``Economics is not about goods and services; it is about the actions of living men. Its goal is not to dwell upon imaginary constructions such as equilibrium. These constructions are only tools of reasoning. The sole task of economics is analysis of the actions of men, is the analysis of processes.”- Ludwig von Mises Logical Catallactics Versus Mathematical Catallactics, Chapter 16 of Human Action
Marketing guru Seth Godin has this fantastic advice on quality,
``When we talk about quality, it's easy to get confused.
``That's because there are two kinds of quality being discussed. The most common way it's talked about in business is "meeting specifications." An item has quality if it's built the way it was designed to be built.
``There's another sort of quality, though. This is the quality of, "is it worth doing?". The quality of specialness and humanity, of passion and remarkability.
``Hence the conflict. The first sort of quality is easy to mandate, reasonably easy to scale and it fits into a spreadsheet very nicely. I wonder if we're getting past that.
In essence, everything we do accounts for a tradeoff. When we make choices it’s always a measure of acting on values.
For instance, the “quality” of providing investment advisory is likewise a tradeoff. It’s a compromise between the interests of investors relative to the writer and or the publisher. It’s a choice on the analytical processes utilized to prove or disprove a subject. It’s a preference over the time horizon on the account of the investment theme/s covered. And it’s also a partiality on the recommendations derived from such investigations.
So “meeting specifications” which is the conventional sell side paradigm has mainly the following characteristics, it is:
-short term oriented (emphasis on momentum or technical approaches),
-frames studies based on “spreadsheet variety” (reduces financial analysis to historical performance than to address forward dynamics),
-serves to entertain more than to advance strategic thinking,
- promotes heuristics or cognitive biases
-upholds the reductionist perspective or the oversimplified depiction of how capital markets work and
-benefits the publisher more than the client (Agency Problem)
Yet many don’t realize this simply because this has been deeply ingrained into our mental faculties by self serving institutions that dominate the industry.
And instead of merely meeting the specifications which is the norm, here we offer the alternative-the “is it worth doing?” perspective.
Why?
-Because we realize that successful investing comes with the application of the series of "right" actions based on the “right” wisdom and rigorous discipline.
And with “right” wisdom comes the broader understanding of the seen and unseen effects of government policies that IMPACT asset markets or the economy more than just the simplistic observation that markets operate like an ordinary machine with quantified variables.
-Because government policies shape bubble cycles which underpins the performance of asset prices.
Think of it, if markets operate unambiguously on the platform of “valuations” or the assumption of the prevalence of rational based markets, then bubble cycles won’t exist.
Hence, the failure to understand policy directions or policy implications would be the Achilles Heels of any market participant aspiring success in this endeavor.
For instance, with nearly 90% of oil reserves or supplies under government or state owned institutions, any analysis of oil pricing dynamics predicated on sheer demand and supply without the inclusion of policy and political trends would be a serious folly or a severe misdiagnosis.
Of course, money printing by global central banks adds to the demand side of the oil equation. Moreover, price control policies can be an interim variable. The recent attempt to curb speculative trading in oil can be construed as a significant factor for the recent oil collapse in oil prices.
-And also because I try to keep in mind and heart Frederic Bastiat’s operating principle, ``Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, - at the risk of a small present evil.”
In short, the seen and unseen effects of policy actions and political trends are the operating dynamics from which underlines our “is it worth doing?” perspective.
Financial Markets As Fingerprints
We have repeatedly argued against the mainstream and conventional view that micro fundamentals drives the markets [see Are Stock Market Prices Driven By Earnings or Inflation?].
Stock markets, for us, have been driven by principally monetary inflation, and secondarily from sentiment induced by such inflation dynamics. All the rest of the attendant stories (mergers, buyouts, fundamentals such as financial ratio, etc…) function merely as rationalizations that feeds on the public’s predominant dependence on heuristics as basis of decisions in a loose money landscape.
In an environment where liquidity is constrained, no stories or financial strength have escaped the wrath of the downside reratings pressure.
The disconnect between market price actions over the performance of corporate financials or the domestic economy have been conspicuous enough during the last bull (2003-2007) and bear cycles (2007-2008) to prove our assertion.
Moreover, up to this point our skeptics haven’t produced any strong evidence to refute our arguments. Instead we had been given a runaround, alluding to some regional securities as possible proof of exemptions.
Here we discovered that inflation and inflation driven sentiment seem to apply significantly even in the more sophisticated markets of Asia as well.
So, instead of weakening our arguments, the wider perspective has even reinforced it.
Moreover, financial markets shouldn’t be seen as operating in uniform conditions. Such reductionist view risks glossing over the genuine internal mechanisms driving the markets. The underlying structure of every national financial markets appear like fingerprints-they are unique.
For instance, they have different degrees of depth relative to the national economy as seen in Figure 1.
Figure 1: McKinsey Quarterly Mapping Global Capital Markets Fifth Annual
The McKinsey Quarterly map reveals of the extent of distinction of financial market depth across the world. Yet growth dynamics are underpinned by idiosyncratic national traits.
So it would be an “apples to oranges” fallacy to take the Philippines as an example to compare with the US markets or other markets in trying to ascertain the degree of “fundamentals” affecting price actions versus the inflation perspective.
Finding scant evidence that the Philippine market is driven by fundamentals, we’ll move to ascertain the impact of inflation to US markets-the bedrock of the capital markets.
The US has deeper and more sophisticated markets, where [as we pointed out in PSE: The Handicaps Of A One Directional Reward Based Platform] investors can be exposed to profit from opportunities in all market directions- up, down and consolidation, given the wide array of instruments to choose from, such as the Exchange Traded Funds, Options, Derivatives and other forms of securitization vehicles.
This leads to more pricing efficiency in relative and absolute terms.
This also implies that deeper and more efficient markets tend to be more complicated. Nonetheless this doesn't discount policy induced liquidity as a significant variable affecting asset pricing.
In lesser efficient markets as the Philippines or in many emerging markets, the lesser the sophistication and the insufficient depth accentuates the liquidity issue.
The fact that the broad based global meltdown in 2008 converged with almost all asset markets except the US dollar, had been a reflection of liquidity constraints as a pivotal factor among other variables.
S&P 500 Total Nominal Return Highlights Rapid Inflation Growth!
Since we don’t indulge in Ipse Dixitism, the proof in the pudding, for us, is always in the eating.
Figure 2: Investment Postcards: Components of Equity Returns
This excellent chart from Prieur Du Plessis’ Investment Postcards (see figure 2) showcases the categorized return of equity capital since 1871. That’s 138 years of history!
Says Mr. Plessis, ``Let’s go back to the total nominal return of 8.7% per annum and analyze its components. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 1.8% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!”
While it is true that dividends accounted for as the biggest growth factor in equity returns in the S&P 500 benchmark yet, where inflation so far has constituted about 25.3% (2.2%/8.7%) of total returns, what has been neglected is that rate of growth of inflation has far outpaced the growth clip of both capital and dividend growth.
Notice that inflation had been a factor only since the US Federal Reserve was born in 1913. Prior to 1913, equity returns had been purely dividends and capital growth.
And further notice that the share of inflation relative to total returns has rapidly accelerated since President Nixon ended the Bretton Woods standard by closing the gold window in August 1971 otherwise known as the Nixon Shock.
To add, the share of inflation has virtually eclipsed the growth in real capital!!!
In other words, investing paradigms predicated on the pre-inflation to moderate inflation era will unlikely work in an environment where inflation grows faster than dividends or capital.
Hence it is a folly to latch on to the beliefs of “fundamental driven” prices without the inclusion of policy induced inflation in the context of asset pricing.
This is a solid case where past performances don’t guarantee future outcomes!
To further add, if inflation has a growing material impact to the pricing of US equity securities, then the degree of correlation with the rest of the global markets must be significantly greater under the premise of market pricing efficiency.
Policy Induced Volatilities Against Mainstream Fundamentalism
Here is more feasting on the pudding (this should make me obese).
Figure 3: Hussman Funds Secular Bear Markets And The Volatility Of Inflation
Another outstanding chart, see figure 3, this time from William Hester of Hussman Funds.
Mr. Hester uses the volatility of inflation as a proxy for economic volatility.
In the chart, low inflation volatility extrapolates to higher price P/E multiples and vice versa.
Here it is clearly evident that when volatility is low, bubble valuations emerge (left window), whereas the regression to the mean from excessive valuations occurs when volatility of inflation or economic volatility is high (right window).
Mr. Hester adds, ``It's not only the level of volatility and uncertainty in the economy that matters to investors, but also the trend and the persistence in this uncertainty. Shrinking amounts of volatility in the economy creates an environment where investors are willing to pay higher and higher multiples for stocks, while growing uncertainty brings lower and lower multiples.” (bold highlight mine)
So, it isn’t just economic volatility (as signified by inflation) but uncertainty as a major contributory factor to the gyrations of price earning multiples.
And where does “uncertainty” emanate from?
It is rooted mostly from government intervention or political policies instituted by governments, such as protectionism, subsidies, higher taxes et. al.. or any policies that fosters “regime uncertainty” or ``pervasive uncertainty about the property-rights regime -- about what private owners can reliably expect the government to do in its actions that affect private owners' ability to control the use of their property, to reap the income it yields, and to transfer it to others on voluntarily acceptable terms” as defined by Professor Robert Higgs.
In actuality, Mr. Hester’s technical observations of the proximate correlations of inflation and price/earnings multiples is a reflection or a symptom of the operational phases of the business cycles.
As depicted by Hans F. Sennholz in the The Great Depression, ``Like the business cycles that had plagued the American economy in 1819–1820, 1839–1843, 1857–1860, 1873–1878, 1893–1897, and 1920–1921. In each case, government had generated a boom through easy money and credit, which was soon followed by the inevitable bust. The spectacular crash of 1929 followed five years of reckless credit expansion by the Federal Reserve System under the Coolidge administration.” (bold highlights mine)
So it would be plain shortsightedness for any serious market participants to blindly read historical “fundamental” performances and project these into future prices while discounting political or policy dimensions into asset pricing.
As we noted in last week’s Inflation Is The Global Political Choice, the financial and economic milieu has been hastily evolving post crash and is likely being dynamically reconfigured from where asset pricing will likewise reflect on such unfolding dynamics, ``the unfolding accounts of deglobalization amidst a reconfiguration of global trade, labor and capital flow dynamics, which used to be engineered around the US consumer, will likely be reinforced by an increasing trend of reregulations which may lead to creeping protectionism and reduced competition and where higher taxes may reduce productivity and effectively raise national cost structures, as discussed in Will Deglobalization Lead To Decoupling?”
Hence, any purported objectives to attain ALPHA without the context of the measurable impact from policy or political dimensions over the long term are inconsistent with the intended goals.
Instead, these signify as lamentable and plaintive quest for short term HOLY Grail pursuits which is not attributable to investing but to speculative punts.
Hence, traditional “fundamentalism” serves as nothing more than the search for rationalizations or excuses that would conform to cognitive biased based risk taking decisions.
It’s not objectivity, but heuristics (mental shortcuts or cognitive biases) which demands for traditional fundamentalism metrics since evolving market and economic realities and expectations don’t match.
Under A New Normal, Old Habits Die Hard
London School of Economics Professor Willem Buiter [in Can the US economy afford a Keynesian stimulus?] makes the same policy based analysis when he predicts that the US will prospectively underperform the global markets due to the political direction,
``There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard.” (bold highlights mine)
Indeed, old habits, mainstream but antiquated beliefs are even more difficult to eliminate.
Figure 4: John Maudlin/Safehaven.com: Buddy, Can You Spare $5 Trillion?
In an environment where the dearth of capital will be overwhelmed by the expansive liabilities of global governments deficit spending policies [see figure 4], the underlying policy trends will determine, to a large extent, the dimensions of asset pricing dynamics.
And as we noted last week, deficits won’t be the key issue but the financing. Here a myriad of variables will likely come into play, ``the crux of the matter is that the financing aspect of the deficits is more important than the deficit itself. And here savings rate, foreign exchange reserves, economic growth, tax revenues, financial intermediation, regulatory framework, economic freedom, cost of doing business, inflation rates, demographic trends and portfolio flows will all come into play. So any experts making projections based on the issue of deficits alone, without the context of scale and source of financing, is likely misreading the entire picture.”
Yet, like us, PIMCO’s Bill Gross in his June Outlook sees a “New Normal” environment where investing strategies will have to be reshaped.
``It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.” (bold highlights mine)
So yes, ALPHA can only be achieved with respect to the understanding of the scope and scale of policy and political trends and its implication to the sundry financial assets and to the global and local economy as well as to industries. For instance, industries that have endured or will see expanded presence of the visible hand of governments will have systemic distortions that may nurture bubble like features of expanded volatility or could see underperformance over the long run.
And any models or assumptions built around traditional metrics are likely to be rendered less effective than one which incorporates political and policy based analysis.
In short, like it or not, in the environment of the New Normal, government inflation dynamics will function as the zeitgeist which determines financial asset pricing trends.
This brings us back to the issue of quality. For us, in almost every sense, it appears that the "is it worth doing?" perspective is the more profitable approach than simply abiding by the conventional “meeting specifications”.
Nonetheless for those who can’t rid themselves of such archaic habits, we suggest for them to enroll in local stock market forums where traditional fundamental information from diverse sellside sources or even rumor based information can possibly be obtained for free! Forums are recommended sources of information for short term players seeking market adrenalin and excitement.
