Investing like a Nobel Laureate

In January we went to a session, organised by Barclays, with Nobel Prize winning economist Robert Shiller. From inflation to social discord, Shiller’s main message was that the current economic environment makes it nearly impossible to know what the future holds.

“It’s very hard to predict the markets, as you all know, but I think you can predict volatility and there may be higher than normal volatility going forward.”

With that in mind, here’s a look at the four main takeaways from the talk and how they can help investors.

This article isn’t personal advice. If you’re not sure if an investment is right for you then ask for advice.

1. Narratives shape the market

Shiller’s new book, Narrative Economics, argues that a story or feeling can shape market behaviour. While his view on narratives has been seen as controversial by some, he pointed to the pandemic as an example.

When coronavirus first came on the scene, markets tumbled as investors worried about the impact of a global pandemic. Since then, the stock market has recovered on the belief that a vaccine will return life to normal.

That narrative, he noted, is fading. The excitement of an incoming vaccine has been on investors’ minds for months. Now that vaccinations have started, the market could shift towards new narratives.

That doesn’t mean the stock market will turn around though. Instead, new narratives take over and the way the market behaves will follow suit. It’s important to remember, all investments fall as well as rise in value so you could get back less than you invest.

Shiller noted some powerful, rising narratives he sees in today’s market:

Communication Services: Connectedness is a driving force, and technology that advances it is a hot commodity. That’s a big part of the reason the US stock market, which is particularly tech-heavy, has been on such a tear.

This narrative has been around for a while. But Shiller believes it’s still running strong, and a trend worth watching.

Cloud computing, which is expected to become a $304.9bn industry by the end of the year, is one example of this digital trend. Others like Artificial Intelligence have a much steeper growth curve because they’re less developed, but it’s harder to pick out long-term industry leaders.

See our picks for 5 shares worth watching this year

Biden Presidency: The shift in the US presidency is another, newer narrative that people are grabbing hold of. For now, it looks like worries about social discord are starting to fade. Biden’s entry into office saw a renewed focus on global cooperation. Of course, that can change, especially considering the deep divide that gripped America in the lead-up to the inauguration.

With that in mind, worries about another trade war with China and its impact on companies that rely heavily on Asia are muted for now. Biden has shown he’s willing to continue negotiating a favourable trade deal, but lots expect his actions to be much less disruptive than Trump’s.

There’s also potential for a so-called ‘victory vacation,’ a term coined in the post-WW2 era because people celebrated being on the other side of a catastrophe. The Biden administration could usher in an era of calm following months of social unrest.

ESG investing: There’s also been a shift toward socially responsible investing with the introduction of Environmental, Social and Governance (ESG) ratings. It reflects a passing of the baton to investors in the fight against a ‘profit-at-any-cost’ mentality, but Shiller pointed out this narrative is still fragile.

According to Shiller, buying based on ESG scores is a charitable donation, for now. In theory, buying companies that are committed to protecting the planet should pay off because those businesses are more in touch with the communities they serve.

If future regulations mean companies have to keep their environmental impact more in check, it makes sense for companies to start shifting their operations now. In practice, that might not be the case. If the ESG index underperforms, the push toward socially responsible investing might not maintain its momentum.

2. Ballooning debt is off investor’s minds for the time being

At this point, people are questioning whether the stock market can continue to feast on the low interest rate environment. Interest rates have been on a downtrend for a while. They might dip below zero, but they can’t stray far into negative territory. That’s caused some to wonder what central banks will do if the state of the economy gets worse.

Shiller says rate decreases aren’t the only way to stimulate the economy. He made an argument for a modest tax increase on high earners. This should help redistribute wealth and kick start the economy without adding to the amount of debt. But he thinks this is unlikely at the moment.

Shiller noted that we’ve all become complacent with rising debt, and perhaps that’s ok in the current climate. While borrowing is cheap, it makes sense for companies to take on debt to fund their projects. But there’s a tipping point in every industry where too much debt becomes a risk, particularly if interest rates rise.

We don’t expect interest rates to rise anytime soon, but we’re still concerned about overwhelming levels of debt. Debt makes it harder for companies to manoeuvre in times of stress – we saw a number of retailers fall victim to that pitfall when coronavirus cut off their foot traffic.

In the longer term, we can expect interest rates to rise eventually. That would hit everyone on the market, but some industries would fare worse than others. Housebuilders, for example, would see both volumes and prices decline as mortgages become less affordable.

3. Inflation won’t burst our bubble yet

Inflation is where things get tricky. If governments and central banks work together, they can theoretically control the money supply, which in-turn helps to keep a lid on inflation. But Shiller noted that the underlying cause of inflation – high levels of employment and wage increases – still exists.

Shiller was careful to note he’s not predicting hyper-inflation, or even an inflationary environment. In fact, he said it was likely a long-way off. But it’s still a threat, especially if people start to worry about it.

Worries about inflation that existed in the 70s have been all-but forgotten. That’s not to say they could resurface at some point over the next few years and become a new narrative for the stock market though.

4. Diversity is key and value is important

“I believe in diversification with a value tilt.”

With lots of asset classes, like shares and bonds, near record highs and uncertainty abound, it can be daunting to invest. For that reason, diversity is more important than ever. Shiller noted that not everything declines in lockstep. So spreading your money across asset classes, sectors and geographic regions adds some insulation in case of a downturn.

Trying to time the top or bottom of the market is a fool’s errand – a diversified, long-term portfolio could help balance losses in one segment with gains in another. It might not be the most exciting investment strategy, but over the long-term it’s a sound one.

Diversification: why it pays to be smartly spread

When it comes to searching for value stocks, we think it’s useful to take a balanced approach.

A good place to start is by looking at a company’s P/E ratio – which tells you how much investors are willing to pay for each pound’s worth of profits. You can then use other metrics like the Price to Book ratio and dividend yield. If any of them are below the company’s long-term average, it could be worth investigating.

From there, you can then determine whether you think the company’s future looks bleak, or it’s being underestimated.

Growth vs Value investing – what’s the difference?

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