Consensus vs. Confidence, Blog-Style

Last week I was on a bike trip with my old friend Mike, who is also a client.  I showed him my first blog post.  He read for a minute or two, and then told me, “This is not a blog entry, it is a magazine article, and not a very interesting one.”  So here is my revision of my first-ever post, hopefully shorter and more to the point.

In the 1990s and 2000s, the two parties fought like heck about issues on the periphery of economic policy — Bill Clinton’s zipper issues, George Bush’s wars.  Today they are fighting about issues at the center of policy.  What should the Federal Reserve do?  Should we have one?  Should we refuse to raise any taxes?  Should we tax millionaires at 90% plus?  Should we make changes to Social Security to reflect demographic reality, or fight to the very last inflammatory adjective to keep the program unchanged?

Investors recognize that a prior benign consensus has broken down, and bipartisan agreement on policy is very unlikely.  This leads to a fundamental lowering of confidence in Washington, in Wall Street, and even about the future of the American experiment.

How does this broken confidence affect the investment markets?  We think it is reflected not as a discount function (structurally lower stock prices), but as a volatility multiplier.  Each piece of bad news leads to a sharp decline.  Contrasting good news drives a sudden rally.

Since our valuation metrics suggest that long-term stock returns will be in the 4% to 7% range, and that bond returns will be flat-to-negative, we have an ugly picture — low returns combined with high risk (measured by volatility).  We don’t like it any better than you do.  We still need to earn positive returns somewhere, and low returns (stocks) are better than no returns (bonds and cash).

At least, that is how it looks to us.  Even though we have changed our manager selections significantly, tilting toward investments with historically lower volatility, it is still a darn bumpy ride.


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