That 70s Show

I reached adulthood in the 1970s.  It was an era of pessimism, economic malaise and confusion. And don’t get me started about the hideous fashion. The overall zeitgeist of that era was hard to describe to younger folks, until quite recently. (“Too many college grads without real jobs” resonates today in a way that it did not, for example, during the tech boom of the late 1990s.)

Back then, the principal economic model was Keynesian demand management, which so dominated policy thought that in 1971 President Richard Nixon proclaimed, “We are all Keynesians now.”

By the end of the 1970s, the grim result of a decade of Keynesian stimulus was stagflation — an ugly combination of chronic inflation with persistent unemployment.  Under prevailing economic theory, this was an unanticipated result, so much so that our economic problems seemed not just insoluble, but beyond understanding.  Economist Robert Heilbroner declared in 1981 that, “Nobody really understands what causes inflation.”

In short, the economy sucked and nobody knew how to fix it.  (Sound familiar?)

When Ronald Reagan took office in 1981, he brought a different perspective.  He believed tax rates should be lower, regulations less onerous, and that the proper inflation rate was zero, or somewhere close.  At that time, James Tobin of Yale, the rough equivalent of Paul Krugman today, denounced Reagan’s plan.  Instead of lowering taxes and wringing out inflation as Reagan proposed, Tobin thought tax rates should be raised and monetary policy loosened.

Reagan got his way.  Inflation declined sharply and the nation entered a brief but brutal recession, after which economic growth exploded.  (A huge share of the credit for lower inflation must go to Paul Volcker, a Democrat and head of the New York Fed, who Jimmy Carter reluctantly appointed as Chair of the Federal Reserve in 1979.)

Within four years of Reagan taking office, a global revolution was under way.  Governments across the ideological spectrum, from the coalition of conservative Democrats and Republicans tin the U. S. to Mitterand’s Socialists in France, put in place policies of lower taxes and tight money.

This was was not a question of ideology or intellectual persuasion, but of practical politics.  In a democracy, results usually trump theory.  Even for self-identified socialists, higher economic growth leading to higher tax revenues was an irresistible benefit, since it produced more money to spend on favored policies and constituencies.

I was trained as an historian, not an economist, so I didn’t have a dog in this economic policy fight.  As a financial guy, my concerns were entirely practical — I wanted the economy to get well and stocks to go up.  Observing the predictions of the Keynesians and the results of Reagan’s supply-side policies, I came to the simple conclusion that Keynesian economics was dumb.

My views have evolved over the last thirty years, but not reversed.  These days, I have fundamental problems with the more passionate advocates of efficient-markets theory, whose principles were clearly implicated in many of the financial-markets practices that proved so disastrous during the 2008-09 crash.  I have also developed a deep affection for Keynes’ insights into the irrational aspects of financial markets.

I remain entirely unpersuaded by fundamentalist Keynesians like Paul Krugman, who truly believe their complex models of the economy, based on Keynesian principles, can offer reliable predictions and sensible prescriptions about economic policy.  For me, that issue was settled back in the early 1980s, in the laboratory of the real world.

I am left without a satisfying economic model-of-everything.  In this I suspect I’m not alone.

Reinhart & Rogoff Redux

Some pretty interesting information has come to light on the research performed by Reinhart and Rogoff on the relationship between growth and government debt levels.  Briefly, R&R’s 2010 paper,titled Growth in a Time of Debt, examined the relationship of public-sector debt to economic growth.  Their analysis showed average growth sharply lower above a public-sector debt level at 90% of GDP.  (U. S. public debt is now at 106% of GDP.)

It turns out that the two authors made a spreadsheet error in their calculations.  Instead of debt above 90% being associated with slight economic contraction (growth rate of -0.1%), the data support a reduced, but still positive, growth rate of +2.2%.  A pretty significant difference.  (Note that they reported a median growth rate of +1.9%.  We often catch our own analytical oversights when medians deviate significantly from averages.)

The issue of accuracy in a three-year-old academic paper is important, in large part because their analysis has been used by conservative politicians and commentators to argue against additional borrowing, and for more aggressive cutbacks in spending to achieve budget balance.

Yesterday, Reinhart and Rogoff made a sort of non-apology apology in The New York Times.  Krugman et al have been all over the authors, arguing that the pro-austerity argument has now been entirely exploded.

It may be worth noting that Rogoff was the Chief Economist for the International Monetary Fund from 2000 to 2003.  The IMF’s principal job is to help countries rescue their economies when public finances blow up.  What causes such blowups?  Pretty reliably, large public-sector deficits that trigger unaffordable borrowing costs.  Once you can no longer service your debts, you end up in the not-so-sheltering embrace of the IMF, which requires budget-balancing measures as one of the conditions for providing emergency funding.

We know that water runs downhill, and we know that enough water risks drowning you.  Reinhart and Rogoff suggested that we have quite an accurate measure of when the water level reaches our necks.  The recalculated data suggest the debt danger point is less precisely quantifiable than economists would wish; it is much more a continuum than a precise inflection point.  That does not change the historical observation that over-spending and over-borrowing, carried far enough, usually leads to be unpleasant consequences.

My concern remains that debt crises arrive without warning, even more so now that the Reinhard/Rogoff 90% tripwire has sharply-diminished predictive credibility.  Once a debt crisis hits, as it has surely done for dozens of nations over the last several hundred years, you are left without attractive policy options, and with no serious alternative to the most brutal austerity.

Musings on Cash

We have a client, a very smart physician, who loves to accuse us of market timing.  it is a wounding accusation, given the consistent contempt we’ve offered in our various communications for the idea of getting in and out of the market, based on fear and greed, on reading the tea leaves, even on (heaven forfend) listening to Jim Cramer.

If you sense a humbling confession in the offing, you are roughly on the mark.  But before I get to my pending self-abasement, let me reprise an argument against market timing, in the form of a story about one of my former clients.

Betty attended a class I taught at the local community college, back in the mid-1980s.  Recently widowed in her late sixties, she was taking over the management of her investments for the first time in her life.

She was an excellent student, and went well beyond the material in the basic investment course, asking for and reading more advanced books and articles.  On the basis of her reading and some of my comments in the course, she became convinced that the market was over-valued.  She sold all of her stocks and went to cash in late July of 1987.

Betty absolutely nailed the timing.  Late August was the market high, and within three months the stock market had fallen by more than 36%.  On October 19 of 1987, the market suffered its worst one-day point decline in history, down 508 points or 22.6%.

Did her perfect timing help her to enhance her wealth over time?  It did not.  She was convinced that she had a handle on market timing, and was determined to wait for the bottom before buying back in.

The market’s intra-day low actually occurred on Tuesday October 20, the day after the crash.  She did not buy back in on that day, or any other in 1987.  In fact, when I left the brokerage firm to start our investment advisory practice, more than two years later in early 1990, she was still entirely in cash, waiting for a market low that never came.

Getting the timing of an exit from the stock market correct is challenging.  It is far more likely that you will sell before a market advance, because you are scared, than near a high and before a decline, when market sentiment is positive.

But let’s assume you are considering either a full or partial move to cash when the market is acting well, as it has been so far in 2013.  (I’m ignoring the recent slide.)  Even if you get the sale right, you still have the challenge of getting back in.

Which brings us to the current market environment.  We are concerned about the valuation of the market.  By the measures we follow, the market is not cheap.  It is on the high side of fair value, but not (yet) in bubble territory. So we are in an environment of enhanced risk and constrained opportunity.

More on this in coming weeks.  And Doc (you know who you are), get ready to gloat.

Hedge Funds Still…Stink

Another data point in the stream of information confirming that hedge funds are a lousy bet.  This latest is a study by Robert Arnott of Research Affiliates, as reported on his firm’s web-site:

http://researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/F_2013_April_The-Lure-of-Hedge-Funds.aspx

Briefly, Arnott’s study shows that adding hedge funds to a portfolio systematically increases risk, and decreases returns.

Why do people keep buying an asset class with such high costs and low returns?  I think the answer remains the same — most investors are unhappy with the prospective returns in the financial markets, and smooth-talking salesmen convince them that higher returns are to be had in the hedge fund space.

As P. T. Barnum said, “There’s one born every minute.”

Just the Facts, Ma’am?

A client sent me a link to an interesting article, about what we have learned concerning the intersection of fiscal policy with financial markets.  The article’s author, PBS correspondent Paul Solman, makes some observations about who is honest enough to learn from their mistakes, and who is not.

It turns out Paul Krugman takes the prize in honest learning.  Back in 2003, Paul Krugman, New York Times columnist, Nobel laureate, and Princeton economics professor, trashed the Bush administration for failing to pay for its expensive wars, and predicted that financial markets would ultimately exact a heavy toll in the form of rising interest rates.

More recently, Krugman has been entirely on the other side of this debate, arguing strenuously that rates will not go up, regardless of how much the government spends or how large the deficits. That being the case, we should borrow liberally and spend hugely, in order to build infrastructure, hire teachers, or just dig holes and fill them up, all so we can get the economy moving again.  Fear of deficits, Krugman argues, is a sort of right-wing witch craze — irrational, ignorant and deliberately regressive in its policy effects.

With the national debt having doubled during the Bush years, and doubled again in Obama’s first term, I thought we were already borrowing like crazy, but Krugman believes that deficits in excess of $1 trillion a year actually represent dangerous austerity, and that our borrowing and spending should be much bolder.

On the other hand Gregory Mankiw, who was President Bush’s chief economic adviser back when Krugman feared rate-increasing deficits, recently made a point of juxtaposing Krugman’s 2003 comments with his recent position, wondering at the inconsistency.

It turns out this apparent inconsistency is simply intellectual growth on Krugman’s part.  He retracted his beliefs about the dangers of deficits in 2010, because (in his phrase), “My thinking has evolved. If you haven’t updated your views in the face of new experiences, you’re not doing your job.”  Solman of PBS approves of Krugman’s evolution, and observes that Mankiw remains stuck in error, still thinking budget red ink can result in higher interest rates.

I think this is the wrong conclusion to reach.  Here are my takeaways:

1) Economists, across the political spectrum, consistently over-estimate their ability to predict the future consequences of present acts.  They are hardly alone in this persistent error, which is characteristic of human beings as a species.  Research shows that sophisticated economic models are essentially valueless in predicting economic activity, from GDP growth to interest rates to unemployment.

2) Since the late 1970s, a variety of economic models have competed to predict the direction of interest rates.  In the late 1970s and into the 1980s, flow-of-funds models were dominant, which predicted that large public-sector deficits would “crowd out” private investment, driving up rates.  Instead, interest rates fell from 1981 to the present, even as deficits swelled during the Reagan years.  In the 1980s and into the 1990s, many economists switched to a rational expectations model, which asserts that rates will rise or fall according to the expectations of investors about the effects of economic policy.  After 2008, some conservative economists (not to mention radio talk-show hosts) predicted rates would rise as Fed stimulus triggered higher inflation. So far we’ve seen only modest inflation, and absolutely no rate spike. Another model bites the dust.

3) The greater the degree to which your economic perspective is informed by your political preferences, the more it compromises the value of your insights.  (I’ve talked about this at length in terms of investment decision-making.) What Krugman is engaging in here, and arguably Mankiw as well, is an adjustment of perspective based on whether the observer is sympathetic or opposed to the policy ends for which deficit spending occurs, and the political party engaged in the borrowing.

We seem to have wandered into a sort of parallel intellectual universe, in which Krugman, the Keynesian, is arguing that the bond market’s pricing of interest rates is so perfectly efficient that it deserves to be the final arbiter of the wisdom of public policy.  He is buying the efficient markets hypothesis in toto, less than five years after the EMH model’s spectacular failure in the financial crisis of 2008-09 cratered the entire world economy.

4)  So what is the relationship between deficits, debt, and interest rates?  Given the experience of Japan over the last twenty years, and of the U. S. over the last five, I think we must conclude that it is neither simple nor linear.  But are we really prepared to believe that debt and deficits are unrelated to inflation and interest rates, as Krugman appears to argue?  How then to understand the experience of Greece, Spain and Italy in recent years, the nightmare of rising inflation and interest rates in the United States in the late 1970s, and Argentina’s serial disasters every decade or so for the last century?

As I’ve noted in prior posts, rates stay low until they don’t, and if you have large debts when rates rise, you are in a world of hurt.  Once rates move, it is too late to fix your fiscal problems without profound pain.

My own conviction remains that our debt is perilous. The fact that we can borrow cheap does not mean it is smart to do so, any more than the fact that in 2007 a bank would give a McDonalds fry cook a half-million dollar negative amortization mortgage meant it would end well for either the bank’s balance sheet or the burger flipper’s credit rating.

I fear that both inflation and interest rates will rise at some point, and that we will eventually suffer a debt crisis, somewhat like Greece, somewhat like what we had in the late 1970s under Carter.  I think the size of our structural budget gap can’t be sustained long-term, and probably not medium-term.  Krugman disagrees.

Which begs multiple questions:  When?  How bad?  And what if I am wrong?

What’s Wrong with this Picture? (Stock Market Edition)

Since the market low in March 2009, the U. S. equity market has “climbed a wall of worry,” up more than 120% from the bottom through year-end 2012.  Yet until quite recently the bulk of new savings dollars flowed to bonds, not stocks.  A huge amount of cash remains on the sidelines, in money market instruments paying next to nothing.

In January, that picture began to change, with significant cash flows into the equity markets.  Is this the start of a new bull market, or only the end of a recovery rally within a long-term secular bear market?

I’m going to offer several data points, some making a bullish cash for equities, some a bearish case.  As I did with the election, I’ll list them in order of my perception of declining reliability, and note whether these are bullish or bearish indicators:

Here are a few of the arguments, just from the last two weeks:

There are few persuasive alternatives to stocks.  The universe of cash and bond investments yield too little to preserve lifetime purchasing power.  Cash has never been a successful long-term investment, but in the wake of QE3, with cash yields near zero for the foreseeable future, those with dollars on the sidelines are beginning to  understand their plight.  If they don’t buy now, when will they?  (Bullish.)

Portfolio managers are playing catchup.  With lots of dollars on the sidelines, earning nothing while the equity markets race toward new highs, money managers face pressure to get invested.  (See my recent post on hedge funds.)  Several smart folks make this point, but unfortunately Jim Cramer of CNBC’s Mad Money agrees.  Normally I would score this one bullish, but given that  Cramer is an utter horse’s behind, having him along for the ride is a bad sign.  (Neutral.)

Bullish sentiment is high.  The AAII Bull Index (American Association of Individual Investors) is in the top 5% of observed, the Greed Index is at a super-high level. Newsletter writers are also very bullish, and there have been ‘The Bull is Back’ headlines in several prominent financial publications. (Bearish.)

Cash is finally flowing into equities.  (Bearish, though if this is a bull market, and not a bear-market rally, we would expect to see much more than one month of positive equity flows before a final market top.)

The Dow Theory just issued a buy signal.  The Dow Transports hit a new high, following a post-crash high for the Industrials.  (Bullish, and less utterly meaningless than most technical indicators.)

The January effect:  As the market goes on the first trading day of the year, so goes the week.  As the market goes in the first week, so goes the month of January.  And as January goes, so goes the year. The S&P 500 was up 2.5% on January 2, up 5.2% for the month, the best start since 1997.  Since 1950, this indicator has only failed seven times, most recently in 2001.  (Bullish.)

The market is expensive.  Earnings are at an unsustainable high as a proportion of GDP, and those who think the market still has room to run are counting on the fantasy of  “forward operating earnings,” which are both meaningless and unpredictable.  When earnings mean-revert, the S&P will give up at least half of its post-2009 rise.  (Bearish.)

The market is cheap.  Priced against projected 2013 earnings, the S&P 500 is trading at only 13 times forward earnings.  Strong earnings growth and a return to the 2007 peak multiple will carry the market 16% higher in 2013.  (Bullish.)

The economy is strengthening.  Real estate prices are recovering, inventories of unsold homes are falling, and both consumers and business are spending more.  (Bullish.)

The economy is running out of steam. Jobless claims are up, as is unemployment, and the economy actually contracted in the fourth quarter.  (Bearish.)

Event risk remains high:  There are multiple potential market-crushing events on the horizon, including a debt ceiling fight in three months, another fiscal cliff showdown when the automatic sequester comes back into play, renewed European instability, the U.S. debt time bomb, a possible Israeli attack on Iran…and the beat goes on. (Bearish.)

Things are quiet in Washington.  Congress avoided default by temporarily raising the debt ceiling, and kicked the can down the road on spending. Could we be entering a new era of bipartisan compromise? (Bullish.  Until the next battle between two sincere, committed and incompatible political philosophies.)

The election cycle.  Historically, the first year of a Presidential term is on average negative for stocks.   (Bearish, but meaningless. While this is true on average, it is wrong about half of the time.)

The Superbowl Indicator:  When the NFC wins, the market goes up.  AFC wins, markets decline.  The Ravens from the AFC East just won the Big Game.  (Bearish.  And we’re kidding here, right?  Time to re-read Fooled by Randomness.)

From time to time, clients will ask, ‘How do you make sense of it all?’  The answer is that, in terms of reading all of the contrary voices every day, we don’t.  Most of this babble is just noise, useless for making prudent investment decisions, and we ignore it.  Instead, we look to long-term valuation measures, and we track six different relative-value ratios day-by-day.If the day-to-day is noise, what is the signal?

In terms of valuation, we start with the CAPE (Cyclically-Adjusted Price-Earning ratio), developed by Robert Shiller of Yale University, which connects the trailing ten-year price/earnings ratio to subsequent ten-year performance.  This measure shows the market slightly above the historical average price, with a projected future return of about 7%. (Neutral to slightly bearish.  More on this in a future post.)

The measures referenced above that seem most interesting to us are the large amount of cash on the sidelines, which suggests the possibility of a buying panic at some point, against the sharply-improved investor sentiment, which suggests a strong possibility of at least a short-term pullback.

Happy Days?

It is nice to know that I have not lost my mystical ability to move the markets at will.  I’m referring to the fact that I went on vacation last week, and the markets responded with a move toward new highs.  The same thing has happened before, most notably in March of 2009, when the Great Panic ended the day after I went on holiday.

My ability to single-handedly move markets, generating billions in profits for investors, including millions for our own clients, is both well-documented and entirely coincidental.

Now that we understand that I don’t actually deserve any credit for the strong advance in recent weeks, I will point out that we at TGS do deserve some credit for keeping our clients invested through the dark days of 2008 and 2009, and for remaining stubbornly over-weight stocks through the last two years, as Euro zone crises and Washington DC battles roiled the bourses.

From the market low almost four years ago, the S&P 500 is up more than 120%.  Finally, after a four-year recovery, we are beginning to see meaningful net inflows to stock mutual funds, and to hear more bullish voices.  (Dow 20,000, anyone?) Of course, both bullish sentiment and net stock flows are contrary indicators.  Investors are always most bullish at market highs, most bearish at market lows.

Now that the bullish case is beginning to gain broader credibility, we are becoming predictably more cautious.  I’ll offer some broader thoughts about the competing bull and bear cases in a future post.  For now, I’ll simply observe that few of today’s emerging bulls were buying stocks in fall of 2008 and spring of 2009, when we were backing up the truck and loading up on equities.

What is Broken, and What is Not

Last week I was in Palo Alto, California for a two-day conference at Singularity University, a think tank created to address the fast-moving effects of the information-technology revolution on the world.  Presenting at this event were Peter Diamandis, creator of the X Prize, and Ray Kurzweil, inventor and futurist.

Diamandis discussed a spectrum of the world’s most urgent issues, such as clean water in the developing world, and detailed how new technology will radically improve the lives of the poorest billion people in the world within the next decade.  To give a single example, inventor Dean Kamen has created a box the size of a washing machine, called a Slingshot, that can process even the most polluted water source, producing 1,500 liters a day of water clean enough to use for medical injection.  This single invention, once disseminated to poor communities in Africa and Asia, could save millions of lives each year.

It was an inspiring presentation by two extraordinarily bright and energetic guys.  Flying back Friday night, my head was buzzing with possibilities and action plans.  Until I got off the airplane and got to work finishing my recent post on the fiscal cliff deal. Thinking about our nation’s failure to address our long term fiscal imbalances will surely beat the optimism right out of you.

I feel it necessary to make a point about public policy, which hopefully will not be seen as a partisan comment on the current Washington stalemate.  The crisis of our time is fundamentally a crisis of government — of its size, cost, power and purposes.

Back in 2008, many on the Left believed we faced a crisis of capitalism and free markets, red in tooth and claw, susceptible to correction by energetic new regulation and equally energetic new spending.  Then Greece blew up, followed by Spain and Italy, with France in the on-deck circle. There is a growing recognition, across the political spectrum, that changing demographics, large debt overhangs, and slower economic growth all contribute to a crisis of the modern welfare state.

Saying that we face a crisis of government does not suggest that government is bad or useless, any more than having your cardiologist tell you, after a heart attack, that cardiac disease is the greatest risk to your health suggests that your heart is a bad or useless organ.  I will leave open for the moment questions about whether government is the only thing we have in common, should be shrunk small enough to be  drowned in a bathtub, must be fixed by tax increases or spending cuts (or both), should regulate more or less, and ignore the question of which party is the bigger obstacle to solving our problems, and when and whether they will eventually be resolved.

For now, my intent is simply to note that government is the place, within the vast and complex workings of our modern mixed economy, that the decision-making structures are so dysfunctional, the inputs and outputs so fundamentally out of sync, the promises so inconsistent with the resources, and the potential financial consequences so negative and profound, as to imperil the operation of the rest of the mechanism.

Here is a small thought-experiment to test whether I am right.  If the lead story on tonight’s news was that Congressional leaders had met in secret over the weekend, and had emerged with a bipartisan deal including a restructure of the tax code; a bold infrastructure construction program valued at $500 billion and suspending Taft-Hartley contracting restrictions; reform of Social Security and Medicare, raising the retirement age and partially means-testing benefits; reform of Sarbanes-Oxley, reinstatement of Glass-Steagall, imposing taxes on too-big-to-fail financial institutions (is this list long enough yet?)…if all this happened, would you not feel more optimistic about the future?

Now, let’s turn this around and look at it from the other side.  Identifying government as the thing that is broken, without requiring ourselves to take sides on how it should be fixed, lets us open ourselves up to the reality that there are vast open meadows of human endeavor, apart from government, that not only are not broken, but offer possibilities for progress that have rarely been observed in human history.

Over the next decade, more than one billion new brains and voices will join the global conversation, connected online with smartphones, ready to invent, produce, consume and discuss.  This is great news.  We just need to be willing to hear it.

Naked, But Damn Rich

We like it when facts confirm our opinions.  Probably a better way to phrase that is, we like it when our fact-based insights are ultimately recognized as true by a broader universe of more mainstream opinion.

You don’t get much more mainstream than The Economist, the venerable British newsmagazine.  One of the leads in their December 20 edition was an article on hedge funds, a particular bete noire of ours for many years, titled Going Nowhere Fast.

As of the article’s publication date, the trailing one-year return of the HFRX index of hedge funds was +3%, compared to an +18% return for the S&P 500.  Even worse, hedge funds under-performed the S&P 500 for nine of the last ten years, and under-performed a standard 60%/40% balanced portfolio by a cumulative 73% over ten years.  (Balanced portfolio: 90%, hedge funds: 17%.)

Which begs the question:  Why in the world does any sensible investor put his money in a high-cost, low-return investment with impossible-to-quantify risk? 

Our position remains the same — the hedge fund emperor has no clothes.  Hedge fund managers are paid ridiculously well for doing a bad job for most investors most of the time, while periodically putting the world’s financial markets at risk as an unintended by-product.

There is nothing in the performance of the asset class as a whole that justifies the standard fees of 2% of capital and 20% of profits.  Quite the contrary, as documented above and in The Economist.  I think Jean-Marie Eveillard, former First Eagle and SoGen mutual fund manager, said it best:  “Hedge funds are a compensation structure, not an investment strategy.”

Remember my post of a few weeks back, about Steven Cohen of hedge fund SAC Capital?  His own money represents $8 billion out of $14 billion in his fund.  In no non-financial business of similar size, anywhere in the world, do the managers, rather than the investors, reap such an utterly disproportionate share of the total rewards of the enterprise.

In my mind, the strong performance of a small number of hedge funds does not justify including this asset class in a prudent portfolio strategy.  This is even more true given the gruesome history of some of the top-performing hedge funds of the last two decades.  Among high-flying funds that suddenly lost most or all of their value are Long-Term Capital Management (lost $4 billion in weeks in 1998, 95% of prior capital, and almost tanked the financial system), John Paulson’s Advantage Plus Fund (lost 51% in 2011 and 19% in 2012), and the two Bear Stearns High-Grade Structured Credit funds (lost 98% and 100% respectively in the 2008 financial crisis).

Over time, the primary marketing hook for hedge funds has changed from superior performance (not much of that visible) to diversification benefits.  If diversification is the goal, do investors really need to pay such punitive fees to acquire it?  After all, investors in equities are moving steadily away from actively-managed funds and toward index offerings.

What is the alternative to hedge funds?  From time to time, we have considered engaging that question directly, through an alternative design based on the underlying architecture of our proprietary DYCOPS asset allocation process.  For now, though, we’re content to just trash the competition.

The Price of Pessimism

Over the last year, one of the primary drivers of market action has been the continuing crisis of the European Union. Europe’s agony is structural not cyclical, as the continent struggles to reconcile stagnant economies and aging populations with the costly promises of the modern welfare state.

In our White Paper, They Came for the Greeks, we shared our concern that our own budget challenges, here in the United States, are fully as serious as those in Europe.  Indeed, several European governments have made fundamental and effective budget reforms far beyond those contemplated in the current political negotiations between Democrats and Republicans in Washington.

If our problems are so severe, how are we integrating our structural concerns about the U.S. economy into our investment process?  To place this in a more colloquial context, how can we justify being over-weight stocks when Western civilization is going straight to hell?

We reject the strategy of going on strike against financial markets until John Galt returns from his mountain fastness, or the Republicans get control of Washington again, or the United States returns to the gold standard.  Which would, by the way, make it the only country in the world with currency backed by the yellow metal. Somehow Switzerland, Sweden and Singapore manage to preserve the real long-term values of their currencies without the strait-jacket of gold.  (If you want to get an idea of the limitations of the gold standard, look at British incomes from 1927-1931, when Churchill put the pound back on gold at pre-Great War parity.)

Well, why not a return to a more personal gold standard?  If the U.S. government refuses to support the real value of the buck, why not convert our own portfolios to gold?  We’ve covered this ground before in other posts.  Gold has no economic return.  Converting your assets to gold only works if you already have enough wealth to buy a lifetime supply of tuna fish, gasoline and the other necessities of life.

So do we just ignore the potential fiscal calamity?  In terms of choosing which assets to own, yes.  Our default assumption is that something scary that features prominently on the front page of the Wall Street Journal several times a week may already be fully discounted by the markets.

But we think the debt picture can reasonably be reflected in another aspect of our financial advice, in the form of our capital markets assumptions.  We use these most notably to project the sustainable lifetime cash flow from an investment portfolio.  Borrowing from recent research by Rogoff and Rinehart, with U. S. Federal debt now in excess of 100% of GDP, we plan to reduce our baseline return expectation for U.S. economic growth, and therefore for stocks, by 1%.

In short, we’ll continue to use the best tool we have (relative valuations) to decide what to own, and improve the best tool we have to project lifetime cash flows.  And keep smiling.