I freely admit to being bearish about equities and especially investment trusts. For equities generally, I take a value perspective and don’t like what I see when I connect those measures of valuation to the bigger picture dominated by rates (interest rates, inflation rates, default rates). As for trusts I’ve already mused about the structural headwinds, not least the fact that there are too many sub-scale closed-end funds with huge discounts.

As we’ll discuss, I would maintain that the bear case is strong but I’m also mindful that we are all victims of our own narratives – the stories we tell ourselves to justify our actions – and that there’s a growing case to be made for saying that those of us with a bearish outlook might be missing the wood for the trees. In simple language, the bulls may be right, and we might be set for something much more exciting in the next months and years.

Bear case

First let’s gallop through a summary of the bear case:

• Technical measures of investor positioning in risk assets versus cash are closing in on extreme lows indicating widespread investor fear.
• Complementing that, money market funds are showing massive inflows –investors like cash.
• Distressed debt defaults are increasing fast.
• There’s growing hedge fund activity in shorts and in the main measure of volatility, the Vix, the ‘fear index’, is trending downwards. It’s well above its long-term average which is nearly always a worrying sign
• Investors are worried generally about liquidity pressures building as interest rates rise. That feeds through into concerns about banks as well as commercial real estate which is looking wobbly.
• As we can see in the current quarterly earnings reporting cycle, corporate profits are declining, and more and more chief executives are warning of an impending slowdown and possible recession.
• More generally, investors are concerned about a regime change in which we move to a new world of higher for longer interest and inflation rates.

Like many concerned investors, I chew over these arguments and find no reason to get excited about buying more shares, even deeply discounted investment trusts, and would thus prefer to sit tight in more cash waiting for a more ‘opportune’ moment.

Flipping the bear

Nevertheless, I also find myself thinking that all these scenarios have been priced into most, if not all markets. More to the point, the points I listed above can be flipped to a bullish argument:

• In the past, very negative investor positioning is usually a classic buy signal.
• Distressed debt levels may be rising but overall corporate defaults look much less threatening.
• Hedge funds frequently get their short positioning wrong, find themselves squeezed and then flip back into strong bullish positions driven by fear of missing out (FOMO).
• Many markets, not least the UK look dirt cheap.
• Corporate earnings may be declining but the pace of decline is less than many feared and so far most numbers are surprising on the upside, both in Europe and the US.
• Investors have been stunned by the strength of many corporates’ pricing power, sparking talk of ‘greedflation’. If inflation moderates, these businesses will be able to hold the line and boost profits.
• It’s almost a mathematical certainty that inflation rates will now start declining. It’s also highly likely that interest rates are very near their peak and that at some stage – this year, maybe next – they’ll head down.
• We may be entering a higher-for-longer scenario, but investors are already pricing in a new ‘normal’ where interest rates bump around the 2.5% to 5% range while inflation also bumps around the 3% to 7% range. If they stay in this range, investors won’t be alarmed.
• Folks like Cross Border Capital who track global liquidity measures reckon that the current liquidity decline might switch very soon as central banks start to loosen monetary taps again.

So, I think we can quite easily build a case for the bulls which says that valuations, especially in the US, aren’t super keen but the market has priced in many risks and there’s only upside from here. Note I am not saying this argument is right, just saying that it’s not nonsense.

Risk aversion

Which brings me to investment trusts and the persistent discount problem. I can’t help but think there’s another driver at work here which consists of two structural factors: the importance of narratives and the power of asset allocation strategies.

My hunch is that many of the big buyers of investment trusts are professional managers of multi-asset strategies be they wealth managers or bigger institutions. These investors have learnt the hard way that smart asset allocation is the name of the game, allied to picking the right managers of underlying funds to add alpha (above average returns) when risk is on. In the good old days, they’d just sit tight and buy the market through thick and thin.

But this buy-and-hold strategy is vulnerable to big regime changes which involve the macro-economic picture changing drastically – a move to low rates for longer or the reverse, higher rates for longer. Thus, as professionals, they’ve become more focused on avoiding the downside risk. And they’re not wrong to think this as there’s actually a fair bit of academic literature that backs up the idea that what’s called dynamic asset allocation – avoiding the worst downside risks – can add value at the portfolio level. It also, handily, justifies higher fees.

Thus, we have set up a series of incentives for these professionals which says their main job is to avoid downside risk, which forces said professionals to overvalue the big-picture macro signals I’ve listed above. Why? Because if you read too many macro-economic reports, it’s almost impossible not to feel a bit bearish – the whole news reporting industry is predicated on hyping bad news stories and underplaying boring good news stories.

Discount problem

So, we have a structural factor at work – dynamic asset allocation which involves avoiding risk – married to a strong narrative driver, which is that the macro picture is volatile and bad things are more likely than not to happen next. And there’s one other idiosyncratic funds-based risk: discount risk. You might find a great fund that ticks all the boxes but it’s sub-scale, it doesn’t quite fit inside your research process, and the discount widens, precariously. So, as an asset allocation type what do you do – the answer is to avoid investment trusts.

But there’s a danger with this world view: it’s backward looking. It fetishises historical macro data and trending discounts. It potentially misses out on sudden changes and over-emphasises a risk aversion framework. It also emphasises simple binary decision-making, be it risk on, risk off or arbitrarily switching between broad asset classes or even just avoiding investment trusts altogether.

One example of this is that I’m fairly convinced that many alternative income funds are involved in a beauty show with long-dated gilts, treasuries and corporate bonds. As we’re approaching a turning point in rates, these government bonds are starting to look more attractive and – if rates plateau – increasingly risk-free (except for the corporate bonds, of course).

So why take a risk with alternative income funds when you could invest in a scenario where 10-year gilt yields move from sub-4% yields to around 2.5% over the next few years?

What are we missing?

The net effect is to overestimate avoiding risk, over-invest in risk-aversion strategies and potentially miss out on a risk rally. So, we end up with a situation where close followers of the investment trusts sector look at many impressive, listed funds, see the massive discounts on offer and scratch their collective heads, while muttering under our breath ‘What am I missing here?’.

But at some point, the market corrects itself. Eventually other buyers emerge who aren’t as obsessed with dynamic asset allocation strategies – private equity buyers with huge mountains of deployable cash jump to mind or sovereign wealth funds that can take a long-term view. Traditionally pension funds with a long-term view of equities would have played this role but regulations have forced them into a pre-emptive risk cringe which has over-emphasised owning gilts, so they’ve vanished from the market.

But if the bulls are right, at some point value will out and enough buyers will emerge to snap up the bargains ahead of a ‘FOMO rally’. I’m not saying we’re at this point, but I am saying this argument is rational, seductive and might even be right.

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