From Nick Hubble in Scoops Lane:
We’ve figured out how the stock market works…sort of. At least, we’ve got a theory that explains some odd goings on in the stock and bond markets of the world. Odd goings on like negative interest rates and 16 year range bound shares:
Finance academics and practitioners alike will tell you ‘markets discount’. That’s how they explain that stock markets and bond markets predict the future and turn their predictions into a share and bond price. If you expect good times in the future, you buy shares.
If you expect bad times, you turn to the fixed payout safety of bonds. At all times, both prices should be ‘discounting’ the future into appropriate prices.
That’s the existing theory, not the Hubble Market Theory.
But how far into the future does the market discount? For bonds, it’s theoretically an easy answer because bonds have a fixed payout on a fixed day. The time horizon of that bond is dictated by its maturity date — the day the loan is repaid.
Although bond investors could consider selling out before the maturity, in which case they could factor in a shorter time period. But shares last forever. So how far does a shareholder look into the future in determining the right price of a share?
The mathematical answer is that future events are given less ‘weight’ when finance analysts try to determine a fair value share price. Next year’s dividend is important in working out the right share price. But next decade’s dividends are less important. Next century’s end up being given so little weight that you can ignore them in your valuation.
It’s an odd idea to grasp, but it’s the kind of thing that investment bankers get up to. Or are supposed to get up to, anyway.
Back to reality. Did Broken Hill Proprietary Company Limited shareholders foresee and take into account the Billiton merger of 2001 when they bought shares in 1885? Probably not. Why? Because they would have been dead. That’s the eureka moment which led to Hubble’s Market Theory.
Hubble’s market theory is that investment prices are driven by time horizons. How much you are willing to pay for an investment, and which investment you buy, are determined by when you need to profit from it.
We’ll try a different angle to make it clear.
Economics and finance is a continuous narrative. It never ends. But how far out do share prices look to figure out if they are too high or too low?
The answer, according to the Hubble Market Theory (HMT), is that it depends on investment horizons. When you’re young, you have a long life ahead of you. You can see and care about things that happen long into the future.
This justifies a buy and hold strategy for shares. Even during bad times, things are likely to get better in your lifetime. So there’s no need to sell your shares during, say, a recession.
But when you near retirement, you suddenly have a defined investment horizon. It begins to matter what your investments are worth in one decade rather than four. If the last decade’s measly returns were your last before retirement, it would have a significant impact on what you can afford in once you give up work.
HMT has several implications, which explain the odd goings on in investment markets that we mentioned.
The demographic effect of the baby boomer population bulge, for example. Shorter investment horizons are beginning to dominate asset prices as the average age of the investor gets older. Investments that you know will be repaid at a certain value at a certain time (like bonds) are in demand.
Assets that are uncertain and often take temporary hits (like shares) are out of favour. That’s why some bond prices are so high that their interest rates are negative, and why shares are going nowhere.
Risky assets are also more likely to be dumped rapidly, leading to a crash, when investment horizons are short. That’s because shorter investment horizons make losses more painful. The fear of losses makes markets more jumpy. This explains the volatility of stock markets since 2007.
Another implication of shortening investment horizons is that investments become things you sell for cash, rather than…investments. Small business owners run their business with a view to continuing its operations. Stock market shareholders sell out and kiss their company goodbye.
It’s an interesting thought to ponder whether this explains the risky and unethical behaviour of management teams of large listed companies. Not to mention their compensation. Either way, it creates a short term mentality on everyone’s part.
Lengthening investment horizons have the opposite effects. People become willing to hold shares during rough patches. That creates stability and long term management styles. Investment legend Warren Buffet likes to hold his shares ‘forever,’ and he is famous for his long term management style.
Isn’t all this the same as simply saying retirees need lower risk assets? That’s hardly a revelation. Well, actually, it is in Australia. Our Super funds were caught out in 2008 with far too many shares and not enough safer assets like bonds. That’s why we had the 2nd worst performing pensions system in the world since the global financial crisis.
If you can find places to invest where investment time horizons are growing longer, equities will be more favourable. Where might that be happening? Where the environment is changing in favour of long term investments. Demographics are just one factor. The rule of law, the discovery of technologies, and family values are other good examples. We’d better explain that last one.
In India, it is common for extended families to live in large houses. The idea being a sort of privatised social security system where the bread winners take care of their parents and children. Under that kind of system, long term planning makes a lot of sense.
Under a government run welfare system, you either milk the welfare state for what it’s got, or you’re the one being milked by the welfare state. The future consists of the next Centrelink cheque or the next financial year. Think like that in an Indian household and you’ll get a clip around the ears from your elders and youngers.
Another interesting idea HMT proposes is that having longer time horizons will make you richer. If you can handle the idea of wealth being enjoyed well in the future, you can take more risks and handle more downturns.
There’s a reward for being patient. Investing for your children’s benefit could imply higher returns than investing for your own benefit. But it’s pretty hard to set up a family structure with that much trust.
Here in Australia, all these trends are working against you. Time horizons are growing shorter as the baby boomers retire. People are realising how much at risk their savings are in the stock market. They realise their existing savings won’t last through retirement, so they’ll be dependent on the government. And they don’t have enough safer assets, as the poor Super fund performance showed.
It’s difficult to know whether you should get ahead of the curve and buy safe fixed payout investments, or continue risking it in the stock market. Tomorrow, I’ll reveal how to combine the two.
for The Daily Reckoning Australia
From the Archives…
China’s GDP Growth Ponzi Scheme
19-10-2012 – Greg Canavan
An Australian Property Boom and Bust all at Once
18-10-2012 – Greg Canavan
The Fed’s New Stooge
17-10-2012 – Bill Bonner
Discordian Religious Advice for the Investor
16-10-2012 – Nick Hubble
Electric Cars and Platinum Mines
15-10-2012 – Dan Denning