Chicken Little got hit on the head by an acorn, believed the sky was falling and spread panic in the farmyard, to the ultimate benefit of an opportunistic — and hungry — fox.
As a moral for investing, this ancient story works well. Financial markets are full of foxes and for someone to win, someone must lose. But the moral isn't about avoiding acting quickly. It's about avoiding acting on insufficient information.
We've already written for Herald readers about the near impossibility of knowing when markets are going to correct or sink into recession. We've also written about how it's possible, but not easy, for investors to prepare for bad markets and invest through them well, provided they have the appropriate thinking, tools, ability, discipline and — ideally — past successful experience.
Information is critical. To preserve and grow capital, a good investor must have information and must know how to interpret and respond to it. There are many approaches to this, but no investor will use a single data point to decide when to get into and out of markets, and by how much. An acorn won't cut it: it's not even a good indicator of the health of the tree it came from, let alone of global extinction.
So, what does cut it? What inputs do you need and what are you looking to extract from them to help make good investment decisions? We can't say how everyone else does it, but we can share how we do.
It's important to say that what we're working towards is deciding how much cash is in our funds. That's not everyone's focus. For us, however, cash is important because it insulates a fund from the worst impacts of poor markets and is the key resource for returning to the market (to snap up paranoid chicks and ducks).
Our cash level is the single most important active decision we make, so high-quality information must underpin that decision. Too much cash at the wrong time and performance is less than the market, and less than competitors who made better calls. Too little and your fund copies — or even amplifies — bad market performance.
In that context, when we choose information sources and interpret them, we're trying to accurately gauge human confidence. All markets are simply a collective expression of how confident people are to participate at all, and if so, in what markets, and how (buying, selling, how much). Confidence comes in cycles — this is what market cycles are, at their core — and investors should know or at least have a view of where they are, right now, in that cycle. Growing confidence is positive; overconfidence is negative; sinking confidence is negative; rock-bottom, hide-under-the-bed confidence is positive.
As well as looking at how confident people are, we shift upstream and look at what makes them confident. This involves a combination of market data, company fundamentals, economic information and sentiment.
If we start at the furthest point upstream, we look at unemployment. The wellspring of confidence, at least in an economic sense, is whether people have jobs and can buy things (benefiting companies) and invest (benefiting markets).
Then, are they actually buying or at least making concrete steps to buy? We look at car sales and, in the corporate sector, at mergers and acquisitions and how much debt companies are taking on to fund their growth. We also look at how much investors are prepared to pay for companies relative to their expected future earnings.
And then we look at how confidence is playing out in financial markets. What is the return on credit? How volatile is the market? How expensive are commodities like oil and copper? What is the market return compared to medium- and long-term averages?
Finally, we look at sentiment — how are investors feeling? Are they afraid or greedy? How keen or reluctant are they about investing in shares in the next six months? What, according to experts, is the likelihood of a recession in the near future?
In all this information, we look for trends and changes. Particularly sharp movements; hitting peaks or troughs way above or below the historical norm for the indicator; and signs trends are changing from up to down or vice versa. Extremes are important because, by definition, they don't continue — that's why we say overconfidence is a poor signal and no confidence is a good one.
No single indicator has a big influence on our cash levels, but if they're working together then we need to pay attention. For example, lots of fear in investor sentiment is not concerning unless it is accompanied by slowing car sales and signs that the number of people finding jobs is slowing down.
Plus, even the overall result is not instantly fed into our investment decisions. It is simply a transparent, factually robust input for debating and deciding how to position for current and emerging market conditions.
The whole idea is having enough information to separate true signals from noise and, like Foxy Loxy, to respond accordingly. To know a falling acorn is a prompt not to evacuate, but to polish your knife and fork.
- Mike Taylor is founder and CEO of PIE Funds.