Up To The Crash

2018-08-03T14:58:09+00:00

By Mike Fortunato, CIM®, FCSI®

image: http://metuchenliving.com/why-do-we-sell-low-and-buy-high/

Eleven years ago, in the summer of 2007, I landed my first finance related job as a bank teller for one of Canada’s Big Five national banks. Like most entry level roles, being a bank teller taught me valuable lessons about customer service, organization, problem solving, and teamwork. It also gave me a great introductory view of the broader finance industry that I still work in today. When I started my career at the bank, my goal was to eventually work with investments. Now that I’m a member of a portfolio management team I still find myself leveraging knowledge about economics, markets and investments that I picked up while I was a teller over 10 year ago. The most important lessons I learned however, didn’t come from the training or mentorship I received, but instead came from simply observing our clients’ reactions to the global financial system that was collapsing around us all during a period that we now call: The Great Recession (or 2008 Financial Crisis).

Just a few months after processing my first bank deposit I watched the world’s equity markets fall into complete pandemonium. During the year and a half that followed, the world experienced a terrifying bear-market where stock prices plummeted from all-time highs to levels not seen for almost a decade. Being a teller during that time was like having a front row seat to watch the panic unfold. On a daily basis I observed my branch’s customers and advisors trying to make sense of chaos. I remember thinking to myself at the time, “how is it that so many people didn’t see this coming?”. In the weeks leading up to the crash I recall that many analysts on the financial news, and most of the investors I spoke with, were actually quite bullish. Their positive outlook even continued into the first few months of the crash, when each new market low was often celebrated as an opportunity to double-down in anticipation of a correction bottom that never seemed to arrive. While trying to make sense of all that was unfolding I noticed a phenomenon that gave me tremendous insight into the interplay between market fundamentals and basic investor psychology: the most expensive and riskiest investments are often the most attractive to investors who don't understand the cyclical nature of markets.

As a bank teller I was stationed at the font of the branch directly facing a wall of promotional posters that the bank had setup to drive various product offerings. A large part of my role involved answering client’s questions about those posters. The bank’s marketing team would periodically change the content advertised on the posters to coincide with whatever new campaign the bank was promoting at that time. Every time the posters changed, the bank’s clients would come to me to inquire about the writing on the wall. Being on the front lines literally put me in the best position to observe both the timing of the bank’s investment offerings and the client’s reaction to them. Overlaying both these observations against the backdrop of The Financial Crisis as it was unfolding, was a revelation into the powerful micro-economic forces that drive market cycles. Since acquiring this knowledge 10 years ago, I’ve witnessed this powerful phenomenon play out several other times in many other markets: the stock market, forex, commodities and multi-unit residential real estate market. The next three instalments of this article will focus specifically on the how this dynamic unfolded: during the bull-market leading up to the crash, during the crash itself and finally, during the recovery that followed.