The Explosive Bias at the Heart of the Investment Industry

BY VERN GOWDIE

The US August jobs data that came out over the weekend was weaker than expected.

Last week the European Central Bank (ECB) ‘shaved’ rates from minus 0.1% to minus 0.2%

The ECB also launched an asset purchase program to buy debt products from European banks.

These actions prove the economic patient is — after six years — still in intensive care. Yet, the US share market (S&P 500 index) hit a record high over the weekend.

The disconnect between reality and fantasy is wide.

Why did the market rally? Well, the bad news means the central bankers will continue spiking the punchbowl, keeping interest rates low (or lower) and continuing to prop up the financial sector anyway they can. Party on.

With central bankers clearly signaling their intent to prop up markets, it’s little wonder last week’s Investor Intelligence survey reported 85% of advisers as bullish. This level of optimism has only ever been recorded twice before — December 2013 and September 1987.

Do we ever learn? Apparently not.

Central banks are giant economic laboratories overseen by mad professors. They keep mixing the same toxic chemicals (in ever increasing quantities) and wonder why the lab keeps blowing up.

While on the subject of explosions, here’s how Australia’s major institutions latest and greatest plan will end in a better bomb.

The dominant players in the investment industry are on the PR offensive.

Almost daily revelations of wrongdoing by institutionally aligned planners and brokers have them scrambling to limit brand damage.

The sins committed during the good times are being exposed to a glare of publicity. This is never fun for the sinner, but it’s worse during reporting season. Record multibillion dollar profits contrast starkly with the anguish of Australians left in ruin because of poor and fraudulent advice from those same institutions.

Part of the PR offensive has been to take the initiative and set education standards for financial planners. The major institutions have declared that, by January 2019, any planner working in their offices must have either a Bachelor’s Degree along with a CFP (Certified Financial Planner) qualification or a Masters of Financial Planning.

Prima facie, this appears to be a step in the right direction. The public may give the institutions a few brownie points for their initiative.

But the higher education requirement is just a good old fashioned smoke screen. Sure, more knowledge and higher professional standards are, on the surface, good things. But we’re more concerned with what’s below the surface.

The smoke screen is designed to take the public’s attention away from the root cause of the trouble with the financial planning industry.

First of all, planners should NOT be employed by institutions. For the same reason your GP is not employed by a drug company, a financial planner should not pick up their pay cheques (or receive any form of reward) from financial institutions. The conflicts of interest are obvious.

We accept and understand new car salespersons affiliating with a dealer. Such a relationship, however, is completely unacceptable in matters of health and wealth.

Planners should be completely independent. And not part of a sales force.

Second, all percentage based remuneration for financial planners should be banned. The newly independent planners created by such a law should charge a professional hourly fee for their service, just like an accountant or solicitor.

With these two simple changes, the industry would be transformed into a legitimate profession.

Of course, introducing these changes is not part of the PR offensive. Funny that. Without a tied sales force, the institutionally managed funds would have to attract investors based on merit. A quick glance at the industry’s performance tables would tell you why this doesn’t appeal to the institutions.

Absent any real reform, the institutions instead focus on the planners and their need to elevate their game. A clever diversion.

Of course higher education standards and ongoing professional development sounds like a good thing.

At present, education in the financial services industry takes on two main components:

1. Technical — tax law, superannuation, social security.

2. Investment — portfolio construction, economic forecasting; risk assessment, techniques and strategies.

The technical component is straightforward. Tax rates, super contribution limits, asset test thresholds, etc. are ‘black and white’ legislative stuff. It’s essential knowledge if you advise clients on tax liabilities and benefits.

The second component is where the industry’s education standards fail. The investment industry has an inherent bias to the share market.

In fact, the industry owes much of its existence to the greatest secular bull market in history. From 1982 to 2007, the Australian share market rose an unprecedented 15-fold in value. When you include dividends, the compound return over this 25-year period was an impressive 15% per annum. While the share market was going gangbusters, interest rates over the same period fell from 18% to 4%.

These twin dynamics put the wind beneath the wings of the investment industry. If you want to test the veracity of this observation, imagine how much interest (pardon the pun) there would be for planners and investment advice if there were a 25-year period low to no share market returns and all the while interest rates were rising from 4% to 18%. As an aside, we could be on the cusp of such a period right now.

The inherent share market bias (which is indicative to me of psychological conditioning from a secular bull market) is ever present in course material.

Let’s start with how shares are described. The industry labels them ‘growth’investments. The reality is shares can shrink.We are told ‘growth’investments are best for those with long term investment horizons (typically seven years or more).

The following table (copied from a major institution’s website… It would be unfair to name them as they all have similar tables) shows how the various asset classes are perceived and who they are best suited for.

These suggested time frames are clearly a function of the market’s performance since 1982.

Did you know that from July 1968 to July 1982 the Australian share market only managed to grow from 412 points to 460 points? A pathetic 48 point rise over 14 long and lonely years…that’s less than 1% per annum.

14 years is double the industry’s current suggested timeframe, and negligible growth.

As it stands today, investors who piled into the Aussie market in 2007 are (seven years later) still about 20% underwater.

While the mentality of shares being a reasonably sure bet over the long term prevails, the ‘education’ system supporting the industry is flawed.

The fact that share markets have performed so well for so long should actually ring alarm bells. Never — not once in nearly 30 years in the industry — have I read or heard anything from the educators, institutions or industry economists (mostly employed by the institutions) about secular (long term trending) markets.

The fact that markets have behaved like they did between 1968 and 1982 is conveniently airbrushed out of the industry’s version of events.

In the 140-year history of the US share market, there are at least two other prolonged periods when shares barely eked out a 1% per annum return (1900–1920 and 1929–1949).

I’ll leave you today with the following chart and an observation.

The chart might looks like a Jackson Pollock painting, but it could actually be worth a whole lot more than a real one.

Crestmont Research (check out their website for more brilliant data) have plotted the market P/E ratios and inflation rates since 1871.

The current data point (‘we are here’) puts us in the midst of the orange data points (tech bubble, Fed 1998–Aug 2001). We know how that period ended.

The other text box in the graph points outthe only other months with a P/E above 25 were Aug–Sep 1929.

We also know how that ended.

We are in very dangerous and unpredictable territory. History tells us it won’t end well.

Yet the industry educates us to believe ‘growth’ investments will deliver the goods in seven plus years.

The industry’s proposed education standards are not only built on a questionable premise, but one that just so happens to support the managed funds business model.

While this inherent industry bias remains, higher education will only result in planners building a smarter bomb.

Vern Gowdie+
For The Daily Reckoning Australia

Read the full article at The Daily Reckoning