Even amid a rising stock market individual investors in the U.S. continued to pull money out of equity mutual funds in July, handing those funds their 15th consecutive monthly net outflow. Bond funds, on the other hand, saw net inflows. In fact, reacting to the financial crisis in 2008 investors have reduced their exposure to equity mutual funds for five years running (see chart courtesy Globe & Mail).
Over the past 15 months, 7-billion has left equity funds, while 1-billion has flowed into bond funds. Within bond funds, investors have demonstrated “a clear preference” for corporate bonds according to National Bank Financial Chief Economist Stéfane Marion. Corporate bonds offer much higher yields than government bonds, whose yields are near historic lows.
Equity Risk Premium
The equity risk premium, defined as the the earnings yield of public companies less the corporate bond yield, has rocketed to levels last seen in the mid-1950’s (chart courtesy Globe & Mail). When the equity risk premium is this elevated either stocks are very cheap or bonds are very expensive, or a combination of the two.
A number of equity strategitsts have recently noted that when the equity risk premium is substantially above average – and that clearly is the case now – the subsequent decade long returns are generally much more robust. This is the case even when economic growth is sub-par.
Note that the equity risk premium in 2000 was at one of the lowest points in the 
55 years shown in the chart above. Investor returns for the decade starting in 2000 were negative – something not seen since the Great Depression (see DJIA chart at left). Conversely the last time the equity risk premium was as elevated as it is now was in 1956, and the market returned a generous 11% compounded for the following decade as measured by the Dow Jones Industrial Index (see chart).
If history repeats, the elevated equity risk premium should yield much better returns for long term equity investors over the next decade.
Energy Sector Developments Remain Positive
Investors are avoiding the equity markets the energy sector marches onward. Developments in the energy sector last month were as follows:
- The Energy Information Administration (EIA) reported that global crude oil supplies are tightening. Global oil production averaged 88.7 million barrels per day in July, which is below the 90+ million barrels per day that is now being consumed.
The EIA now estimates that global surplus oil production capacity is down to 2.4 million barrels per day, almost all of which is in Saudi Arabia. This compares to an average of around 3.6 million barrels per day excess capacity from 2009 to 2011. The last time surplus production capacity dipped below 2.0 million barrels per day was in early 2008 and West
Texas Intermediate prices spiked to 7/bbl. - In a further sign of tightening, the EIA pointed to the recent shift toward ‘backwardization’ in the Brent crude futures market. In backwardization oil sold for immediate delivery is more costly than the oil sold for delivery in subsequent months.
In the chart at right, courtesy The Financial Times, note that oil for immediate delivery is roughly a barrel more expensive than a barrel for delivery a month from now – a signal that the current market is tight. Traders and producers will try to pull supply forward to the present to receive the higher price. - Global demand for oil is increasing relentlessly, and will continue to grow for years to come. The developing world, primarily China and India, are in an ongoing transition toward the developed world’s high-consumption lifestyle. North Americans only represent a small percentage of the global population yet we consume a huge percentage of the oil that is produced. The rest of the world is striving to have our comfortable lifestyle.
The IEA projects a 1.0 million barrel per day increase in crude oil demand next year (to 90.9 million barrels per day - a record level). This compares to an increase of 0.8 million barrels per day estimated for this year and 0.7 million barrels per day seen in 2011. Demand growth is driven by developing economies such as China, India, and the Middle East. The U.S., Europe, and Japan areexpected to see stagnant or declining consumption. Chart courtesy The Financial Times. - As a result of the international economic sanctions, Iran's oil exports fell to 0.94 million barrels a day in July from around 2.60 million barrels per day a year ago. Experts expect Iranian oil exports to remain below 1.3 million barrels a day for the remainder of the year. Chart courtesy Wall Street Journal.
- Developmental costs, especially drilling and fracking costs, are skyrocketing. For example a well in western Canada today, on average, costs three times as much to drill and complete as it did six years ago (chart courtesy National Post). The reason is that horizonal wells require larger and more powerful rigs, more casing, and massive hydraulic fracturing programs.
Well costs in the U.S. are increasing in a similar manner. The result is that many of the ‘new’ higher cost energy resources require much higher crude oil prices to support developmental activity. Tar sands and other alternative enery sources also require elevated prices to be economic.
Due to the lower cost of development these companies drilling conventional wells, or developing low cost enhanced recovery projects, should be able to generate attractive returns for investors.
Studies: The Biology of Financial Risk Taking
John Coates was a Wall Street trader then went on to get degrees in neuroscience and endocrinology. He writes an incredibly interesting book on the biology of risk taking entitled “The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust” (2012). Coates focuses on financial risk, but he notes the biology is the same for any type of decision that involves risk. The author argues that our brains and bodies are much more integrated than most people believe and that modern neuroscience proves it.
Evolutionary biology indicates that we have developed genes that automatically generate certain hormones in stressful situations - dopamine (euphoric impact) and testosterone are the drugs of excess, cortisol the hormone of pessimism. The brain is designed to organize movement in response to stimuli according to Coates, and automatically releases chemicals in response to the stimuli. In situations of fear, opportunity, or uncertainty chemicals are generated by our bodies that influence decisions and decision making. Many times the individual is not aware of the chemically induced emotional changes.
Because testosterone and dopamine are released when the outcomes are positive and/or unexpected, the behavior producing a positive outcome tends to be repeated - sometimes on a much larger scale - ‘leveraged’ - for a larger expected reward. Coates claims individuals are encouraged to take risks by the brain’s feedback caused by the chemicals released by the body. Such feedback from experience – many times not noticed by the individual – tends to develop intuitive skills, or 'gut feelings', which the author says can be utilized by investors and traders.
Coates claims that pattern recognition is a skill that can be developed by investors from experience, which is one reason investor intuition sometimes can be uncanny. Traders may not be able to verbally explain their decision or even identify the underlying facts and data they considered, but much like the skills needed to ride a bicycle the data is stored in the brain and can be recalled instantly and effortlessly years later.
Extreme uncertainty can create a freeze up of emotion and decision making, driven by the body’s release of cortisol, which leaves traders prone to inaction and unable to make a decision. When we have a market crash, a portfolio meltdown, or other crisis the manager will have a hard time making decisions and concentrating due to the flood of cortisol released in the body.
To counter the human biology and genetically driven response to risk taking the author suggests that individuals can be trained to become somewhat more resilient to the emotional feedback loops. He notes much study needs to be done, but exercise, and other situations where the body is stressed and then is allowed to recover - like heat and cooling stress to the body (sauna), might build resilience. Age also tends to moderate the impact of hormones on decision making. Coates notes that studies on how to develop resilience are just being undertaken.
The book is more focused on the biology of decision making then on finance or investments. But the impact of our body on the brain’s analysis of risk and subsequent decision making, reactions we have genetically inherited, are issues an investor should be aware of.
