Grains of truth - The three factors that exacerbate stockmarket stress points


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

William Blake once wrote about the ability “to see the world in a grain of sand” and, while romantic poetry might be a little outside the usual scope of The Value Perspective, we were interested to read financial writer John Maudlin’s recent thoughts on how grains of sand could offer some insight into the world of investing.

Maudlin pointed readers of his weekly thoughts from the frontline e-letter towards a 1987 experiment, in which physicists Per Bak, Chao Tang and Kurt Weisenfeld sought to better understand what they called “non-equilibrium systems” – and what we might call instability – by running many, many computer simulations of a pile of sand being built one grain at a time.

In each simulation, as the pile grew ever higher, a single grain eventually triggered an avalanche of sand and yet initially there seemed no way of predicting when that might happen. The heights of the piles, the total amounts of grains of sand, the sizes of the avalanches – everything always appeared different – but the scientists eventually came to understand the crucial factor was not size but steepness.

They did so by reprogramming their simulation to look down from above and then colouring the shallower, more stable areas of a pile green and the steeper, less stable areas red. Initially a pile would be wholly green but red areas would gradually build up and eventually one grain of sand on a red area would cause an avalanche that might trigger a chain reaction of avalanches in other red areas.

You may well have guessed where we are going here because, like those piles of sand, the stock market is a complex and unstable system that builds up stress points. Furthermore, the exact origins of any fall will not be obvious – for example, no-one can say with certainty which single ‘grain of sand’ finally caused the technology bubble to burst in 2000 or the 2007 sub-prime crisis.

So how might this sand analogy help us as investors? Here on The Value Perspective, we believe the market’s stress points – in essence, the steeper, red areas in a pile of sand – are exacerbated by three factors, the first of which is debt. Put simply, the more debt there is in the system, the more unstable it becomes. The red parts of the pile increase – in this instance, literally.

The second factor is valuation, with higher valuations signalling a redder, more unstable pile. Some investors may have felt things were more unstable in 2009 than in pre-crisis 2007, when the economic outlook appeared so much better. Yet things were actually ‘greener’ in 2009 as valuations were so low, while the high valuations of 2007 were indicative of enormous stresses in the system.

The third factor is the passage of time. Following any crash or crisis, people tend to be more cautious but, as time passes, that caution fades and instability builds. As GMO co-founder Jeremy Grantham put it when asked what people would learn from the sub-prime crisis: “we will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term.”

As the market seemingly marches ever upwards from its 2009 lows, it is worth examining the stability of the current rally’s foundations. While debt is at a similar level to 2009, it has shifted from the corporate and consumer sectors to the government. That may seem a plus for equities yet, just because debt is now in a different part of the economic system, it does not mean it cannot hurt share prices.

For their part, valuations, though not egregious, are up significantly from their troughs and can by no means be described as cheap while, as for the passage of time – well, time passes, as it always does. This September, it will be five years since Lehman Brothers went bust and, while it would be wrong to say any lessons have already been forgotten, greed can filter back into the system surprisingly quickly.

Maintaining our sand analogy, pockets of the market are undoubtedly red although there remain areas of green that still look attractive due to, for example, lower valuations or, in the case of financials, shocks so severe that, almost five years on, they are still very much front-and-centre in people’s minds. Thus, while it is certainly possible to construct a portfolio from these green areas, as the market continues to increase, it is becoming ever harder, the pile is growing ever redder and investors now need to be very careful about where any grains of sand might land.



Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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