Time’s wingèd chariot is galloping through February. Markets, especially equities, remain resolutely cheery, while investors struggle to explain quite why. ‘Twas ever thus. If markets ever behaved logically, we could all become robots. Or maybe that is already happening.
You may have read about something called ChatGPT. This is an incarnation of artificial intelligence, or what clever people refer to as ‘AI’. ChatGPT, by all accounts, does a more than passable impression of a real person. It may even be writing this column, have an appreciation of 1970s music and believe that Despicable Me is the greatest film franchise. The advances of AI (I use the abbreviation for succinctness, rather than a forlorn attempt to appear clever) are extraordinary, have only just begun and open to considerable doubt.
Those who have watched television whilst using simultaneous subtitles will know that these are, shall we say, far from perfect. I remain profoundly sceptical of self-driving cars whilst the world seems incapable of making a headlight that recognises fog. To be fair, the world also has its fair share of homo sapiens who do not know that their jalopies fail to understand fog and insist on driving with no illumination. Those who build AI have had a propensity to name them ‘Deep’. Thus IBM’s Deep Blue famously won a couple of games of chess against Garry Kasparov. They then improved the software further and called it Deeper Blue. It is probably more impressive that something called DeepStack has a habit of winning games of poker. Unlike a chess board, it has no idea of what the other players hold, and unlike a sighted person, it cannot see the involuntary dilations of the pupils that reveal someone bluffing.
I digress, though. The point I wanted to make this week was about passive investing and the performance of indices. Last week, a well-known index of large UK companies (which goes by a name that copyright forbids us from mentioning) rose above 8,000 for the first time in its history. We all like to deal in round numbers, so 8,000 is a headline-grabbing number, despite being no more important than 7,999 or 8,001. A passive investment in this index, however, would have been a very poor decision. The index was famously, or notoriously, within a midge’s eyelash of 7,000 on the last trading day of the last millennium. That was December 30th. We all had the 31st off work and to hide in our Anderson Shelters in anticipation of the Millennium Bug unstabling the Four Horsemen of the Apocalypse. Anyway, that equates to a gain of 14% over the past 23 years. Which is not brilliant.
The problem with many equity indices is that they are biased in favour of the largest businesses. Size is determined by the value of the equity of the company, rather than by sales, or profits, or dividends, or number of spaces in the executive carpark. What this means is that the more popular, or more over-valued a company and its share price become, the greater the weighting in the index. And the more they weigh, the more ‘passive’ investors have to buy. It is a self-fulfilling process of buying the most popular (and probably over-valued) at the expense of the least popular and probably cheapest. Buy high and sell low.
This is a fun problem. Human investors, we all know, are prone to the twin emotions of fear and greed. We have been designed with this propensity to buy what everyone else is, regardless of value, and to sell whatever has gone down, in case it goes down any more. The question is now whether AI, where the algorithms are initially coded by humans, can think differently? If that can be done, then perhaps these equity indices will stop becoming homes for the most trendy and the most expensive. And if that were to happen, would that make them any better?
I may be an old stick-in-the-mud, but I do not see it happening. If markets are perfectly efficient, how should they react to the unknown? What would have been the logical reaction to the covid lockdowns? Perhaps it moves us to a time and place where the short-term has no bearing on the performance of markets; no matter how good or bad the world may appear to be, markets will return 5% (or 8%, or whatever the algorithms decide is the right return, year-in and year-out). Or could it be that they decide that the more profitable reaction, rather than the most logical, is to force a series of booms and busts – as it is only inefficiencies that genuinely create buying and selling opportunities.
At this, my head spins too much. Or, as Andrew Marvell concluded, “though we cannot make our sun stand still, yet we will make him run.”
Finally, well done to everyone who knew last week’s list of things that could not be seen from Mrs Richards’ window in Fawlty Towers. Today, we go back to 1999 and an easy lyric: “You think you’re a genius, you drive me up the wall. You’re a regular original, a know-it-all.”
Jim Wood-Smith – Market Commentator and Head of Climate Transition
All charts and data sourced from FactSet
Hawksmoor Investment Management Limited is authorised and regulated by the Financial Conduct Authority (www.fca.org.uk) with its registered office at 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. This document does not constitute an offer or invitation to any person in respect of the securities or funds described, nor should its content be interpreted as investment or tax advice for which you should consult your independent financial adviser and or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. The editorial content is the personal opinion of Jim Wood-Smith, Market Commentator and Head of Climate Transition. Other opinions expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represent the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. Currency exchange rates may affect the value of investments.