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I just finished reading Daniel Kahneman's Thinking Fast and Slow. Kahneman is the only psychologist to ever win the Nobel Prize in Economics. He pioneered the field of behavioral economics. While the book is a summary of his work on the psychological pitfalls of our thinking in all levels of decision making and analysis of information, it has great relevance to investor behavior. A nice summary of his views as particularly applied to investing is here.

One of his observations is that experts are very poor at forecasting and experts in economics, financial matters and politics are among the worst predictors. Furthermore, the shorter term the forecast the more likely it is to be wrong. Forecasting that stocks will outperform T bills over a 20-year period is a forecast that has a high likelihood of being correct. The shorter the period the less accurate any forecast will be. The longer term the forecast the more likely there will be a reversion to the mean and results will be close to a “base rate."

Thus, it is not surprising that most forecasts for 2011 issued around this time last year proved terribly wrong. As such a wise investor will pass on reading all those 2012 forecasts he sees on the covers (physical or digital) of the year-end issues of financial magazines or forecasts appearing in electronic media or elsewhere. He would be far better off ending the year with time spent reading the Kahneman book.

Part 1 Macro Economic and Bond Market Forecasts

A dominant theme of the forecasts focused on the dismal outlook for U.S. financial markets. In particular, the deadlock over the budget, the high level of U.S. indebtedness and the Fed's low interest rate policy were forecast to combine to create terrible returns for investors in the U.S. bond market.

Inflation would surely come, investors around the world would surely lose faith in the U.S. and investors around the world would flee the dollar and U.S. Treasuries. Far from being a safe haven U.S. Treasury securities would be among least attractive instruments in the world. As 2011 began, pundits warned that U.S. Treasury debt could be downgraded, a sure disaster for U.S. Treasury securities.

As a consequence the recommendations for 2011 for investors included:

Avoid U.S. Treasury securities, especially long term Treasuries. A 10-year Treasury bond yielding 3.5% as the year began was a guaranteed loser. High inflation would cause higher interest rates and major losses for holders of long term Treasuries. Furthermore, with dividends of stable companies higher than the 10-year Treasury, the prospect of a higher total return on those stocks vs. Treasury bonds was a sure thing.

Impending inflation and overall economic crisis argued for owning commodities, especially gold and silver.

Short dollar positions would allow investors to profit from the debasement of the U.S. dollars.

Investors instead should hold investments in non U.S. bonds, especially in emerging markets which have trade and budget surpluses, With the U.S. in twin deficits it was a sure thing U.S. bonds would underperform those in emerging markets and probably elsewhere in the world as well.

The dismal economic and high levels of expenditures and declining tax revenue would surely lead to widespread defaults municipal bonds.

What really happened?

Inflation: Forecasters were wedded to the idea that an “easy money” monetary policy of low interest rates and Federal Reserve purchases of securities would lead to inflation very quickly. These forecasters failed to review their Econ. 101 notes. Even Milton Friedman (the godfather of monetary economics) who stressed the link between money supply and future inflation knew that Fed policy was only one part of that link. He emphasized money supply and the “velocity” of money, i.e. how often it changed hands.

If banks took the funds injected into the economy and lent to them at near zero and simply invested it in treasuries instead of lending it, there would be little increase in the velocity of money. If no money was lent there wouldn’t be more transactions in wages, spending by consumers, and payments to business suppliers. Furthermore the lack of optimism among consumers and businesspeople in response to economic conditions further reduced the velocity of money. Low velocity of money equals low inflation even with an increase in the money supply because the “money multiplier” was so low.

Without an increase in the velocity of money there was no increase in aggregate demand and thus no inflation. Add in the slower demand from Europe and one can see the case for inflation was in reality very weak. The Fed was in the position of “pushing on a string,” rates were down to near zero and the unemployment remained high and economic activity low. Hence the Fed entered into “QE2” quantitative easing and made clear it will not raise interest rates till 2013.

The logical result of this was to push demand further out on the yield curve as investors sought to earn something on their money in the Treasury market. With the near term outlook for inflation low and the Fed on hold, investors felt comfortable buying long-term Treasuries. The beneficiaries: Those very holders of long term Treasuries who were told they were going into a “guaranteed loser trade” with 10-year yields at 3.5%. That 10-year yield is currently at 2%.

Lack of Faith in the U.S. Economy and a Flight From U.S. Treasuries and the U.S. Dollar: This failed to materialize as well. While the U.S. fiscal picture and political decision making were hardly encouraging, the news from Europe was even worse and ended the year in severe crisis. The flight to quality and the search for a safe haven turned investors to the dollar and U.S. treasuries not away from them. Even the downgrading of U.S. debt had no negative impact on Treasury prices. In fact TLT, the long term treasury ETF, rallied 25% since the summer budget fiasco and downgrading of Treasury debt.

Below are 10-year (TLH), 15-year ((NYSEARCA:TLT)) and Extended Duration (NYSEARCA:EDV) U.S. treasury ETFs charted against EMB emerging market bonds, and International Treasury Bonds. U.S. treasuries were the clear winner. All bar graphs show returns on top and volatility underneath.

TLH(green)TLT(blue) EDV(yellow) EMB(black)

Commodities

Most commodities declined this year as the global economic slowdown, which even included a relative decline in Chinese growth, drove prices lower. Gold and silver rose through most of the year. But long gold was far from being the best way to position for the economic crisis in Europe that could potentially have an impact on the entire world financial system.

In fact, as year-end approached and the economic crisis in Europe had grown more acute, gold has fallen. It is down a little over 11% over the past two months.

Below are 12 month returns for agricultural commodities (DBA green ), base metals (DBB blue), energy (DBE yellow), gold (GLD black) and silver (SLV red). While the airwaves were full of ads and pundits recommending gold, the GLD ETF is ending the year with a 12 month return of 15.8% which might look impressive compared to U.S. stocks. But compared to U.S. bonds (see graphs above), GLD returns don’t look that impressive.

As for the demise of the dollar, the euro fell sharply as the European debt crisis intensified. The flight to quality was into the US dollar, not away from it.

And that muni bond disaster? After a bit of a sell-off in the early part of the year, muni bonds rallied sharply and in fact outperformed the aggregate U.S. bond index. Many muni bond investors sold in panic. Those investors never experienced relatively large declines in their bond prices, nor were they comfortable with the default predictions. And since many owned individual bonds in their portfolio they suffered even larger losses as they found the illiquid non exchange trading muni market an expensive place to trade. Their losses were greater than those reflected in the MUB (muni bond ETF) chart below.

What is the bottom line conclusion based on a review of year-end forecasts for 2011? They obviously proved wrong as is often the case. Investors are far better off with a diversified global portfolio, a long-term strategy and a rebalancing discipline to buy underperforming asset classes and sell off some of the winners to maintain the long term allocation. Skip the forecasts for 2012. Instead pick up the Daniel Kahneman book or read the article. It will do much more to make your investment results improve in 2012.

>> Continue to Part II

Source: Conventional Wisdom Predictions For 2011 Were Wrong: A Cautionary Note For 2012

Additional disclosure: Mr Weinman's clients have positions in MUB.