“Davidson” submits:
There are as many investment styles as there are investors. Yet, markets are often discussed as being monolithic (all investors acting in one uniform response to economic conditions) or multilithic (separately defined multiple investment responses to various aspects of existing economic conditions). Sometimes we wish markets were this simple. But, this will never be.
The multiplicity of participant interests, skills and importantly investment horizon (expected period in which investment outcome is expected) make the markets highly complex and basically unpredictable over short periods. But, this does not stop us from being aware to changes in the market even though we do not base our investment decisions on short term events. It is important to monitor markets every day.
Markets should be “rational” over the long term. By this I mean that improvements in economic fundamentals should be generally reflected in improved security prices unless one has missed important information. The markets do transmit important information in the form of price activity that can be used to confirm or deny our assumptions and this is the reason behind paying attention to a myriad series of economic and market inputs. Economic measurements of employment, production and inflation should be reflected in security pricing in a sensible fashion over time. But, assuming that each and every price movement in some fashion carries important “hidden” information critical to investment decision makers is where the market becomes “irrational” in my view. Many seem to have taken Hayek’s “Free Market” Mark-to-Market as the definitive and sole measure of value determination. However, when market valuations fluctuate with the immediacy of market psychology rather than being based on economic returns over several years of productivity, then markets take on an entirely different cast much akin to a shark feeding frenzy.
The recent craze of gold investors is a notable example of this in my opinion of investors making certain inflation assumptions and chasing price movement (which furthers the price movement). This activity is exacerbated with great effort to justify a fundamental case for gold investment over longer time periods as if some unique insight is offered by the pundit-salesman. Most often the talk is that gold has never gone to “zero” or that it has been the “best” investment in the past Xyrs. By illustration below is the 36yr gold price in US$. Gold is not a producer of economic value over time, but is thought as a store of value during times of economic uncertainty such as the current period with a recent high of $1214.04 on Dec 3, 2009. Gold pricing has in my view a significant psychological component the extent and intensity of which is all but impossible to predict. Spot gold is priced this morning at ~$1090. The chart below reflects an investor panic that may have just peaked in similar fashion to the 1980’s spike. I think that this is an example of some investors’ belief that momentary pricing per Hayek’s Mark-to-Market concept carries valuable investment information. I think not! In the past 20yrs there have been numerous spikes similar to this with future returns likely also similar to that which followed the 1980 spike.
Gold is an interesting sideshow but a good example of what not to do in my view.
Market volatility is predictable in that it will occur, but I know of no means to predict when, where or how high/low. But, it is possible to comprehend how the markets even with the short term volatility and cross currents hew to simple valuation concepts on which one can make decisions if one looks longer term. By longer term I mean over the business cycle which may be anywhere from 3yrs-8yrs. By studying economic history and the associated market responses over multiple investment cycles, one gains an appreciation of the longer term growth rate of economies with average deviations, stock and bond market responses to economic cycles, the political influences (usually not that much), the influences from inflation (always very important), a historical comfort or discomfort of Fed Reserve action and how each of these interact and create feed-back responses. One can arrive at some simple investment concepts within which one can negotiate what appears to be a constantly irrational environment.
Markets have gross predictability over the long term.
1) The relationship that higher stock and bond prices are coupled to economic growth is very strong.
2) The relationship that market valuations vary inversely with inflation is very strong (higher inflation leads to lower market prices).
3) Predicting short term market directions comes very close to being an exercise in utter futility.
4) Avoiding the periodic market manias that occur has predictably been beneficial over the long term.
Recently, a change in the investment character of the SP500 seems to have occurred that while no changes are necessary to portfolios as we are using a business cycle time horizon it is still interesting to observe that underlying processes continue to support our current market exposure. Importantly, it appears that some of the capital residing in US Treasuries is now in the process of entering the equity markets. In the chart below you will find the SP500, the XOI (Amex Oil Index) and the FXE ( US$/Euro ETF).
You can see that the XOI came to dominate the price activity of the SP500 in 2007 with the market’s focus on “Peak Oil”-SP500 is the gray line-XOI is the dark blue line. This close connection remained throughout the correction and recovery period till the last week in Oct 2009 when a decided break in the lock-step market activity occurred. There are several events occurring during 2007-Present of which I will point out a few I thought important, but not inclusive.
1) 2007 strong interest develops in “Peak Oil” concept-US$ becomes weak-market participants add excessive leverage and crowd into oil as “must have” trade. XOI climbs, FXE reflects weak US$, non-natural resource equities weak causing SP500 to fall.
2) July 2007-Sept 2008 Sub-Prime increasingly recognized as a problem-banks pull back lending to all including leveraged investors
3) Sept 2008-Oct-2008 Lehman Bro fails, Money Markets become illiquid, banks issue margin calls, market panic selling explodes, US$ and Treasuries become safe haven for global investors driving T-Bill rates to 0%. XOI,SP500 collapse in panic-FXE reflects stronger US$.
4) Oct2008-March 2009 US Fed Reserve adds unprecedented liquidity.
5) March 2009 carry trade uses dollar to buy natural resource-US$ becomes weaker as XOI and SP500 recover in lock-step-RED LINE
6) Oct 2009 the lock-step XOI-SP500-FXE market activity ends as US$ becomes stronger-XOI and FXE fall-GREEN LINE
7) Oct 2009 SP500 continues to rise with Treasury Rates now rising as risk capital moves from safe haven Treasuries to the equity markets (?)
The observation that one can make is that the estimated ~$4Tril+ may now be entering the equity markets and in the process this drives Treasury rates higher while at the same time stock prices continue to rise. The observation is in line with the temporary fall in natural resource stocks, but with enough offsetting capital entering the market that the SP500 continues to rise. This means that a significant number of participants have turned bullish of late.
One would expect to see this type of change if one has a business cycle horizon. I have no recommendations other than that of remaining invested, balanced and to encourage you to make capital additions if you are so inclined. I anticipate that the recovery will be more visible as it evolves and that based on historical precedent reasonable returns are likely for the next 2yrs-3yrs.