By Dr Shane Oliver, Chief Economist and Head of Investment Strategy for AMP Capital Investors
Myth #1: High unemployment will prevent an economic recovery
This argument is wheeled out every time there is a recession. If it was correct then economies would never recover from recessions but simply spiral down into the sort of crises that Karl Marx predicted would ultimately lead to the demise of capitalism. Of course it doesn't happen. Rather, the boost to household discretionary income from lower mortgage bills (as interest rates fall) and tax cuts or stimulus payments to households during recessions eventually offset the fear of unemployment for the bulk of people still employed. As a result they eventually start to spend more which, in turn, stimulates the economy. In fact, it is normal for unemployment to keep rising during the initial phases of an economic recovery as businesses are slow to start employing again fearing the recovery won't last. Since sharemarkets normally lead economic recoveries, the peak in unemployment often comes a long time after shares have bottomed.
Myth #2: Business won't invest when capacity utilisation is low
This argument is also rolled out during recessions. The problem with this myth is it ignores the fact that capacity utilisation is low in a recession simply because spending - including business investment - is weak. So when demand turns up, profits improve and this increases business investment which then drives up capacity utilisation. So while business investment in key countries right now is poor, providing there is a pick up in demand - and several indicators are pointing to this later in the year - then business investment will start to improve even though many factories are still idle.
Myth #3: Corporate CEOs, being close to the ground, should provide a good guide to where the economy is going
Again this myth sounds like good common sense. However, senior business people are often overwhelmingly influenced by their own sales figures and have no particular lead on the future. In the late stages of the past recessions, anecdotal comments from CEOs were generally bearish - just as recovery was about to take hold. This is not to say that CEO comments are of no value; but they should be seen as telling us where we are, rather than where we are going.
Myth #4: The economic cycle is suspended
A common mistake investors make at business cycle extremes is to assume that the business cycle won't turn back the other way. After several years of good times it is common to hear talk of "a new era of prosperity". Similarly, during bad times it is common to hear talk of "continued tough times". But history tells us the business cycle is likely to remain alive and well.
Myth #5: Crowd support for a particular investment indicates a sure thing
This "safety in numbers" concept has its origin in crowd psychology. Put simply, individual investors often feel safest investing in a particular asset when their neighbours and friends are and the positive message is reinforced via media commentary. The only problem with it is that, while it may work for a while, it is usually doomed to fail. The reason is that if everyone is bullish and has bought into the asset there is no one left to buy in the face of any more good news, but plenty of people who can sell if some bad news comes along. Of course the opposite applies when everyone is bearish and has sold - it only takes a bit of good news to turn the market up. And, as we saw in March, this can be quite rapid as investors have to close out short (or underweight) positions in shares. The trick for smart investors is to be sceptical of crowds, rather than drawing comfort from them.
Myth #6: Recent past returns are a guide to the future
This is another classic mistake that investors make which is again clearly rooted in investor psychology. Reflecting the difficulty in processing information, short memories and wishful thinking, recent poor returns are assumed to continue and vice versa for strong returns. The problem with this is that, combined with the "safety in numbers" myth it results in investors buying an investment at the wrong time (when it is peaking) and selling at the wrong time (when it is bottoming).
Myth #7: Strong economic growth and strong profit growth are good for stocks and poor economic growth and falling profits are bad
This is generally true over the long term and at various points in the economic cycle, but at cyclical extremes it is usually very wrong and constitutes another big mistake investors make. The big problem is that sharemarkets are forward looking, so when economic data is really strong - measured by strong economic growth and low unemployment - the market has already factored it in. In fact the sharemarket may then start to fret about rising cost pressures and rising short term interest rates. As an example, when global sharemarkets peaked in October/November 2007 global economic growth and profit indicators looked good. Of course the opposite occurs at market lows. For example, at the bottom of the last bear market in shares in March 2003, global economic indicators were very poor and the general fear was of a 'double dip' back into global recession. As it turned out, stocks tunred around despite this 'bad news', with better economic and profi t news only coming along later in the year to confi rm the rally. A similar situation may be occurring right now with GDP fi gures worldwide confirming the worst global recession since the 1930s and unemployment also spiralling higher. Yet sharemarkets have been moving higher for the last three months. History indicates time and again that the best gains in stocks are usually made when the economic news is poor and economic recovery is just beginning or not even evident.
Myth #8: Strong demand for a particular product produced by a stock market sector should see stocks in the sector do well and vice versa.
While this might work over the long term and for a while, this myth suffers from the same weakness as Myth #7. That is, that by the time something like housing construction is really strong, it should already be factored into the share prices for building material and home building stocks and they might even start to anticipate a downturn.
Myth #9: Budget deficits drive higher bond yields
The logic behind this myth is simple supply and demand. If the government is borrowing more (higher budget deficits) then this should push up interest rates (the cost of debt) and vice versa. But it often doesn't turn out this way, because periods of rising budget defi cits are usually associated with a recession and therefore weak private sector borrowing and falling infl ation and interest rates. This means that bond yields actually fall not rise. This was evident in the US in the early 1990s recession and in Japan right through the 1990s. While currently surging public sector borrowing around the world has contributed to a rise in bond yields so far this year, reduced "safe haven" demand as investor confi dence has stabilised may be the main factor. It remains to be seen how bond yields will behave as the rising level of excess capacity globally puts further downwards pressure on infl ation which normally occurs in the aftermath of a recession. History suggests bond yields might actually head a bit lower again.
Myth #10: Having a well diversified portfolio means that an investor is free to take on more risk
This mistake has been clearly evident in recent years. A common strategy has been to build up more diverse portfolios of investments less dependent on shares and with greater exposure to alternatives such as hedge funds, commodities, direct property, credit, infrastructure and timber. This generally led to a reduced exposure to truly defensive asset classes like government bonds. So, in effect, investors have actually been taking on more risk helped by the 'comfort' of greater diversification. Yes, there is a case for alternative assets. But unfortunately the events of the last two years have exposed the danger in allowing such an approach to drive an increased exposure to risky assets overall. Apart from government bonds and cash, virtually all assets have felt the heat of the global fi nancial crisis.
Myth #11: Experts can tell you where the market is going Economic and investment forecasts are often seen as central to investing.
But, at the risk of being thrown out of both the "economists club" and the "market strategists club", no one has a perfect crystal ball. And sometimes they are badly fl awed. It is well known that when the consensus of experts' forecasts for key economic or investment indicators are compared to actual outcomes, they are often out by a wide margin. This was particularly the case last year. Forecasts for economic and investment indicators are useful, but need to be treated with care. Like everyone, market forecasters suffer from numerous psychological biases and quantitative point forecasts are conditional upon information available when the forecast is made, but need adjusting as new facts come to light. If forecasting the investment markets was so easy then everyone would be rich. The key value in investment experts' analysis and forecasts is to get a handle on all the issues surrounding an investment market and to understand what the consensus is. Experts are also useful in placing current events in their historical context and this can provide valuable insights for investors in terms of the potential for the market going forward. This is far more valuable than simple forecasts as to where the S&P 500 will be in a year's time.
Conclusion
The myths cited here might appear logical and consistent with common sense, but they all suffer often fatal flaws which can lead investors into making the wrong decisions. The trick to successful investing is to recognise that markets are highly complex, they don't go in the same direction indefinitely, they are usually forward looking and that, for investors, avoiding crowds is healthy.
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