“Only in quiet waters do things mirror themselves undistorted. Only in a quiet mind is adequate perception of the world.” Hans Margolius

Good morning,

I trust the weekend was good to everyone and you’re settling into the new rhythms of September life.

It’s certainly been quite the month in the markets, quite the year in fact as we continue to tackle inflation with higher interest rates, deal with uncertain geopolitics and continue to see bouts of volatility across assets classes. Despite the wild year we have had thus far in, we are enthusiastic about these markets, extremely constructive on our positioning and excited about the opportunities that higher rates are presenting to us as investors, which will be amplified as we see inflation start to come inline over the months ahead. From our perspective here at Henderson Wealth, it’s a world of opportunity at the moments, across asset classes in public markets, private markets, real estate and alternatives.

Perspective

Perspective is defined as a particular attitude towards, or a way of regarding something; a point of view, and it is something that investors need to have throughout their financial journey. Perspective is something which all investors need to have whether markets are climbing and particularly when markets are volatile. Howard Marks once said that, “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” The way you think and then respond to a given situation or event can sometimes make the biggest difference to your journey. It can be the reason for your success or can cause failure. Thus, more than anything else, it is important to understand why you respond the way you do and how you can control your responses.

In his path breaking book, ‘Thinking, Fast and Slow’, Nobel Prize winner Daniel Kahneman helps us comprehend critical thinking processes like judgmental errors, decision making, perception and analytical thinking, all themes relevant to any of us who are interested in understanding our behaviors in an effort to be mindful, intentional and calculated with our approach and our actions. Although certainly not an investment or financial text, I thought it would be cool to share with you a few themes and lessons from the book, as they lend themselves to our investment world and relate to behavioral finance, as well as its relevance in our everyday decisions.

Human beings have two ways of thinking

The human brain is a curious thing, working in ways that are not always sensible and rarely easy to understand. To address this point, Kahneman introduces the idea of ‘system one’ (that is, thinking fast) and ‘system two’ (thinking slow) – or what we might effectively think of as the subconscious and conscious parts of the human mind. According to the Kahneman, our ‘system one’ subconscious reacts and makes decisions automatically for a variety of sound evolutionary reasons and does so with little effort or indeed understanding on our behalf. For its part, our ‘system two’ conscious is involved in all our deeper thinking but is also inherently lazy and would rather do nothing if an instant judgment is on offer from our subconscious. A real life example of this is like when we when we are asked a difficult question, we will often subconsciously ‘flip’ it so that, while only subtly different, it is considerably easier to answer.

Here’s an example……

Someone asks you “How happy are you with your life these days?” yikes, this is actually a tough question that involves a degree of thought so we subconsciously jump to a slightly easier one: “How is my mood right now?”. Isn’t that interesting..!! Translating this to the world of investment, this means when someone is asked whether they view Company X, say, as a good business, they are more likely to consider how they ‘feel’ about Company X.

Depending on who they are that might take them in various directions but, in all likelihood, their answer will be based more on emotion and gut reaction than the altogether trickier matter of whether Company X may or may not be a good investment. The real answer to that will, of course, be dictated almost entirely by numbers yet the human brain prefers more ‘touch-feely’ considerations such as brands or pricing power or logos or indeed, in modern-media terms, anything that can be illustrated with a pretty picture. That is all fine when it comes to filling the pages of the financial press but it is irrelevant in the assessment of the potential quality of an investment.

The human mind instinctively responds to heuristics

‘Heuristics’ are essentially mental rules of thumb or short cuts developed over many millennia and through which the human brain sacrifices intellectual rigor for the sake of reaching a speedier decision. As investors, being aware of this is critical for us, such behavioral finance biases can often lead to poor investment decisions.

Kahneman goes into many of these biases in detail, including;

• Anchoring - where people subconsciously base their perceptions on the current environment rather than recognizing that something entirely different could happen in the future
• Prospect theory - also known as loss aversion - this is the idea human beings feel the pain of financial loss twice as keenly as they feel the enjoyment of any gain.
• Endowment effect – the idea that once you hold a view, you become very attached to it and find it hard to change your position, even if new facts suggest you should
• Base rate neglect - his has nothing to do with interest rates but involves attributing less weight to more general probabilities and more to newer or more immediate information.

Intuitive prediction

This is a solid one….it is linked to one of the foundation of investing because it relates to the human instinct to make forecasts on what we feel to be right rather the strength of the available evidence – not least how most aspects of life tends to revert to their long-term average. This concept of ‘regression to the mean’ is a bigger and stronger phenomenon than most people tend to recognize and one that captures many of the subtleties about the world that extrapolating the future from the present does not – competition, say, or a whole host of other factors no-one could hope to understand fully about the difficulties inherent in growing either a business or a country.

Fascinating examples of how we can potentially allow our emotions to have greater weight then actual data or analysis, all as we can all find examples of these as we walk through life and highlight the importance of understanding your values and your vision, and having a developed framework and strategy for your journey ahead.

“We must look at the lens through which we see the world, as well as the world we see, and that the lens itself shapes how we interpret the world.” Stephen R. Covey

And now, to the Markets

Global markets have been laser focused on inflation readings all year. And, while that was still a big preoccupation for investors over the past week, another issue has emerged that could soon overtake it as the predominant market concern: the risk of recession and its impact to corporate profits. We discuss recent developments on both fronts below.

The U.S. Consumer Price Index (CPI) for August was released over the past week and it was up 8.3% year over year, below the reading for July but higher than expected. Food and energy price pressures remained elevated, although the latter declined as expected. More troubling may have been the core measure, which excludes food and energy. It was higher than expected and above the July reading. Moreover, it wasn’t driven by one particular category but showed relatively broad pricing pressures.

Nevertheless, our view on inflation remains largely unchanged. More specifically, it should recede in the months to come. One doesn’t have to look too far to understand why. Shelter is the largest component of inflation, accounting for nearly a third of U.S. CPI. It is made up of lodging away from home, rent, and housing-related costs. The latter two have shown no signs of slowing yet, and in fact increased in August. But, these two categories have historically followed home prices with a meaningful lag. We know home prices are under pressure as a result of substantially higher mortgage costs. As a result, it is just a matter of time, in our view, before trends in the largest component within the CPI basket begin to subside.

Inflation may also be at risk of falling victim to recessionary-like forces that appear to be on the rise. In recent days, a few industrial conglomerates ranging from aluminum and steel makers to shipping and parcel delivery companies have warned of deteriorating conditions in their respective businesses that have led them to issue profit warnings. Part of this appears to be cost-driven and a meaningful shift in demand away from goods towards services. Weakness overseas was also cited as a notable driver by some management teams. But, it’s hard to imagine weaker demand avoiding its way into the North American economy. After all, the Bank of Canada and U.S. Federal Reserve have been aggressively tightening financial conditions with the hope that demand and activity would slow. We may finally be starting to see the impact of their actions.

A weakening economy is by no means something to look forward to……..but, it will have a lasting impact on inflation. Ultimately, that will prove to be a very important and constructive development for the longer-term return prospects of most assets. In the interim, we expect equities to remain vulnerable as markets digest the risks to corporate earnings. Opportunity in equities, opportunity in real estate, opportunity in high quality bonds as their yields stabilize and as these short term growth concerns eventually overtake inflation risks as the main market concern.

As we head into the week, remember that perspective is the way we see things when we look at them from a certain distance and it allows us to appreciate their value. Life is about perspective and how you look at something... ultimately, you have to step back and be sure you have the appropriate vantage point to uncover all opportunity your journey has to offer.

“The real voyage of discovery consists not in seeking new lands but in seeing with new eyes.” Marcel Proust

Be well & enjoy the moments

Derek