The latest Eclectica Fund commentary courtesy of the FT:
Good people are becoming desperate. I know a man who is planning to capitulate and buy stocks. He cannot comprehend what is happening today. He is, to employ Churchill, a fanatic; he won’t change his mind and he can’t change the subject. But, fearing the loss of his franchise, he will change his portfolio.
He laments that it is as though last year’s events never happened. Rhetorically, he asks whether we have all been sent through time to invest in equities at the end of the 1970s when stocks were cheap and society had thoroughly deleveraged (the opposite of today). “Why do other investors not contemplate the prospect of further household deleveraging when building their profit forecasts?” he fumes. “Can they not see that the private sector’s deleveraging is more than offsetting the public sector’s expansion?” Despite such ranting my Minskian friend remains a most entertaining and charming individual.
Now I know I have not covered myself in glory these last few months. Stock markets have gained 50% from their lows and the Fund has little to show for it except a modest reversal and no wild swings in our monthly NAV. Nevertheless, I would contend that this game of playing “chicken” with the market is not for us. Our ambition has been modest. To survive the onslaught of a positive change in social mood without being forced to capitulate in the face of a frenzy of optimism; so far so good, I think?
In this regard we have been helped immensely by a quote from Robert Prechter in early April. Having correctly called for a counter-trend rally in stock prices in late February, he then described the most likely nature of the advance, “…regardless of its extent, it should generate substantial feelings of optimism. At its peak, the President’s popularity will be higher, the government will be taking credit for successfully bailing out the economy, the Fed will appear to have saved the banking system, and investors will be convinced that the bear market is behind us.”
So far his prophecy reads well. It is reminiscent of Warburg’s line that the business cycle is “a subject for psychologists” rather than economists. Bernanke is already being compared favourably with Volcker. Continental Europe has apparently “escaped” from recession. Positive economic growth across the world for the remainder of the year seems certain. And yet Prechter went on, “Be prepared for this environment: it will be hard for most investors to resist. But beware… [the next move] will be the most intense collapse in stock prices”
This seems hard to reconcile with the determination of governments to resist the bear market; the more plausible Cassandra scenario remains something more akin to the long drawn out agony of the Japanese stock market. Nevertheless, let us assume that he is right, what could possibly generate such a black turn of events as to send stock prices back to challenge their March lows?
Not withstanding, of course, a tapped out private sector, lingering high levels of unemployment, capacity utilisation levels which never rally sufficiently to raise industry profitability, a speculative orgy in China which is likely to burst at some indeterminate moment and the complete uselessness of fundamentals in determining turning points.
Apologies, I am susceptible to my friend’s ranting after all.
Rain, rain, go away…
In attempting to answer the question of what could reignite a sell off in risk assets I have found myself returning time and again to my February 2006 investment report in which I drew the obvious parallels between the economic circumstances of the 1920s and today. The paper had the title, “Trees don’t grow to the sky”, and focused on the economic consequences of those periods when one country or region dominates world trade.
In the 1920s it was America in the ascendancy but something similar arose in the 1950-60s with the recovery in continental Europe, in the 1980s with the rise of the Japanese economy to preeminent creditor nation status and, of course, today with the rise in China. The one constancy is that unbalanced world trade has a tendency to pit domestic monetary policy considerations against international and, as a result of this tension, credit is created which fuels asset price bubbles and their resulting busts.
I want to spend some time reviewing such periods because I believe they suggest an outcome which challenges today’s near universal fears concerning the US dollar. I believe they reveal something distinctly non-consensual: that weakness in global economic demand can force the most painful adjustments not on the “sinful” low savings trade deficit countries but rather on the “virtuous” high savings trade surplus economies.
Consider for a moment the economic disequilibrium left behind by WWI. Europe was saddled with debt and America had become both a creditor nation and a net exporter. If economic orthodoxy had prevailed, the US should have imported more and the Europeans, especially the Germans, should have exported more. Under this scenario, gold, the international reserve currency, would have flowed from the US to Europe, and financed the latter’s reconstruction.