‘The stock market leads the economy'
On Thursday night I attended the CFA Society of Bermuda's forecast dinner during which Tony Boeckh gave the keynote address. What follows are a couple of key points I picked up from the address and from reading his book “The Great Reflation” that I hope may help investors.
1) Following the credit driven excesses of the last three decades, the figurative 'balloon' finally found its 'pin' in the credit crisis.
In response, central bankers have pumped and will continue to pump money into the financial system in order to help the world's weak economies and prevent a debt-deflation spiral. This is the essence of the Great Reflation.
The result of these efforts is unclear and the ultimate outcome is very uncertain. It is virtually assured, however, that we will continue to see increased volatility and instability in the world economy and financial system. In this world of instability a buy-and-hold investment strategy is unlikely to be very successful. Investors and advisers will need to have tools and a framework for understanding how to shift successfully among various asset classes to garner decent returns.
He suggests “an eclectic approach that is based on common sense, strong logic, and objective data, balanced by right-brain intuition and lots of curiosity, is what works best”.
Beware of what I call “model myopia” a feeling of a false sense of comfort from a fantastically complex model that one adheres to without stepping back to look at the big picture.
2) Tony believes money and credit changes are the main drivers of bull markets. He also suggests that “the avalanche of new money created by the Great Reflation, the near-zero returns on short-term money, and the contagion effect of sharply rising asset prices since the panic ended suggest that we may be off to a good start for the next mania.”
Investors and advisers need to be cognisant of future manias and pay close attention to some common characteristics of manias:
a.) In the late stage of a mania people actually do not believe they are speculating regardless of the evident buying frenzy or the price they are paying. They are mesmerised by the “story”.
b.) A common, but not necessarily universal characteristic of a mania is that the speculative asset in question is extremely difficult to value. Take the tulip mania in Holland as an example. This was an asset with a great story but offered little intrinsic value.
c.) Toward the end of a bubble, the price tends to rise almost vertically. Common sense suggests that exponential increases in prices are NOT sustainable, and a collapse is eminent.
3) Tony is constructive on equities and still believes a large portion of your overall asset allocation should be committed to what he refers to as “business assets”. He also says: “One of the most common mistakes investors and forecasters make is to project where they think the economy is going and then assume the stock market will follow … the stock market leads the economy, not the other way around”.
I can't tell you how many times I hear the phrase along these lines “Things look really bad in the economy so I'll wait to get back into equities after there is some clarity on the economy”.
4) A large portion of the discussion during Thursday's dinner revolved around gold.
He mentioned that gold has already had a fantastic run but the “mania” could last much longer. Gold has already reached about two standard deviations above its long-term trend line so from a rational long-term investment perspective gold does not have a compelling case at these levels.
Tony suggests holding 5%-15% (depending on your asset allocation, time horizon and overall wealth) in gold as an “insurance policy” against a collapse in the dollar or other potential threats associated with wealth destruction.
In his book Tony notes that gold has not provided much long-run diversification benefit since 1969 and returns have exhibited correlation of 0.52 with the S&P 500 and 0.65 with Treasury bonds since then.
5) One concept talked about at the dinner and in Tony's book is the danger of government policy missteps in this fragile economic world.
He would suggest that a harsh austerity measure to counter growing debt levels is not necessarily a panacea to resolve fiscal issues. Slashing government support in periods of anaemic growth could actually have a counter-effective outcome by escalating contraction in a country's GDP and subsequently its overall tax revenues.
With lower growth and lower tax revenues the debt burden continues to spiral upward.
He mentions work by Carlo Cipolla where countries and empires that are in periods of decline “develop resistance to sort of change that is needed for reform, particularly to generate growth, production and an increased tax base, and to reverse structural weakness in the economy”.
Declining countries often “exhibit arrogance, conceit, and complacency, the focus of people shifts to rights from duties, and the public spirit falters”.
Tony also cites Robert Nisbet, in the Twilight of Authority, who suggests sign posts of decline include “social ills drugs, crime, poverty, obesity, poor health, infant mortality, huge prison populations become entrenched and are shocking to witness in such a wealthy country”.
Sage words to heed for any government.