The U.S. stock market as measured by the S&P 500 index (500 largest U.S. stocks) (NYSEARCA:SPY) reached its peak for 2011 on April 29, with a value of 1,363.61. From that point, the index declined to its most recent closing low of 1,265.42 on June 15, a loss of 7.2%. This decline, spanning the past month and a half, has many investors ready to run for the hills. Such an exercise is an example of market timing, and historical evidence shows that market timing contributes little if anything to portfolio performance (see pie chart below). Furthermore, the mere fact markets continue to exist indicates that no one person or group of people possesses an oracle-like ability to time the direction and magnitude of market movements. If such a group existed, there would be no market because the group would gradually accumulate such a large share, the natural interactions between buyers and sellers would cease to occur. This is why financial prognosticators and the CNBC talking heads who claim to predict the timing or magnitude of market movements are either the beneficiaries of dumb luck or taking liberties with the truth.
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So What’s the Problem Today?
To conjecture as to the immediate future direction of stock indexes is to completely ignore the most important theme in all of our daily lives, which ultimately drives stock prices, gas prices, and virtually every financial transaction: debt. The U.S. government, the eurozone, Japan, the average guy on street, they are all struggling with an addiction to debt. It was debt that fueled the nearly 30 year bull market beginning in the early 1980s. It was debt that kept home prices surging upward year after year, and derivative forms of debt which kept goods flying off the shelves, giving banks the ability to inject still more debt into the global financial system. Now, as a global society, we have reached the point of intervention. We must either choose to seriously address our debt problem, or deny it, perpetuating an economic collapse of biblical proportion.
Investors, particularly at the individual or household level, tend to focus most of their attention on the “stock market.” After all, it is the stock market that receives the lion’s share of media attention, seeming to create overnight millionaires and Internet billionaires year in and year out. Further supporting this view is the relative outperformance of the S&P 500 (U.S. stock market) which returned 7.7% annually in the 20 years spanning from 1991 to 2010, while such an investment in the bond (debt) market returned 6.1% annually. Ironically, the average investor returned just 2.6% annually over that period. This drastic under performance of the average investor illustrates that many try to time markets based on prognostications and emotions.
More worrisome is that many seem to demonstrate a fundamental misunderstanding of the capital structure and what forces drive capital markets. While estimating the size of global markets is not yet an exact science, according to the World Federation of Exchanges, the global bond market is larger than the stock market by a factor of about 2. Therefore, as a function of sheer magnitude, action in the bond market has far reaching implications, well beyond those of the stock market. From a fundamental, bottom up perspective, debt is senior to equity (stock) in a company’s capital structure. Put simply, the principal and coupon/interest payments to bondholders are contractually assured before dividend distributions to stockholders. The return on a stock investment is a secondary concern to the return of principal and interest to a bondholder.
How Did We Get Here?
Just as the real estate market began forming a top in 2006, the world’s largest banks had essentially made a one way bet that prices would rise in perpetuity. They sought to monetize this view first by packaging pools of loans into securities and distributing them to asset managers like mutual funds as well as other institutions like insurance companies and pensions, assuming the law of large numbers would prevent catastrophic loss. Banks and insurance companies then concocted Credit Default Swaps (CDS) to insure against significant impairment of loan portfolios, assuming such an event would never materialize. Much like an insurance policy protects a family, a Credit Default Swap serves to protect a pool of loans. Banks profited immensely from this arrangement, collecting fees for packaging the loans, facilitating trades, and collecting premiums for CDS insurance. Of course, we all know what happened next. Real estate prices began to decline, inventories began to rise, and construction began to slump, essentially bringing one of the largest industries in the world to a standstill. Construction and real estate professionals were quickly out of work and unable to sustain their traditional level of consumption. Furthermore, home equity was no longer available as a source of additional purchasing power, and corporate earnings declined precipitously in this “trickle up” as the economy’s formerly vibrant pulse faded.
These developments created a severely undercapitalized financial system. Worse still was that the divisions of banks and insurance companies engaging in this risky business were under the same umbrella as the entities holding bank deposits and insurance policies. Accordingly, the U.S. government and governments around the world were forced to create tremendous bailout packages, essentially shifting the burdens of the financial industry onto the public balance sheet. Then, in an attempt to stimulate the economy and most importantly create jobs, the government injected further stimulus, bringing us to where we stand today, on pace to exceed our self-imposed debt ceiling.
What Can We Do About It? How Can I Protect Myself?
Governments are not efficient distributors of capital. Rather at best they are consumers paying for the goods and services provided by government employees and at worst they are corrupt gang lords rewarding select constituents with pork barrel funding and exclusive contracts. This distribution model is tremendously inefficient as political clout trumps innovation, equilibrium pricing and responsible risk taking. Until the government returns this function to the free market, requiring banks to once again serve as capital allocators rather than proprietary traders, we stand at the economic precipice. Unfortunately, government regulators seem poised to continue pursuing limits on debit card fees and other trivial functions, relying on the chairman of our central bank to devalue the national debt in real terms by achieving a modest rate of inflation. We need to reduce spending, limit the size of government, and reform the entitlement programs draining the life out of our economy. This is not about Democrats or Republicans, as party lines too often dictate outcomes. Rather it is about creating a free market system through which we can return to prosperity.
Ultimately, we as investors face a set of binary outcomes, and we must account for both in the design of our investment strategies.
1) Inflation: We continue printing money, a balancing act that seeks to gradually devalue the currency and by extension the real value of the outstanding debt. Investment strategies to combat this outcome include precious metals, commodities and commodity-linked stocks, and to some degree all stocks. Assets tied to “stuff” like gold and commodities should perform well by any measure. Stocks in general may deliver positive returns, but the returns must be discounted by inflation in which case they may not be as attractive. During this time, conservative investors sitting on cash and high quality bonds stand to suffer most.
2) Deflation: We meaningfully cut spending and reform programs to get our fiscal house in order. The economy and by extension the stock market experience a shock, perhaps even an extreme shock, eventually giving way to a new era of prosperity. During the shock phase, high quality government bonds and cash equivalents will perform well due to their ability to preserve nominal value. Defensive sectors of the stock market may also perform admirably due to the critical function they provide, with utilities being a clear example. Assets tied to cyclical businesses which produce non-essential products will suffer greatly as the purchasing power of the middle class diminishes. Though after the rain comes the rainbow, at which point investors may have a once in a lifetime opportunity to buy stocks at extreme depressed values.
As it stands today, Chairman Bernanke insists upon creating a mildly inflationary environment, which is easier said then done. The possibility of further QE and the like remains on the table, which means we cannot rule out the inflationary outcome. Conversely, the political appetite for increasing our national debt appears to be fading and thus we cannot rule out the deflationary outcome. Therefore, it remains prudent to account for both outcomes in the design of your investment strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.