In yesterday’s post, I outlined the Pimco investment case, contained in a Financial Times article, which boils down to: we’re in a time of great uncertainty, so buy government bonds.
For what it’s worth, I think the world is a lot less uncertain place than it was two years ago. In a way, uncertainty is old news. That isn’t to say our situation is good, but we now know:
1. world governments will act to avoid the worst economic outcomes (this is the #1 worry in any macroeconomic crisis)
2. financial regulators in the US and the EU have been doing a terrible job
3. banks are weaker companies than we thought, and generally poorly managed, to boot.
In my opinion, a lot of this news is already reflected in security and currency prices.
What uncertainties still exist?
1. Economically speaking, the developed world is still a fragile place. The effects of the large excess supply of housing and business space created in the US and UK over the past few years, and of those countries stopping adding to it, are still with us.
2. The steps that policymakers may take, and the economic effects of those actions, are hard to foresee. The world has used up much (all?) of its safety margin for dealing with mistakes.
3. The econometric models that economists use in predicting how our economic future will play out–essentially, elaborate trend-following devices–don’t work well in times of economic transition. They also didn’t predict the financial meltdown. So a major tool (bond) portfolio managers have wielded in plying their trade is out of action. Managers are now working in a room whose lights have been turned out. (If you believe Nobel laureate Joseph Stiglitz, however, these models were radically flawed from the outset–and were a contributing cause to our economic woes.)
3. The behavior of economic agents, especially portfolio investors, is harder to predict. In particular, the chances of extreme, far-from-consensus, and really bad, outcomes has increased.
What does the article conclude from this litany of sorrows? –we are in a “world where the realized return rarely (emphasis added) equals the expected valuation.”
a curious argument
Okay. Now comes the weird part.
We’re in a world where no one can tell how the world economy will play out and where investment managers’ portfolios are going to blow up in their faces. But luckily for us, Mssrs. Clarida and El-Erian are affected by none of this. They know (no explanation given) how the US economy will develop–very low growth and structural unemployment for as far as the eye can see. They also know that while virtually every other investment strategy founders on the rocks of uncertainty, one–buy government bonds–will not. Again, no explanation given. Just by coincidence, both authors happen to work for a bond fund manager and have this product available for sale to us.
Another point: The thrust of the Clarida- El-Erian argument is that economic circumstances demand that investors carefully rethink their investment strategies, because macroeconomic conditions today are radically different from what they’ve been before. Their actual conclusion, however, is far different. It is that investors will almost never (rarely) be able to figure things out. In the paragraph above, I’ve pointed out that they think this situation applies to everyone except them.
My point here is that they provide no support for the actual conclusion they draw. What they write looks like an argument in support of a conclusion, followed by the conclusion as a logical consequence of what they said before. But that’s just a kind of sleight of hand. The idea that no one (except themselves) will be able to figure out what’s going on is a bald assertion, no more.
extreme outcomes don’t all favor bonds
I think it is right to give extra thought to the possibility of extreme outcomes. In can imagine three, although I’m sure there are more:
1. The US and EU play out like Japan since 1990. This would mean bonds would be fine Stocks would have a period of stability followed by maybe another 30% decline.
2. The US and EU recover faster than we now think. Stocks might go up by 25%. Government bonds would fall, maybe by 15%.
3. The rest of the world loses faith in the US and EU. Their currencies fall by 15% vs. the rest of the world and their bond yields rise. In this case, safety would lie in stocks, not bonds. Stocks +35%, bonds -15%.
To me, it seems that the possibility of extreme outcomes is an argument for diversification, not concentration in one asset class.
the authors seem to know nothing about stocks
If we exclude financial Armageddon, equity investors can operate successfully under a wide variety of economic conditions. In particular:
Value investors do use reversion to the mean, but in a narrower sense than is used in the Pimco article. The value investor looks for assets that are worth $100 that he can buy for $30 and hopes to sell for $60-$70. Given that stocks are the cheapest they’ve been vs. bonds (a proxy for the cost of financing purchase of such assets) in about sixty years, this should be a fertile ground to work in.
Growth investors do have deep economic concerns, but they’re generally microeconomic, not macro. Will, for example, well off thirty- and forty-somethings continue to buy iPhones and iPads? Will TIF continue to sell jewelry to Europeans trading down or to newly affluent Asians trading up? Will the casinos in Macau keep on booming?
Yes, if world economies implode again, equities will be in trouble, at least for a while. But equity investors don’t need to understand the entire globe to be successful. All they need is a stable playing field and one or two places where they’re ahead of the consensus.