Things We Think We Know
“It ain’t so much the things we don’t know that get us into trouble. It’s the things we know that just ain’t so.”
I’ve been writing some more optimistic commentaries recently – or maybe just less pessimistic – and the response has been interesting to say the least. I don’t remember so many people telling me how dumb I am since 1999 when I had the gall to question the wisdom of paying over 100 times earnings – and sometimes even more – for the average tech stock. Back then the bulls were absolutely certain that we had entered a new paradigm of prosperity and that I just didn’t get it. Now the bears exhibit similar levels of confidence about their forecasts of doom and apparently I still don’t get it. They may be right I suppose and they do seem to have the facts on their side. All I’ve got is several decades of market experience, a healthy skepticism of conventional wisdom and a belief in the wonders of markets.
One thing I will agree with the bears on is that the world has a lot of problems right now. The US economy is slowing and with little chance of any policy response other than another round of money creation by the Fed, it seems logical to assume that it will continue to do so. Europe is a mess. China is slowing down. Emerging markets that depend on China are slowing down. Japan, as John Mauldin has put it repeatedly, is a bug in search of a windshield. Bond markets are trading at yields so low it is hard to imagine any chance for capital gains outside a depression. Things are so bad in Europe that German and Swiss bonds are offering negative yields for large portions of the curve. So, yes, there are a lot of problems in the world.
This only scratches the surface of the bear case and I could go on but frankly it’s depressing and gives me a headache trying to fathom how we got ourselves in such a mess. The thing I keep coming back to though is that all these things are already known by pretty much everyone and if markets are efficient at all, should already be baked into the market cake. I’m no believer in the strong version of the efficient markets hypothesis but even the weakest version would seem to be able to incorporate the plethora of bearish information.
When I got in this business way back in 1991, my mentor was a veteran broker named Larry Gatto, God Rest His Soul. Larry had been in the markets for decades by then but he took me under his wing and even to this day, I rely on the wisdom he shared with me so long ago. One of the first things he told me was that it was a waste of my time to worry about the things that everyone else was worrying about. As he put it, there’s no profit in the present. He told me that it was my job to be an optimist when being a pessimist was stylish and to do my worrying when everyone else was unconcerned. That bit of wisdom has served me well for over two decades and while I’m sure I’ll get plenty of mail telling me why it’s different this time, I don’t think human nature has changed all that much in that time. And markets are still about people and the emotional baggage they carry from the recent past.
I will be the first to admit that the bull case is pretty thin and it is tempting to just throw in the towel and go along with the crowd. That would certainly be the comfortable thing to do. But I don’t get paid to do the comfortable thing; I get paid to make the hard decisions that our clients can’t or won’t make on their own. In short, I (we) get paid to make money for our clients and it has been my experience that the comfortable is rarely synonymous with the profitable. And so I spend my days trying to think of ways the bear case could be wrong.
I think the most obvious way the bears could be wrong, at least about the US economy, is that we are on the receiving end of all the capital that is now fleeing worse places in the world. There is plenty of evidence that despite attempts to prevent it, capital is leaving China and searching for safer environs. The same can be said about the rest of the emerging world and Europe. I live in Miami and the condo inventory that many believed would take decades to work off is gone, sold to Brazilians, Venezuelans and Europeans. The dollar has been rising relative to other currencies and even gold is down nearly 20% from its peak and basically flat over the last year. Despite the recent inverse correlation of the dollar and stocks, history tells us that a rising dollar is more often associated with rising stock markets than falling ones. If we learned nothing over this last decade it should be that capital flows matter and matter a lot.
A side effect of that capital inflow and a rising dollar is the effect on commodity prices. While oil has rallied over the last few weeks – possibly in anticipation of QE3 – it is still well off the highs of 2011 and earlier this year. Other commodity prices are also well off their highs with the GSCI commodity index down 15% from its post QE2 high. This trend is somewhat muted by the recent rise in agricultural prices because of the drought but it isn’t an insignificant factor for the US economy. Even after the recent rally, crude oil prices are down $17/barrel since March which equates to almost $120 billion annually that can be spent on something other than crude oil. Yes, it is in some ways just a shift from oil company profits to some other industry but in the long run we’ll be better off using our capital on productive investment rather than holes in the ground. A similar story can be told about the drop in natural gas prices over the last few years.
In Europe, it is hard to darn near impossible to see a positive outcome from the debt crisis. I tend to think the Euro will stay together for now if for no other reason than there has been so much political capital – and real capital for that matter – invested in the project that the politicians will do almost anything to keep it together. If that is true, then Spain, Italy and the other PIIGS will have to suffer through their internal devaluations but I think we should remember that the law of supply and demand has not been repealed. As other countries have discovered there is life after austerity. Eventually prices do fall to the clearing level and growth resumes. How far are we from that point? I don’t know but I doubt unemployment in some of the PIIGS – Spain for instance – can go much higher. I suppose it is still possible that the Euro comes apart but I wonder if the fear of that isn’t greater than the reality. If it did, we might get a real world test of whether Too Big To Fail is just something cooked up by bankers to protect bankers. I suspect reality would be a lot less dire than the predictions.
If we’re worried about countries with a lot of debt we have to stop by and fret about Japan which has the highest debt/gdp ratio among the major developed economies. Several analysts have pointed out that as their aging society draws down savings, Japan will be forced to finance their deficits externally. Everyone is sure this means that interest rates in Japan have to rise and as many have pointed out, it doesn’t take much of a rise before the entire Japanese budget is taken up by interest payments. Well, I’m going to bet that someone over at the Ministry of Finance and the BOJ have access to calculators too and they’ll do their best to make sure this doesn’t happen. My guess is that the BOJ will be buying a lot of JGBs over the next decade and the Yen will probably head south as a result. Stop and think for minute what a Yen at 100 or 125 or even 150 means for corporate Japan. I don’t think you’ll hear any complaints from Toyota or Nissan.
This is getting long so I won’t bore you with why I think China isn’t the threat everyone seems to believe. Suffice it to say that it is still a very poor country and has many ways to continue growing. And even if it slows in the short term, the relief from lower commodity prices that would accompany that may be more beneficial to the global economy than any forced growth through government directed malinvestment.
I am not unconcerned about all the problems facing the world, but if the vitriol of the bears in my inbox is any indication of sentiment it seems unlikely that there is any profit left in betting on the end of the world. If you really believe we are headed for a depression then by all means, buy those 10 year Treasury Notes yielding 1.5%. Just remember that if you’re wrong, you and everyone else who’s been plowing money into bonds over the last 4 years will need to find a buyer. Crowds are perfectly safe – until something spooks them and the stampede starts. I may be wrong in the short term. We could easily slip back into recession and stocks would probably fall if we do. I’m not suggesting that anyone go “all in” right now. But the bears seem way too sure of themselves at this point and with everyone worried about how things could go wrong, it might pay to think about how things could go right. Sometimes it is the things we are most sure about that get us into trouble. By the way, that quote at the top of this post is almost always attributed to Mark Twain. There’s just one problem with that – Mark Twain didn’t say it. It is more likely a cleaned up version of something Josh Billings, a contemporary of Twain’s, said: “You’d better not kno so much than know so many things that ain’t so.” Ain’t irony a hoot?
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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