April 20, 2003

Don't follow the herd for profit

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Defined contribution pensions are down 60 per cent since 2000. Your company has just told you that your defined b enefit scheme is closing.

From here on, you will have a defined contribution scheme. Your employer has just passed the risk of ongoing financial market turbulence to you. They were very happy to trouser the surplus when things were good, now when the markets are unstable, you take the risk with your defined contribution payment. How’s about that for a bum deal?

Today you have no idea how much to contribute in order to prevent you from needing a part-time job at a petrol station when you are 68 and you’re still paying exorbitant fees for lamentable results.

Luckily for the pension fund industry, the government continues to offer atax break on money set aside for pensions. Like most subsidised industries, this gives it a huge cushion to protect it.The subsidised pension fund industry is to the Irish economy today what the likes of Irish Steel was to the economy in the 1980s.

For the increasing number of selfemployed people in this country the choice is simple: pay money into your pension or pay tax to pay for someone else’s. While the existence of a tax break encourages saving, the fact that there is a tax break means that the pension fund industry gets a free lunch because people will choose to avoid tax and shelter money in a pension even if there is woeful performance.There is no choice.

The system is predicated on the myth that people cannot be trusted with their own money. But that is the one thing you can trust people with. Therefore, we have an enormous transfer of wealth from the working population at large to a small, politically connected industry with the help of a tax break. Alarm bells, anyone?

If you can’t be trusted with your own money, then the presumption is that the people who manage your money can. Barring fraud, which thankfully rarely occurs, our trust in these characters must be based on their competence. Are they competent? Well, pensions have lost a lot of money over the past few years. So at best, the jury is out.

One of the crucial aspects of the business is making the right call. A successful money manager reads the tealeaves carefully, makes up his mind and makes a call.

The biggest call is the asset allocation decision. Should I be in bonds, stocks or cash? This decision is based largely on how today’s economic environment and consequent policy responses will change the world.

This is a very difficult game and very few people have been right all of the time, but that’s what you pay a fund manager to do. You would not tolerate a doctor that could not diagnose with some degree of accuracy, therefore, why should you put up with a fund manager that does not at least have the conceptual framework to forecast?

The other crucial issue is timing. The best investors down the ages seem to have three essential attributes in common. First, they are independent, courageous thinkers who have conviction in their own views.

Second, they are stoics. Third, they never appear to be driven by cash alone. Of all these, the first characteristic is the most important – independenc e of mind and enor mous intellectual security.

In short, they don’t follow the herd. As Jimmy Goldsmith famously said, “When you see a bandwagon, it has already passed.”

Today,the herd talks of giving up on equities just when stocks have never been cheaper. There is evidence (falling bond yields) that large funds have sold their positions in stocks in the final quarter of 2002 and have drifted into bonds, just when bonds have never been more expensive.

Confused? Let’s try to rationalise. At the moment there are two conflicting global themes exercising the minds of investors: global deflation and re-emergence of the business cycle.

If you believe in deflation, invest in bonds. If you think the business cycle will reassert itself, buy cheap stocks.

Subscribers to the deflation idea suggest that the reason the stock markets continue to tank is that inflation will continue to moderate. If it does, companies will not be able to pass on price increases. Without price increases, profits can only be generated via cost reductions (such as laying off workers) that are in themselves deflationary and the negative cycle continues.

Deflationists point to the experience of Japan in the 1990s and suggest that this will be repeated in Germany.

The similarities are striking. Both have ageing populations with enormous savings. In the early 1990s both experienced traumatic events.

Japan had its property and stock boom/bust cycle, while Germany appears to be still in a unification-inspired state of shock.

In both countries, low interest rates are having little tangible effect on consumer spending and they appear to lack that nebulous effervescence called “economic vitality”.

A nice way of looking at the difference between countries with ageing versus young populations is to think about the difference in noise and energy between an old folks home and a new housing estate on a summer’s evening. Many deflationists argue that Germany will follow Japan into a deflationary spiral.

An additional weapon in the deflationist’s armoury is China. Many suggest that China’s growth will have the same effect on global prices as that of the US in the late 19th century.

The enormous industrial capacity of China will force the price of all consumer goods down as they come to reflect labour costs in the world’s next economic superpower.


Therefore, Sony, Microsoft, Nike and Gap prices will fall as a result of relocating in China, compressing prices across the globe further. Historically, the emergence of the US in the 1880s had the same effect on global commodity prices.The huge grain, wheat and beef production way below European prices caused a global slump in agricultural prices.

At the same time, the enormous productivity of the millions of emigrants forced down the price of steel, coal and most manufactured goods because production left expensive Europe and set up in the US.

The problem for the deflationist argument is that this economic backdrop is already “priced in”. Shortterm interest rates are at their lowest level for 40 years; long-term rates likewise. For the bond market to remain good value, interest rates – particularly US interest rates – cannot rise. But is this plausible?

Plausible yes, likely no.The US has a current account deficit of 6 per cent of GDP and this will put upward pressure on rates. President Bush has just unveiled a $500 billion tax-cutting programme to re-elect him in October 2004. This will also put upward pressure on interest rates.

Most recent data reveals producer prices rising in the US, suggesting inflation around the corner.This week’s corporate results reveal some signs of strength in corporate America, possibly revealing some life in the business cycle. The yield curve in the US – the difference between short-term and long-term interest rates – has not adjusted for this possibility.

The pension herd that was overweight in stocks from 1999 to 2002 and talks of re-adjusting into bonds might get it wrong again. In this case, defined contribution pension ac-counts will be down again, dramatically. The herd rarely gets things right, particularly at moments of change. The pension fund industry thinks of moving into bonds at a time when you are being paid healthy dividends to be in equities.

For bonds to be good value this year and next,the market needs everything to go its way. Arguably stocks are now offering much better value and upside. The time might now be right for stocks. But don’t take my word for it, go on give your fund manager a call and see what he thinks.