Posted By: Matthias Paul Kuhlmey
By now, practically every cautious and, to a degree, bearish investor is beginning to throw in the towel. The embarrassment when working the cocktail party crowd is just weighing down spirits of preservation and caution, and every “doofus” that decided to keep equity exposure after the big fallout has been elevated to the status of unmatchable competence. Related is the simple human characteristic of thinking that we can always have a bit more (aka greed is good), and long forgotten are self-imposed limitations, such as “I do not want to own (more) equities” … 30+ percent returns in front of our noses do exactly that.
Welcome to the investment phase of self-fulfilling prophecies: Bonds are bad, as on a relative basis they are expensive compared to equities, ignoring the notion that bonds could just be really expensive and equities sufficiently priced! Further, we embrace the “miracle” of a prolonged economic recovery justifying the case for higher equity prices, even though estimates for 2014 GDP in the U.S. run anywhere between 2.5-3.5 percent; not exactly stellar. Also, there have been reports of households eagerly improving their balance sheets, but quite the opposite may be the case, as I explained in last week’s contribution to The Huffington Post, “Another Magic Mountain.” With all points considered, the game is on. Between embracing a likely “Santa Claus Rally” and mandatory reallocations of portfolios for the New Year, just a little more of equity can do. This “little more,” in aggregate, has the potential to lift markets higher.
One of the main issues we’re facing is that excess liquidity created by the Fed has just not “hit the mark”; instead of having turned into productive capital (e.g., funding businesses, creating full-employment options, repairing and improving an outdated domestic infrastructure, etc.), flows continue to fund future asset bubbles. You may conclude (too early) that I am a poor observer, but other voices are becoming more pronounced. Highly acclaimed investor, John Hussman, Ph.D., in an open letter to the Fed, addressed his concerns of a valuation bubble in equities and the fact that investors, in absence of credible “safe” return opportunities, have to reach for yields, further perpetuating an artificially expensive bond market. The entire “setup” has turned into a vicious cycle of reachers and givers, a modern relationship settlement practice between the Fed and retail investors.
The guy who couldn’t make the bench at the new Fed, Mr. Larry Summers, recently reintroduced the 80+ year-old economic concept of “secular stagnation” to the discussion. Related to this theory, the U.S. economy, even during the booming years, may never have reached full potential, but this very fact was masked by heavy borrowing and asset price inflation. In applying the stagnation theory (correct or not), developed, advanced economies are experiencing a “hit to potential,” due to declining population growth and insufficient technological progress. In an attempt to revive economic activity, affected nations will create stimulus by cranking up government demand, leading to an increase in public spending and debt. The rest of the story we know, and a willing Fed, now practicing “Yellenomics,” does as well. Who says the Fed balance sheet could not grow to $10 trillion?!
In psychology and social sciences, the “Oedipus Effect” describes “a prediction on the predicted event, [with] the prediction either causing or preventing the event that it predicts.” In short, equity returns may largely become the product of a self-fulfilling prophecy, and markets may further inflate (until they won’t) in absence of absolute value, but on the basis of suggested relative value (the bond vs. equity story). Before you sell all of your fixed income holdings to join the “doofus group” (as above), understand the complex function of holding those assets as a beneficial diversifier in portfolio construction.