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Thursday 26 March 2020

Anchors A-weigh!

Lost At Sea
In these uncertain times, as the Covid-19 virus moves across the planet, we’re seeing markets yo-yoing with wild price fluctuations on almost a daily basis. Jumps or falls of over 5% are commonplace. This is not normal market behaviour.

However, it isn’t unusual behaviour either – in the context of market history. Anyone who remembers 2008 or 2000 or even 1987 will have seen this before. This is what happens when investors lose their anchors – with nothing to attach to they follow each other, and the result is very predictable and not at all pretty.

For reasons no longer apparent, in the age of sail those of a nautical persuasion were inclined to stick an “a” on the front of otherwise common words – so ‘afloat’, ‘aground’, ‘adrift, etc, etc. In this context the word ‘aweigh’ simply means weight – and the phrase “anchors aweigh” means the point at which an anchor starts to take weight as it's hauled in.  Which is, of course, the point at which the anchor is no longer keeping the ship in place ...

In a behavioural context anchoring is the psychological process of fixing on a value against which to make relative assessments. A very common one is with house prices where people anchor on the price they think they should get and refuse to negotiate – which is one reason why house sales collapse in a recession, because no one can get the price they want.

Well, right now, markets have weighed anchor and investors are afloat and adrift in stormy seas. This has a range of perverse consequences, which themselves contribute to the ensuring volatility. Above all we don’t want to find ourselves aground, with losses mounting and no way of alleviating the pain. With anchors there are – at least – three areas that investors should be wary of.

Firstly, people will tend to anchor on the high prices achieved by the market or by specific assets.  This fixation can replace sensible analysis of what a stock is worth. In more placid times investors will buy shares in the expectation that other people will want them but right now you’ll struggle to find someone else willing to take the other side of most trades at a reasonable price.

Secondly, people will tend to anchor on the prices they bought at. Again, these may no longer be sensible – there are a lot of growth stocks out there that are no longer growing. Whether or not those still have much value is dependent on a whole host of things, many of which aren’t in the realm of rational analysis. There’s a point at which investing shades into gambling.

Thirdly, people will anchor on earnings or dividends. As both dividends and earnings are now threatened by the government mandated closure of non-essential businesses and the associated hit to their suppliers it’s hard to be sure of where either will settle. In the UK, for instance, we’ve seen a lot of companies suspending dividends even after they’ve been declared: in a world with no earnings they need to hunker down and hope the storm blows over before their cash runs out.

When anchors get weighed people cast about for new places to land them, and that leads to other sorts of odd behaviour. Typically you’ll markets zigging and zagging as news pushes them one way or another and the herd follows the trend. Herding is a typical bear market phenomenon – we see it in investors but also in analysts. Normally analysts rely heavily on companies to give them their take on the future – when companies have no idea then neither have analysts; makes you wonder whether they ever add any value, doesn’t it?

Generally, though, bear markets follow a distinct trend – you’ll get nasty lurches down followed by beautiful rises, although the legs up never quite manage to cover the falls down. Psychologically it’s important not to buy on up days and not to sell on down days – that’s simply conforming the general trend. If you want to sell do it when markets are rising and vice versa – this implies you have some conviction in your decisions, rather than simply following the herd.

Be clear, though – this isn’t buying the dips. If you’re buying right now you’re doing so in the conviction that when the crisis passes – and it will, although we don’t know when – you’ll be holding stocks that are worth far, far more than their current prices are discounting. Alternatively, you may be waiting for the bottom, for momentum to turn, in the expectation that you’ll be able to invest in your own good time.

No Bell
Well, don’t be too sure. In 1973/74 the UK market saw an unprecedented 70% plus fall due to the oil crisis, an associated run on banks and some fairly stupid government behaviour. In 50 Years of Capitalism At Work John Littlewood wrote about the end of 1973/74 crash thus:
"[The eight weeks that followed the end of the crash] amount to the most astonishing single period in the post-war history of the stock market, although few investors would admit to having enjoyed this frenzied feast while it was happening. Many simply looked on, paralysed like rabbits caught in the headlights ... Far too many institutions had husbanded their cash resources for sunnier days, complacently believing that the time would come when wonderful buying opportunities would be there for the taking at their leisure. In the event, these wonderful opportunities vanished like melting snow in a sudden thaw ...
... Perhaps the greatest psychological effect was inflicted on private investors. Many had sold on the way down; others who sat through the recovery were now disillusioned beyond repair and never wished to own a share again"
The market rose 49% in 8 days in January 1975. Just as not all crashes are equal neither are all recoveries. 

Go-Go Gurus
Other behavioural biases kick in during these scary downtrends. You’ll find people plaintively asking their gurus for guidance – and guidance there will be aplenty ... but when the blind are leading the blind in a landscape with canyons and crevasses galore the results often aren’t pretty. Deferral to experts is an understandable response to scary situations but whereas listening to the medical experts is a sensible strategy – because they’ll be actual experts with qualifications to show it – it is not an intelligent response to defer to people who have real expertise in anything other than talking persuasively – which is the stock in trade of most stock advisers and politicians.

We’ll also seek comfort in company. There’s nothing so comforting as being around people whose views reflect ours. However, when anchors are lost there’s no guarantee that anyone else’s opinion is better than ours unless based on numbers or cold hard logic. Be careful that confirmation bias doesn’t influence your decision making.

Safety in Numbers
It's very easy to get lost when anchors start drifting, but fundamentals and history tell us how to deal with this. Buy stocks with – in normal times – good operating margins and with low amounts of debt. Don’t go all in at any point – that bell you hear ringing is cognitive dissonance, not the bottom of the market: bear markets can last a long time.

Don’t fret that you’re missing out – no one times markets other than by luck – and diversify, regardless of how attractive any particular sector looks right now. Probably markets will eventually anchor at a lower level than pre-Covid-19. It’s a reminder that chasing growth at any price is never a good investment strategy. In the meantime, stay safe.

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