To Invest Well, You Need The Right Mental Model Of The Economy

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Includes: SPY
by: Joe Leider

Summary

Macroeconomic conditions and central bank policy strongly affect market indices.

There are a lot of myths many of us believe, giving us a terrible context for where markets are going.

Learn how those myths are blinding your investment strategy.

As a value investor, I appreciate good dividends, contrarian arguments and general bad news about my prospective investments. Like many other investors, I also freak out at the prospect of big market drops, especially with analysts screaming about high historical valuations. I get tempted to time the market, even though it's not recommended. The chance that the market goes up or down tomorrow is 50/50, just like every day.

But in order to understand stock valuations, you need a proper macroeconomic mental model. A lot of investors feel like QE = inflation, that stocks are in a bubble because of loose Fed policy. Other investors think the bubble will soon pop because of a historically high CAPE or market cap/GDP ratio. These opinions (and others) are based around a faulty mental model of how monetary conditions are evolving. Below are certain myths we need to get away from if we want to understand the big picture of where markets are moving.

Myth: QE = low interest rates
This is not true. As you can read about in my article about "Did Quantitative Easing Work?," whenever the Fed pursued quantitative easing, interest rates spiked because markets believed the economy would get better. Interest rates are a big factor in determining stock prices (see "How the Fed Makes or Breaks Stocks"). When interest rates are low, stocks go up because the return we can get without risk has dropped. The exception is when interest rates fall precipitously with the onset of a crisis.

Myth: Low interest rates = loose monetary conditions
In fact, low interest rates are usually the sign of tight conditions. By mixing this up, we end up at the logical fallacy that the Federal Reserve is blowing bubble after bubble with it's crazy-low interest rates. And we fear where the next bubble might pop. Stocks do trade at higher levels now than they would with high interest rates, but this is not irrational exuberance. This is the rational expectation that, because monetary policy is tight without the political will to loosen aggressively, bonds simply won't pay an acceptable rate of return.

Myth: CAPE or market cap/GDP will always resort to the historical mean
There are "rules" in finance and economics that hold, until they don't. Just because something has never (or always) happened doesn't mean the same will happen in the future. In fact, because of how human psychology and economic feedback loops work, what becomes conventional wisdom will turn out false given enough time. Once we all agree on a certain principle (like stocks always return more than bonds), that rule will turn out to be false. That is, until it turns out to be true again.

Below is a chart of the S&P/GDP ratio against 10-year treasury yields since the late 1970s. There has been a secular trend (with some bubbles) upwards for S&P/GDP. The same holds for the CAPE during the same time period. As interest rates have gone down (monetary policy has become tighter and tighter over time), the amount the public wants to hold in non-government securities has risen. This makes sense, and there will only be a reversion to the mean when the political will exists to actually loosen monetary conditions. With everyone thinking conditions are tight, that time seems pretty far away. Stocks at these elevated levels are the new normal.

Myth: Central banks are pursuing ultra-loose policy (or QE will lead to devaluation and hyperinflation)
A lot of terrible investment decisions have been made based on the misconception that central banks are devaluing or pursuing ultra-loose policies. Just look at returns on gold, mining companies, oil. Conditions are tight, interest rates are stuck near zero (negative in some countries) and the political will to really loosen is lacking. For those folks satisfied with lower returns, like investors in AT&T (NYSE:T) or HSBC (NYSE:HSBC), or other safe, high-dividend stocks, the rewards will be greater than those waiting for hyperinflation.

Now that we've shot down some false mental models of how our economy works, let's look at what's real.

Reality: Macroeconomic trends are feedback loops determined primarily by expectations.
QE can mean interest rates spike (as it has in the United States) or it can mean they drop (this may happen in Europe). What's the difference? In the current economic environment, government bond yields are a signal of the expectation of future inflation. When they move up, it means we're finally expecting growth in aggregate demand and higher inflation. When they drop, we're not convinced that our central bank really has our back. Expectations are everything in a credit economy (read my article "What is Money?"). Instead of looking at what the central bank is doing and saying "that's inflationary," we need to look at market reactions to what the central bank is doing and say "looks like the market isn't convinced on inflation." Markets (usually) know more than we do.

Reality: Individual stock prices are driven by fundamentals. Market indices are driven by a mix of expectation around economic growth vs. future opportunity cost of not holding bonds.
If you're investing in a micro way, picking through individual annual reports and cash flows, trying to find value in a brand, then what's happening in the broader economy may not concern you as much. It should. Even if you can't time the market, you can fish in pools with more potential, and macroeconomic trends can help us find those pools. If you buy the incorrect mental model that QE = hyperinflation, then you'll buy oil stocks, gold miners, other commodities producers. You'll see a cheap P/E ratio, strong cash flows, high dividends and think you've found a great value play.

While I do like the contrarian argument, and a lot of resource companies may be undervalued now, don't expect hyperinflation to make your investments work. Outright deflation, or even prolonged flirtation with deflation, will tear these stocks apart.

On the other hand, you may want to short the market, seeing the rest of us as suckers caught in the biggest bubble yet. Again, you will believe this with a poor mental model of how the macro-economy works. With interest rates falling, we could be in for more market volatility. But with the secular tightening of monetary conditions driving down our expected rates of return, I wouldn't bet on shorting the market.

All of this is unconventional wisdom which, perversely, makes it more likely to be true. When you read this same article 5 years from now, perhaps monetary conditions will actually be loose, and you can look back on this article as the old, conventional thinking that is now past its time. We can only hope.

Disclosure: The author is long HSBC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.