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The New Ecology of Finance

One thing I enjoy about managing my own funds is that the activity is so broad that it can encompass just about anything.  I approach investing more as an art than a science, and in that vein the following essay may be akin to adding a rich stroke of green across the tapestry.

I've been watching the US economy to the best of my limited ability, and came to the conclusion sometime last year that despite what at one point may have been prudence in advocating a bearish strategy, apparently the environment has completely changed.  "Green shoots" was a very popular term last year, and it seems that these shoots, the existence of which almost everyone doubted, have already sprouted into an incredibly robust ecology, replete with accompanying fauna (animal spirits).  This led me to ask exactly what kind of natural parallel could match this kind of torrid and uncontrolled growth, and why such a parallel did not seem to apply previously.

America and Europe both have their origins in wooded lands and grew under the canopy of towering trees in verdant forests.  I would argue that as their natural origins were such, so rooted were their institutions and etc., including economic models.  On a basic level (indeed, I am not an ecologist), I would draw the parallel of torrid undergrowth (small business) that may result from a particularly wet season, one that would consequently cause a dreaded forest fire as the unsustainable undergrowth dies out and increase the likelihood of uncontrollable burn (1929).  Growth after the fire is slow, but absolutely sustainable, as the ash from the burn feeds the shoots and creates a new forest to replace the old.

Today, in both
America and Europe, it seems this ecology no longer applies.  The summers are hot, yes, but so are the winters (Christmas is the hottest season for retailers), and moreover, it is wet all year around as we are awash in liquidity (the aptly named Greenspan comes to mind here).  There are still fires, but they are put out almost immediately (1997, 2000, 2009).  What kind of ecology functions in this manner but a dense, lush jungle, evergreen not due to dire necessity or 'survival of the fittest' but because the weather permits and no longer requires such draconian forms of adaptation for survival.

What are the consequences?  

1) First is the obvious parallel of the Western experience with the jungle – I am thinking specifically of Joseph Conrad’s book ‘Heart of Darkness’, and Francis Ford Coppola’s movie ‘Apocalypse Now’.  Here we see brave men seeking fortune and glory in the jungle only to find madness and despair – this despite the astounding success of Kurtz in both mediums.  Some quotes about the jungle:

"The earth seemed unearthly. We are accustomed to look upon the shackled form of a conquered monster, but there – there you could look at a thing monstrous and free."

"Perhaps I had a little fever, too. One can't live with one's finger everlastingly on one's pulse. I had often 'a little fever,' or a little touch of other things – the playful paw-strokes of the wilderness, the preliminary trifling before the more serious onslaught which came in due course."

"I looked around, and I don't know why, but I assure you that never, never before, did this land, this river, this jungle, the very arch of this blazing sky, appear to me so hopeless and so dark, so impenetrable to human thought, so pitiless to human weakness."

"The woods were unmoved, like a mask – heavy, like the closed door of a prison - they looked with their air of hidden knowledge, of patient expectation, of unapproachable silence."

“I watched a snail crawl along the edge of a straight razor. That's my dream. It's my nightmare. Crawling, slithering, along the edge of a straight razor - and surviving.” (Apocalypse Now)

 

2) To tie this to investing, the second point comes from Jeremy Grantham’s most recent letter (membership required - it's free).  In it, he laments the current state of affairs, and IMHO, makes the case for assuming massive amounts of future liquidity:

"If the economic recovery is slow and if unemployment drops slowly, then Bernanke will certainly keep rates very low, as he has promised in as clear a way as language permits. In that case, stocks and general speculation will very probably rise from levels that are already overpriced. And if they do, Bernanke will definitely not be concerned and has told us as much."

"If we get lucky and have a strong, broad, and sustained economic recovery, interest rates will probably rise before we reach real bubble territory. As rates rise, the market will almost certainly settle down, and we will only have to deal with a substantially overpriced U.S. market and moderately overpriced global equities and risk premiums."

"If, however, the economy only limps along, which seems more likely to me, then we run a very real danger of a third dangerous bubble in stocks and in risk-taking in general.  For in that event, Bernanke will definitely keep rates low quarter after quarter and speculation will surely respond."

There's a wonderful probability tree in Grantham's letter that highlights what he thinks about the chances of the above outcomes.  

To most investors, there’s nothing new here.  Many are assuming that the Fed will do whatever it can to stimulate the economy, and upon achieving its goal, will try to maintain a Goldilocks environment, i.e. a jungle environment with little seasonal variance and plenty of rainfall whenever required, and thus no chance of sustained burning.

 

There are other parallels one could make here.  Emerging markets could be compared to a savannah (or perhaps a forest as once Europe and America were upon a time), one that is receiving a dollop of rainfall.  Even Russia and the Middle East are facing recoveries…perhaps this can be seen as ‘global warming’ in the world of finance.    

Regardless, the lesson is clear – anyone still assuming that the environment is the same as it was in 1929 or 1979 has been, and may be in for a surprise, although there are obvious consequences to our current trajectory.  Good luck with your investments.



Disclosure: I am long in value-oriented US small cap stocks, and various emerging market stocks with an emphasis on commodities.

Disclosure: I am long in value-oriented US small cap stocks, and various emerging market stocks with an emphasis on commodities.