Introduction
Perhaps because of my
cold I am more conscious than at other times to medicine. With all the wonders
of modern science there is no sure fire way to cure the common cold, yet the
market for cold remedies is very large and present in every country. We all
want to get better quickly and will try any so-called remedies.
Wrong medicine sends markets higher
This week we have seen
several examples of governments and/or their central banks prescribing the
wrong medicine to the welcoming stock markets. The sugar pills that are being
rammed down our throats are various forms of Quantitative Easing.
Perhaps exporting our problems helps
The
US used to be accused of exporting our home grown inflation. At other times we
were criticized for our declared strong but actual weak dollar policy. But now
we are exporting a bigger fallacy. The recently retired chair of the Federal
Reserve Board and mentor to the current chair in his continued advocacy of
Quantitative Easing (QE) has quipped that in practice it worked, but in theory
it shouldn’t. Further, he said “We were never concerned about [inflation].
Inflation was never a risk and inflation is not a risk now.” This is from a man
that did not see the many precursors that multiplied and helped created the housing
bubble.
The
evidence of the lowering of underwriting mortgage standards was reported on
within the Fed’s own documents. The comment about no inflation now is
particularly inappropriate when using core inflation, the Fed’s preferred
measure, which over the last twelve months has risen to 1.8%. These mental lapses are acceptable for a busy
ex-Princeton professor who was not challenged in the commercial world. His real
crime against the US economy and now his followers in the central canks of the world
is the belief that QE worked. There appears to be a loose correlation that the
first dose of QE was stimulating. Those of us who follow the performance of
securities prices have learned that correlation does not equal causation. The
proof is that in this market additional doses have had increasingly less
impact.
Japan’s experience
revealing
Our
Japanese friends have relatively quickly observed their own evidence when much stronger
QE medicine was applied to their economy: it has led to them falling back into
recession. On the weight of the evidence I believe we can conclude that QE is a
poor if not bad medicine for economies, but not stock markets who need to
believe. Thus this week’s Euro propaganda by the ECB buying bonds as they
launch their latest QE attempt was good for their local stock markets, but is in
and of itself unlikely to materially help the various economies.
The "Third Arrow" could really help
After fiscal and
monetary changes in Japan, the “third arrow” was a deep and sustained reform
movement which included removing many government imposed controls, including
immigration.
Perhaps if the third
arrow is successful, both the US and Europe could follow Japan’s lead.
In the US, federal tax regulations are spread over approximately 79,000 pages.
Renewed faith in the marketplace to provide much of the regulation with
appropriate oversight would energize each economy. All one needs to do is to
array the starting date of various industries along with the anticipated level
of regulation to see where economic productivity is likely to occur.
What won’t help
Reliance on old
economic theory and practice is not the answer to today’s problems. I won’t go
on paraphrasing Mark Anthony about
coming to bury Keynesian thoughts. I am concerned more about an eighteenth
century ghost of mercantilism. Today, as in the past, governments are trying to
aid their exporters to earn increased amounts of currency. The European governments of past eras were
attempting the same maneuver by lowering the value of their own currency versus
their competitors. This created an era of competitive devaluations.
Both our
Japanese and European friends are trying to accomplish the same thing today.
This will set off a race to the bottom and deprive their homelands of more
expensive imports. In terms of quality of life, cheaper goods often means items
of less value to the user. To defend themselves, much of the wealthy classes are now
exchanging their own currency for foreign luxury goods as a way to protect
their own real wealth. Some of the preferred goods are securities. The $1
trillion dollar Japanese Government Pension Plan has doubled its commitments to
both domestic and international stocks, each to 25% of their total responsibility.
This surge is helping the Japanese market and I suspect is playing a role in the US
as well.
What may be the root cause of the problems?
The as usual intriguing John Authers
in the Financial Times has produced
an article that may explain the unanimity of central bank thinking. In the
article under the column head of “The Long View,” he has a title of “Why we need to break the white male grip on
the markets.” In the article he focuses on group thinking. The bottom line in
the article is homogeneity makes a group overconfident.
Most central bankers
are learned economists. Most economists spend most of their time on macro-economic studies, in other words top/down. Coming from a securities analyst and
race track handicapper my instinct is for micro- economics and focus on details
that make something standout. I also learned at the track and in the
marketplace to challenge the consensus thinking which is right some of the
time, but wrong at other times. When right things go as planned, no problem; but
when wrong they can be disruptive. Central bankers like most boards of
directors and investment committees are made up of polite people that may
occasionally question but rarely challenge the perceived truth. To have all the
major central banks going the same way is an example of extreme consensus
thinking which could well be risky.
Are good stock markets worrisome?
One of my individual
high net worth clients reminds me that while he is delighted with the
performance of his account, the pain of loss would be twice as large as the
pleasure of his gains. He has his pleasure/pain calculus right even though over
time a continuously invested stock portfolio has absorbed major market
calamities with an average annual gain going back to 1871 of 6.8%.
Nevertheless, if the medicine that we are swallowing is giving us sugar highs
we need to be wary. The Lipper Balanced (Mutual) Fund Index is slightly
elevated at 7.47% for the year-to-date. The index is benefiting from its
ownership of large cap core equities that as a stand alone is up 11.42% in 2014.
Neither of these numbers is of the nose bleed size, but after a remarkably
strong 2013, we need to watch closely.
There are two
indicators that we are watching. The first is the ratio of the purchase of call
options as compared with the number of put options owned. This ratio is
historically low and on this measure the market is not looking frothy. However,
Friday’s stock price movements are a flashing cautionary signal. On the New
York Stock Exchange 219 stocks hit new highs and only 15 hit new lows. This may
show that the large amounts of institutional cash reserves are being committed.
The reason for this belief is that on the NASDAQ there were only134 new highs,
but 48 new lows. Often the NASDAQ is a more speculative market.
The patient is recovering
As my cold is leaving
my body this evening I regain some perspective having recovered from the medicine
I took. The issues in counseling my nervous client are the time horizons of his
concerns. Clearly the US market could fall at any time in view of its long
recovery. While the recovery has been long, it is not particularly robust. On a
historical basis, we could see a possible 25% fall which could be recovered in
perhaps five or so years. We are prepared for that potential. However, there is
a bigger risk and it is on the upside.
We may be in a period that many
investors seeing the current gains and the popular belief in QE and other
government remedies quickly re-enter the market and not in the large markets for companies like Berkshire Hathaway*, IBM, Procter &
Gamble as recommended by Goldman Sachs*, but in much more
speculative NASDAQ stocks and call options. This kind of surge could produce
parabolic price patterns as we head to some predictions in the years ahead of
3000 on the S&P 500, but perhaps much sooner than expected. This kind of
enthusiasm could set up my feared spike which could lead to a generational
decline on the order of 50% like we saw in 2008. Normally the next big drop
would be further in the future, but we can not count on it.
*Owned by me personally and/or by the financial
services fund I manage.
The key for my client mentioned
above is what level and duration is his discomfort. He could experience pain as
those around him in the short run make a pile of money before they lose most or
all of it. My task is to be conscious of his pleasure/pain calculus as well as
his longer-term performance.
Question
of the Week: Where are you on your Pain/Pleasure
investor calculus?
__________
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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