The financial press this year has been filled with stories about the economic slowdown in China and the debt crisis in Europe.  Opinions on Chinese growth this year have ranged from dire (a hard landing involving a growth rate most countries would still envy) to bad but not as dire (a soft landing). All the talk of China and its Asian neighbors has been negative to one degree or another and China’s economy has definitely slowed from the 11% or so of recent years to a rate closer to 7 or 8%. In Europe, the debt crisis has moved from one phase to another throughout the year and even today seems far from resolved. Germany’s economy has slowed all year and while it isn’t in recession yet, there seems to be a consensus that it will be shortly. Spain, Italy and their southern neighbors are all still in varying degrees of recession or depression and France is, well, France. If the financial press is to be believed, nothing good happened in Europe in all of 2012.

The press and pundits haven’t been much more kind about the US economy than they have with the foreign ones. We’ve been bombarded all year by pundits predicting a recession that has yet to arrive. They may yet be right – some of the data that Jeff Snider has been highlighting recently is very concerning – but so far the US economy has continued its slow growth ways. As the year comes to an end, all the talk is about the fiscal cliff and the allegedly dire consequences of going over. Even the optimists in this debate acknowledge the negative economic effects of higher taxes and reduced government spending.

For all the economic crystal ball gazers out there, who largely got it right about the direction of the global economy, I have just one question: What benefit did all your economic prognosticating provide for investors? You were right, China’s economy did slow down. You were right, the rest of Asia also slowed. You were right, the European economy is in recession and the debt crisis is still with us. You were right, the US economy did slow down (although we appear to have avoided recession so far). Unfortunately, for all your accuracy about the global economy, anyone who hunkered down in fear that you would prove right missed some pretty good stock market gains. The Asia Ex-Japan ETF (EPP) is up over 20% this year. The China ETF (FCHI) is up nearly as much (19.8%). (Yes, I know the mainland Chinese stock market has had a bad year, but do you know anyone here who owns those stocks?) Hong Kong (EWH) is up over 26%. Recession ravaged Europe (EZU) is up almost 18%. And of course, the US stock market (SPY) is up 13%. All of those figures, by the way, do not include dividends so the total return to investors is even higher.

Figuring out the state of the economy and at least having a notion about its future direction is important information for investors. We spend a lot of time and effort doing both of those things and I think we’ve done a pretty good job of it. But investing, as this year has amply demonstrated, is not just about determining the likely future direction of the economy. The magnitude of the change is also important – a slowing of growth does not have the same impact as a recession. Sentiment – figuring out what the majority expects – is the critical variable for investors. If the expectations of the majority are not realized, they will have to adjust their portfolios to reflect reality and their new expectations. Markets move based on these changing expectations.

Economics is not a science. There is no methodology that will allow you to forecast the direction and magnitude of changes in economic growth or any other economic variable. Even if a method were discovered, once it was known by a sufficiently large group of investors, its effectiveness as a market forecasting tool would erode to the point where its value would be diminished if not rendered completely useless. So, if the future course of the economy cannot be predicted with any degree of accuracy, what good are economic forecasts? As investors, if we can’t figure out what economic growth and inflation will be next year, how can we invest with any degree of confidence?

Economic forecasts are valuable primarily for the information they provide about expectations. Economists are human too – well most of them – and like all humans they seek the comfort of the crowd. Forecasts tend to cluster with the few odd outlier predictions. For investors, the outliers are much more interesting than the consensus. If the consensus is to be wrong, how will they be wrong? Will they be too optimistic or too pessimistic? The consensus isn’t interesting to an investor because if it is realized, the market will have already incorporated that information into current prices. It is much more profitable for investors to concentrate on the outliers, determine how the consensus will be wrong and invest accordingly.

Figuring out current sentiment is not an easy task. I read constantly – across a wide variety of publications, not just financial press – to try and get a sense of the market mood. We use a variety of indicators from put/call ratios to short interest to the myriad sentiment polls and economic forecasting polls. All of them have their drawbacks and they are often contradictory. However, if you look for extremes in sentiment they aren’t as hard to identify. At big market turning points, sentiment is generally pretty uniform, either boisterously optimistic or dourly pessimistic. Those are the times when investors can act as true contrarians with a degree of certainty. It still isn’t easy to buck the crowd and buy the thing that everyone hates but it is generally profitable. It is also very difficult to sell the object of everyone’s desire, especially if you are sitting on a capital gain and will have to surrender some of it to the tax collector, but again it is generally profitable.

As I said in a recent commentary, investing and economic forecasting is not merely a matter of simple math. Heck, it isn’t even a matter for advanced math. Investing successfully requires an ability to figure out the consensus and then figure out how it may be wrong. It requires the ability to avoid things that everyone “knows” are good and buy the things that everyone “knows” are bad. In that commentary, I highlighted a broker who had advised his clients to sell stocks and buy muni bonds due to his fears about the fiscal cliff. In case you didn’t notice, the muni bond market took a big hit last week and stocks have now recovered all their losses since the election. Why did muni bonds take a dive last week? As part of the negotiations to avoid the cliff, there is now discussion that the federal government may tax some muni bond interest. The market has a mean, ironic streak.

By the way, the emerging consensus about next year’s economy is that the first half of the year will be weak due to the effects of the fiscal changes and the second half much better. That seems entirely logical and my guess is that it will be exactly wrong. I don’t know how it will be wrong but it is too neat and simple to be correct. This is probably my last commentary this year unless something really important happens but I’ll be pondering the possibilities over the next couple of weeks. Have a Happy Holiday season and I’ll talk to you next year.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773.

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