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.

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