ViewPoint

Time for family offices to dump the stock market

Over the years, family offices have been persuaded to believe that the stock market is a safe place for them to conduct their business. Perhaps they should think again.

Investors like the market because it claims to offer liquidity. They like to update the value of their portfolios, as others buy and sell. Over the long-term performance, returns are good. Intermediaries work hard to keep investors in line. They talk of the relative value of different investments, rather than the risk of systemic collapse.

As recently as 2021, retail investors were seduced by Meme stocks rising fast on receipt of new information. They have lost all the money they made this year because market narratives have changed and investors now want value stocks propped up by a strong balance sheet and cash flow

But global bond and equity markets are now groaning under a collective weight of investments totalling $210 trillion. 

The rent paid to manage this money goes to financiers who use client assets to trade with each other and conduct business by their own standards. Their takeover of the global economy has been dubbed financialization.

Lord Adair Turner described the world of finance as “socially useless” on becoming chairman of the UK’s Financial Services Authority in 2009. In Berkshire Hathaway’s latest annual meeting, Warren Buffett compared the market to a casino.

Of late, the big beast was powered by a surge in liquidity, generated by central banks in a post-pandemic stimulus, plus leverage.

But growth stocks are already being punished and a broader market exodus could lead to extreme volatility, as we saw in 2000, 2008 and 2020. It is never good news when bonds and equities sell off at the same time. 

Family offices are better placed to ride a market risk than other institutions because their exposure to listed assets is relatively low. But the time has come to cut their exposure further – or dump the market altogether. 

This would usefully reduce their exposure to market sentiment – as war rages in Ukraine, there are not many reasons to be cheerful. Underlying economic conditions are difficult. And we are not just talking about problems for stocks, and bonds – there is a rich array of financial instruments constructed by intermediaries out there.

Sales of listed assets by family offices would also raise capital to reinvest in private assets on attractive terms, including convertible loan stock, as funding capital starts to dry up.

Goldman Sachs has just forecast that private market exposures will treble to $30 trillion over the next five years, following outperformance by private equity and venture capital since 2010.  Cambridge Associates has been recommending family offices to use private asset allocations of 40% for years.

Private assets also work because they offer an illiquidity premium from assets whose supply is constrained. But there is no constraint on the number of narratives which influence the behaviour of stocks. On the contrary, when you buy a listed asset you are paying to access the market’s continually changing view of its worth. You are not investing in the real thing. And you are at permanent risk of selling your exposure at the wrong time, as a result of your own behaviour flaws. 

As recently as 2021, retail investors were seduced by Meme stocks rising fast on receipt of new information. They have lost all the money they made this year because market narratives have changed and investors now want value stocks propped up by a strong balance sheet and cash flow.

Even professionals can be whipsawed by changing sentiment. The credit crisis of 2008 was triggered by the decision of banks to offer subprime mortgages to Americans who could barely pay them back.  

But they only produced subprime loans in volume, when they realised they could create a stream of profits by securitization of the debt and selling it to other investors.

When central banks belatedly pushed up interest rates, defaults looked inevitable to market participants. There was a crash in the value of securitisations on third party balance sheets, resulting in a banking crisis.

All this left the authorities forced to cut rates and inject liquidity into the system via quantitative easing and bailouts. Later on, the Fed stopped raising rates in 2018 following a freeze in the credit markets. It repeated the exercise in 2019 when the repo market seized up. Then again, in 2020, when the pandemic hit stocks.

The belief developed that the Fed would continue to shield investors against a damaging market set back, pushing stocks beyond where they should have gone.

Lyn Alden, a family office adviser, says there now are clear limits to the tightening the Fed is prepared to contemplate for fear of the economic consequences.

Her base case is that the Fed will only tighten monetary policy until something breaks in the US economy, forcing it to loosen all over again. Recession or freeze in parts of the fixed income market are among the possible triggers.

“I think that will happen before they reach 3% short-term interest rates and/or before $1 trillion is off the balance sheet, but we’ll see.

“If the Fed is forced to stop tightening for any number of financial or economic reasons, while office inflation rates are still well above their target due to supply-side shortages then we’ll have effectively entered a new policy regime.”

It doesn’t feel good, does it?

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