There are now about two million people who are in work in Ireland. Of these, about half a million work in the public sector in areas such as administration, teaching and health. The rest are employed in the private sector.
Considering its centrality to our everyday prosperity, the private sector is oddly depicted in our culture. The big businessman is always the baddie. Just think: Mr Burns in The Simpsons, Michael Douglas’s Gordon Gekko in Wall Street, or Leonardo DiCaprio in The Wolf of Wall Street.
On that basis, it’s good to see that a movie has just come out that portrays financiers in a more realistic light: as intelligent people who take risks to make money in a complex financial world in which there are winners, but, by extension, plenty of losers.
The Big Short, released on January 22 2016, is based on an adaptation of the adage of “buy low, sell high” among stock market traders. Going “short” simply reverses the sequence by aiming to “sell high, buy low”. To put it simply, you sell a stock that you don’t own and think is overvalued and undertake to close the transaction by buying it back later.
The protagonists of The Big Short, based on the book of the same name by Michael Lewis, realise in the mid-2000s that the US housing market is an accident waiting to happen and that it is a big candidate to be “shorted”.
It examines several different individuals who independently reached such a conclusion and who had the guts to back that insight with their own cash. As one Bloomberg View writer put it: “It isn’t a spoiler alert to say that the financial world collapses, the protagonists get rich and no one lives happily ever after.”
The most compelling story was that of Michael Burry. He was the founder of the Scion Capital hedge fund which he operated from 2000 to 2008. Mr Burry initially qualified as a medical doctor and left work as a neurologist to pursue his hobby and become a full-time investor. In 2001, Mr Burry’s first full year at the hedge fund, the S&P 500 index fell 11.88 per cent but Scion was up 55 per cent, according to Lewis.
The next year, the index fell again, by 22.1 per cent, and yet Scion was up again: 16 per cent.
In 2003, the stock market finally turned around and rose 28.69 per cent, but Mr Burry beat it again — his investments rose by 50 per cent. By the end of 2004, he was managing $600 million and, as Mr Lewis put it, was “turning money away”.
It was at this point that Mr Burry focused on the US housing market. As the market collapsed spectacularly and others lost lots of money, he was still in profit because he had correctly predicted what would happen.
He later said he shorted mortgages because he had to. “Every bit of logic had led me to this trade and I had to do it,” is how he put it. He has also pointed out that he did not benefit from taxpayer-funded bailouts as he liquidated his shorted positions by April 2008.
One thing is clear from all of this. Mr Burry is worth listening to, especially when it comes to issues relating to the financial markets. In a recent interview with New York magazine, he gave some hints about where the next big-short trading opportunities may come from. He said that he had hoped after the crash that the world would enter a new era of personal responsibility, but instead we “doubled down on blaming others and this is longterm tragic”.
On this basis, the Irish response might not impress Mr Burry. Our reaction to our own banking crisis has been to blame bankers for lending to us rather than to reflect on whether we were wise to borrow and to invest in overvalued property.
Instead of learning lessons, it would appear that we have simply sought out scapegoats to evade personal responsibility. Mr Burry’s comment that “if a lender offers me free money, I do not have to take it” is not one that sits easily in Irish public debate even if it is little more than a statement of the obvious.
The hedge fund manager is not happy either with the current state of global financial markets, which he believes are once again trying to stimulate growth through easy money. “It hasn’t worked, but it’s the only tool the Fed’s got,” he said.
Mr Burry is worried that the markets are using interest rates to “price-risk”, but that mechanism is broken as the interest rates of central banks have been kept for many years at close to zero.
Worse still, he thinks that by using low interest rates to fight the aftermath of one bubble going bust, central banks may just support the development of more bubbles. That’s the big risk today, but it’s also how the US housing market developed into a bubble a decade ago.
In combating the economic decline after the internet bubble went bust in 2000, Mr Burry argues that the Fed kept US interest rates too low for too long.
He argues that we are building up “terrific stresses in the system” and any fault lines will harm the outlook.
The problem with this conclusion is that, despite our progress, Ireland remains one of the most heavily indebted countries in the world. We would face a heavy cost if they were to rise again.
Let us be grateful then that Mario Draghi, the head of the European Central Bank, doesn’t agree with Mr Burry and that eurozone interest rates are likely to remain low for several years to come.
Cormac Lucey is the Programme Director of the IMI Diploma in Business Finance. Cormac is also a Financial Services Consultant and Contractor who has previously worked with PricewaterhouseCoopers, Rabobank Frankfurt and the Department of Justice.
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The American economist Robert Shiller is a Nobel laureate for several reasons.
One of them is the cyclically adjusted price earnings (Cape) ratio. Shiller’s device overcomes a serious defect in the more conventionally used price to earnings (PE) ratio which is often used to measure quickly whether a share is relatively expensive or cheap.The problem with the conventional PE ratio is that if earnings or profits are cyclically inflated, then even an inflated share price can be made to look reasonable.
Shiller’s elegant answer to this problem was to discard annual earnings as the “E” or earnings figure and to replace it with a measure of cyclically adjusted earnings. In order to generate a measure of corporate earnings that reflected the whole cycle, rather than risk being deceived by using cyclical peak earnings, Shiller opted to use average earnings from the previous decade instead.
By comparing today’s share price to average earnings over the previous decade — rather than just the earnings of the past 12 months — the risk that one may be misled by a temporarily elevated level of earnings is significantly reduced.
The advantage of using Cape as a measure of value is that it provides a useful predictor of future equity returns, at least when one uses it to measure value across an entire national stock market.
The best returns from investing in the US stock market were made in the past after its Cape had sunk to levels of 10 or lower. This happened, for example, in the 15 years after 1932, when the Cape hit 6, and 1982, when it hit 8.
Conversely, the worst returns have been made after the Cape has peaked above 25. That happened after 1929, when the Cape reached 30, and 2000, when it hit 44.
Today the US Cape is 25.5 and falling. That’s a medium-term equity market warning. So is Ireland’s elevated Cape of 27.4. Those looking for long-term equity bargains might look at the markets in Brazil (Cape of 7.4), Poland (9.1) or the Czech Republic (9.4).
And, if you want a bargain and have a stomach for risk, you can try Russia, where the Cape is a measly 4.6.
Cormac Lucey is the Programme Director of the IMI Diploma in Business Finance. Cormac is a Financial Services Consultant and Contractor who has previously worked with PricewaterhouseCoopers, Rabobank Frankfurt and the Department of Justice.
IMI associate on the IMI Diploma in Business Finance
....“If a lender offers me free money, I do not have to take it”
A medium-term equity market warning
After The Boom Comes The Bust
The Psychology Behind Good (and Bad) Investments
At one point of the 1973 movie Magnum Force, Inspector Harry Callahan (played by Clint Eastwood) uttered the line “A good man always knows his limitations…” It is important that investors should know their limitations too.
Behavioural finance is the study of the influence of psychology on the behaviour of investors. It finds that investors are not always rational, suffer from systemic biases and are limited in their rational self-control.
The first step to combatting these, often unconscious, biases is to be aware of them. What then are the key behavioural errors that can dog our decisions?
The following errors were identified recently by Joe Wiggins, a fund manager with Aberdeen Standard Investments:
Myopic Loss Aversion – We are more sensitive to losses than gains, and overly influenced by short-term considerations. Often investors check their portfolios frequently, even if they are operating with a long-term investment horizon. Making frequent investment decisions can worsen your investment results. A 2015 study by the Central Bank of Ireland found that 75 per cent of retail CFD clients who invested in CFDs during 2013 and 2014 made a loss.
Integration – We seek to conform to group behaviour and prevailing norms. Like a limping wildebeest at the back of a herd in the Serengeti, we want to keep pace with the herd for fear of being picked off. The problem is that, in investment markets, the herd is more often wrong than right. That’s why Warren Buffett said that it is wise to be “Fearful when others are greedy and greedy when others are fearful.”
Recency – We overweight the importance of recent events. In 2006, one had to look back over a decade and half to observe a year-on-year in Irish residential property prices. Accordingly, most market participants grievously underestimated the possibility of a serious property bear market. Today memories of the property crash are fresh in peoples’ minds and many are fearful of another residential property crash. But that is quite unlikely, with rent yields considerably above mortgage rates.
Risk Perception – We are poor at assessing risks and gauging probabilities. We allow the emotional hope of investment gains override logic in assessing risks. At the height of the residential property price bubble, houses in some parts of Dublin (e.g. Howth, Dalkey, Blackrock) were selling for more than 100 times the annual rental income those properties could command. But many investors were more fearful of missing out on continued gains from property market than they were by the dismal long-term return prospects those valuations suggested.
Overconfidence – We over-estimate our own abilities. Not only is the recorded investment performance of retail investors poor but so too is the record of professional fund managers. The empirical evidence strongly suggests that the vast majority of investors would be better off buying low-cost funds that track market indices. Yet millions of us persist with the belief/hope/illusion that we can do better managing our funds ourselves.
Results – We focus on outcomes when assessing the quality of our decisions. Even as the Irish property market got more and more overvalued between the years 2004 and 2007and risks (e.g. rising interest rates) continued to mount, investors largely stuck with it because they were enjoying positive outcomes.
Stories – We are often persuaded by captivating stories. If you get the chance, make sure to watch Alex Gibney’s excellent documentary about the rise and fall of Elizabeth Holmes and Theranos “The Inventor: Out for Blood in Silicon Valley”. It depicts the rise and fall of a woman and her company that were propelled forward by several captivating stories: replacing injections with thumbpricks for taking blood samples; replacing an expensive blood-testing duopoly with access controlled by clinicians with cheap tests that individuals could order; having a female entrepreneur enjoy the same success as Apple’s Steve Jobs. But it was all a fraud.
In making financial decisions, it’s case of forewarned being forearmed: the more we are aware of our limitations, the better we can avoid them.
Cormac Lucey is an IMI associate on the IMI Diploma in Business Finance. Cormac is also a Financial Services Consultant and Contractor who has previously worked with PricewaterhouseCoopers, Rabobank Frankfurt and the Department of Justice.