If in a dinnertime game show the contestant were offered to choose between a certain prize of 5 euros and a one in two chance of having 10, many would choose the second option. The adrenaline-pumping context and the desire to play would in fact reward prudence and only a recent graduate in statistics would be able to remain perfectly indifferent. However, if the choice were between a certain prize of 5 million on one side and a one in two chance of winning 10 million, almost everyone would opt for the first option. Even if the sure million were only 4, or even less, many, including the statistician, would prefer to take them home anyway.
This preference is modeled in a utility function in which, from a certain amount onwards, regret about the money left on the table is greater than satisfaction with a full win rather than a halved one. Regret grows exponentially as a function of the money involved but is at the same time determined by their marginal utility, which is very subjective. Leaving 5 million on the table would have more consequences for Donald Duck than for Scrooge McDuck, even if we know that the nephew would take it more philosophically than his uncle.
Scholars of the theory of regret (there are too and it is nice to see how far the division of labor has gone) however explain to us that the regret imagined ex-ante, at the table, is overrated by most of us compared to the displeasure actually tried ex-post. Would it make you more angry, they ask in the tests they administer in their university classrooms, to miss a train for a minute or miss it for five? And everyone gives the first answer, adding that the disappointment would still be great. However, if the same question is asked at the station to commuters who have just missed the train by a hair's breadth and to those who have missed it by five minutes, a similar degree of disappointment and a lower intensity than that imagined ex-ante in the desk test.
Studying the theory of regret can be a useful exercise as we all prepare to set the portfolio strategy for 2016. As we see it today, 2016 doesn't look like a normal year. We define here as normal a year in which strategists and managers expect a 5-10 per cent increase in equities and a more modest, but still positive, return for bonds.
2016 does not appear normal because the stock exchanges could return to zero and the bonds could also have a slightly negative final yield. Being totally invested in shares could therefore make the liquidity of the current account zero and make any portfolio choice irrelevant, ex-ante.
The paradox of all choices is that the more difficult and even painful they are, the more indifferent it is to take one path or the other. The more we torment ourselves, the less it makes sense to torment ourselves. If the pros and cons of each option are equivalent, it makes perfect sense, at least in the abstract, to let the coin tossed in the air decide.
In fact, if we think that 2016 will be a catastrophic year, or even simply negative, the choice to stay completely liquid would be obligatory and therefore easy. What can be seen on the horizon, however, are not the black clouds of the end of the cycle, but the white and not particularly threatening ones which announce the cycle's completed maturity and perhaps, in America, the entry into a well-adjusted third age which it looms quite long.
Hence the paradox of indifference. The cash used in one-year government bonds has a negative yield, the one left to the bank (which sooner or later will pass on the negative rates to account holders) is in any case a loan, which in times of bail-in (Cyprus teaches) is for the moment reasonably safe, but which in the event of a new recession could be less so.
Equities and credits, for their part, will be exposed to conflicting winds. On the one hand, modest earnings growth is looming (something more in Europe), but on the other, a headwind from the Fed is looming for the first time in the form of a hike in nominal rates, albeit on real rates, in expecting a rise in inflation, no significant tightening will be felt.
Keeping a diversified portfolio has, until now, meant holding stocks (and many bonds) for performance and cash for safety. From here on out equities will mean diversification and if there is performance it will be in exchange for increased volatility. It is therefore a context in which it makes sense to reduce, but not eliminate, shares and credits.
La volatility, for its part, is smoke and mirrors for many but it can be an opportunity for others. The condition to take advantage of it, however, is to start light and not have too much risk in your portfolio.
We repeat, the idea of calmly lowering the risk profile is not due to a deterioration in the condition of the global economy (for a China that will continue to slow down, there will be an accelerating Europe) but to the transition from a strategic phase lasting seven years to a tactical phase that could last until the end of the cycle and then hopefully a few more years.
On the other hand, we are not particularly concerned by the current malaise on the markets, a malaise attributed to the ECB, oil and the Fed.
The ECB, which disappointed last-minute expectations, nevertheless launched a package of measures even more extensive than the one hinted at during the press conference on October 22, the one in which Draghi threw out the possibility of a rate cut. If we go back to the evening of 21 October, when the extension of the QE was not yet certain and when no one imagined the rate cut, we see that the Eurostoxx was at the exact same level as today and that the 0.51-year Bund yield, then by 0.58 percent, has even risen today to 1.13. Only the euro moved, going from 21 on 1.10 October to XNUMX today.
From this we do not draw the conclusion that the Qe2 born dead, as the markets seem to think, but that of an initial exaggerated and premature celebration which turned into angry anger which will be followed, in the coming months, by a third phase of slow-release beneficial effects, not so much on the euro, which it will remain substantially stable, as for European stock exchanges and credits.
As for oil and raw materials, the fears of the markets are for demand and for the effects on producing countries and mining companies. For oil, however, there is no weakness in demand, which continues to grow steadily. As for the producers, we have entered the final phase of the natural selection process which will see the winners who have the lowest extraction costs (Saudi Arabia, Iraq and the Eagle Ford area of Texas). Saudi Arabia, which is leading the downward price game, is betting on a stabilization and reversal of the trend by the end of 2016. There will therefore be a time (but it is still too early now) when energy stocks will beat the rest of the market and will drag the stocks higher. In short, the more you go down today, the more you will go up again tomorrow. In raw materials it has always worked like this.
As for the Fed, we can't see any drama surrounding next Wednesday's hike. There isn't a corner of the planet where the notice of this increase hasn't already arrived for a year and where it hasn't been widely discussed and discounted in prices. More than a rush to sell, we therefore see likely a big global yawn or even a short burst of bullishness in the event of a particularly reassuring press conference.
