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, Buckingham (74 clicks)
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We continue the exploration of the lessons learned from 2013, beginning with a discussion on inflation.

Lesson 4: Inflation Wasn't, or Isn't, Inevitable

What should I do about the inevitable rampant inflation problem we are going to face because of the huge fiscal and monetary stimulus that's been injected into the economy? This has been one of the most persistently asked questions I've received since 2009.

While there is certainly the risk that the massive budget deficits and the monetary stimulus will translate into rising inflation, this outcome wasn't ever inevitable. Here's another related myth that persists among many investors: I persistently hear that the growth rate of our money supply is exploding. That belief has probably been fueled by those commercials that recommend buying gold because central banks are printing money like it's Weimar, Germany, all over again. The fact is that M2, a broad measure of the money supply, hasn't been growing at rates that would suggest rampant inflation should be expected. The following data is from the St. Louis Federal Reserve's web site and presents the last five years of growth in M2.

Date

M2 in Billions

Date

M2 in Billions

Increase Over Prior Year (%)

11/25/13

10,935

12/3/12

10,338

5.8

12/3/12

10,338

11/28/11

9,612

7.6

11/28/11

9,612

11/29/10

8,778

9.5

11/29/10

8,778

11/30/09

8,487

3.5

11/30/09

8,487

12/1/08

8,068

5.2

The compound rate of growth was about 6.3 percent over this five-year period. As Milton Friedman, one of our greatest economists, noted, "inflation is always and everywhere a monetary phenomenon." Thus, factual data doesn't support the view that we should expect rampant inflation. In fact, despite the views of many investors who seem certain that we will see massive inflation, neither the bond market nor professional economists are expecting anything of the kind. We can at least get an estimate of what the market's forecast of inflation is by looking at the difference between the roughly 3.0 percent yield on 10-year nominal bonds and the roughly 0.8 percent yield on 10-year TIPS. The difference is just 2.2 percent. Clearly, investors in aggregate don't appear to be concerned about rampant inflation. As to the forecast of economists, the Philadelphia Federal Reserve's Fourth Quarter 2013 Survey of Professional Forecasters has a 10-year forecast of 2.3 percent. Again, they don't believe rampant inflation is likely, let alone inevitable.

Don't get the wrong idea. There certainly is risk that inflation could increase dramatically. The reason it hasn't is that while the monetary base has been increasing rapidly (as the Fed expands its balance sheet through its bond buying program, as the chart below demonstrates, the velocity of money has been falling.

Thus, there is the risk that if/when the velocity begins to rise that inflation could increase. Of course, the Federal Reserve is well aware of the risk and thus will likely take action - reverse the bond buying program and raise interest rates - that would prevent inflation from taking off.

Since there are no clear crystal balls, a well-developed investment plan should incorporate the possibility of greater than expected inflation - addressing the risk through the asset allocation process. For example, the more you are exposed to the risks of unexpected inflation, the more you should consider holding TIPS and short- to intermediate-term nominal bonds, avoiding long-term nominal bonds. And if you are more exposed to the risks of a falling U.S. dollar you should consider a higher allocation to international stocks through a broadly diversified low-cost, passively managed fund that also doesn't hedge the currency risk (you want that currency risk).

Lesson 5: The Economy and the Stock Market are Very Different Things

The "conventional wisdom" among investors is that country growth rates are positively correlated with stock returns - if you want high returns, invest in countries that have high rates of GNP growth. While China's economic growth has slowed from double digits, it still grew at about 7.6 percent in 2013. That's more than four times as fast as the estimated 1.7 percent rate for the U.S. economy. Despite the differences in growth rates Vanguard's 500 Index Fund (VFINX) gained 32.2 percent while the China ETF FXI lost 2.2 percent, an underperformance of 34.4 percent. Even more telling is that for the five-year period 2009-2013, despite China's economy growing at a much faster rate of growth, VFINX returned 17.8 percent, and outperformed FXI's return of 7.9 percent by 9.9 percent a year.

Lesson 6: Ignore All Forecasts - All Crystal Balls Are Cloudy

In December 2012, Birinyi Associates collected the forecast from 11 strategists for Wall Street's largest firms. On average, the analysts thought the S&P 500 it would rise 8.2 percent from its close of 1,426. It closed 2013 at 1,848 percent, an increase of 29.6 percent. Including dividends the total return was 32.4 percent.

While we could provide an almost endless list of forecasts from so-called experts that went wrong, we'll focus our discussion on four.

Our first comes from PIMCO's Bill Gross, the co-author of the now infamous 2009 forecast of the "New Normal" which called for years if not decades of poor stock returns. Since that forecast we have experienced one of the greatest bull markets of all time. His top picks for 2013 were commodities like oil and gold, TIPS, high-quality municipal bonds and emerging market stocks. How'd that turn out? While the S&P 500 returned 32.4 percent:

  • Gold fell 28 percent and WTI crude oil rose 7 percent.
  • The Barclays TIPS Index fell 8.6 percent.
  • The S&P Municipal Bond Index fell 2.6 percent and PIMCO's Municipal Bond Fund (PFMIX) fell 3.6 percent.
  • The MSCI Emerging Markets Index fell 2.3 percent.

In every case, Gross' top picks underperformed the S&P 500 by a wide margin. Our second forecast was provided by one of the leading providers of "investment porn," demographer and author Harry Dent. Dent is the founder and CEO of economic research company HS Dent. Over the years he's provided me with a long list of forecasts that proved incredibly ill-timed. The latest example is from September 2011 when he stated: "I think the stock crash started in late April. This is just the first wave down ... I think the crash really starts sometime in early 2012." He went on to warn investors that the Dow could crash to 3,000 in 2013. His latest book, "The Great Crash Ahead," was published in September 2012. You would think that it would be hard to top that bad timing. However, in January 2009, just two months before the market bottomed out, Dent published "The Great Depression Ahead: How to Prosper in the Crash Following the Greatest Boom in History." In January 2006 his book "The Next Great Bubble Boom: How to Profit from the Greatest Boom in History: 2006-2010" was published. Clearly, it would have been hard for Dent to have gotten this one more wrong as not long after publication we experienced the worst bear market since the 1930s. And we don't want to forget that in October 1999, Dent's bestseller, "The Roaring 2000s," was published. The 2000s ended up being known as "the lost decade." It appears that if you are looking for a contrary indicator, Harry's your man. Maybe that's why people keep buying his books!

Jeremy Grantham, chief investment strategist at Grantham Mayo van Otterloo &Co., provided our third forecast.

On February 7, 2013, Bloomberg quoted Grantham: "All global assets are once again overpriced." He described emerging market stocks, Japanese stocks and European stocks as only a little expensive. How'd that turn out?

  • The S&P 500 Index returned 32.4 percent
  • The MSCI EAFE Index returned 23.3 percent.

Our final forecast is interesting because it came from Chris Martenson, a "world-renowned expert on identifying dangerous, yet hidden, exponential growth patterns in global economies, energy demand and food consumption." In March 2013, Martensen was predicting that a 60 percent stock market collapse will strike in the next three months. On March 13, 2013, moneynews noted that "Martenson's opinion isn't to be taken lightly, as his research is highly regarded by the United Nations, UK Parliament and Fortune 500 companies." They warned that Martenson's forecast was based on a "new alarming pattern" he identified - the "a dreaded triple top" (click to view image).

Martenson's research had led him to conclude that the market has proven patterns, including the dreaded "triple top." The article continued: The first "top" was in 1999, followed by a 60 percent market decline. The second "top" was in 2007, again followed by a 60 percent market plunge. And a third top has now formed, and a 60 percent stock market drop is not only inevitable, but that it could strike at any moment.

On the day before his forecast was published the S&P 500 had closed at 1,552. It ended the year at 1,848. A 60 percent drop would have put the index at 621. Martenson was only off by 1,227 points.

These examples demonstrate why Warren Buffett warns investors to ignore all forecasts because they tell you nothing about where the market is headed, though they do tell you a lot about the person making the forecast.

My next post will delve into hedge funds plus much more. The lessons continue.

Source: Lessons From 2013: Part II