Monthly Market Blueprint June 2020

Mon 15 Jun 2020

The “right” fundamentals

Often the first thing we are taught about something, especially if it comes from someone with authority, like a parent, a teacher or our experienced financial adviser, is taken as a “fundamental” truth. In psychology, this is called the “primacy effect”. Any other “truths” that contradict or seek to modify that first one may well cause distress, what psychologists call “cognitive dissonance”. In business school, future analysts learn of the importance of operational cash flows, Price/Earnings ratios, returns on assets or invested capital and so on, as signals of a healthy and productive company. A deviation from those fundamentals, i.e. fundamentals deteriorating but stocks going up, is to an analyst a sign of “irrational exuberance” soon to be corrected by markets. Given the – at least – 10%-40% projected dip in earnings, stocks should be trading down. Instead, since the beginning of the year the US and Japan have turned marginally positive, the UK is down -16% (with earnings projected down by at least double that) and the EU is -7% down against projected earnings losses of 25%-35%.

These “fundamentals”, as we call them, work better in an environment where the market works free from “externalities”, such as central bank and fiscal stimulus, or major legislation changes that affect how businesses compete. As analysts leave university and apply their skills in practical manners, they come to compromise with all the assumptions one has to make to arrive at a “fair” valuation. Over time, they also recognise that the environment is seldom free from externalities. Which is why we see these “value” fundamentals work better at the mature stages of the bull market, where stimulus has been exhausted. Still, “fundamentals” are called that because we always eventually revert to them. But it is a thin line between consistency and stubbornness. 

What university or the CFA programme never prepares analysts for is an elongated period where stimulus is so extended that it dwarfs the predictive worth of traditional fundamentals, like the period we have lived through for the last 12 years, where central banks and governments essentially subsidised the assumption of risk by investors. A period where the dynamics of supply and demand for risk assets are more important that the underlying value of companies and where companies that should have gone out of business thrive on cheap funding. Additionally, portfolio managers are often befuddled by the effects of volatility suppression and the counter effects of algorithmic trading. What our team believes in is that we should take the world is as it is, more so than “what it should be” and invest as such. Today’s fundamentals dictate that we adjust to an environment of suppressed volatility, with sudden sharp spikes, and a fusion of valuation with money supply ratios. There are no “right” and “wrong” fundamentals, just the “prevalent” fundamentals, and these guide our decisions going forward.