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What To Own When The World Turns Sober

One obvious failure of the technological approach occurred in 2008, when all the quantitative economic models failed to render an accurate forecast of the future. The models almost convinced the Fed to start tightening credit (which turned out to be the last thing the economy needed).

Today, we find the strict technological approach is again coming up short. A tremendous amount of liquidity now sits on the sidelines (as nervous investors avoid stocks), and all the economic models are predicting slow growth at best. Yet the stock market inexplicably continues to gain ground.

We can't help wondering what will bring stock prices in line with the models. Will it take a longer period of slow economic growth that eventually catches up with the market? Or will it take a more exciting/scary event such as another market crash?

Unfortunately, no predictable solution exists. Human emotions drive the market even more than economic statistics. And mathematics cannot accurately predict people's actions. Yes, models can help us develop a better guess as to what will happen, but they won't let us nail it down.

One of the best ways to develop a “best guess” is to look at trading patterns and see if they appear rational or irrational. From our perspective, they seem completely irrational today. (Of course, as Keynes said, the market can stay irrational longer than you can stay solvent.) We have no technological tools to tell us when the irrationality will become overextended and provoke a correction.

As an example of the market's irrationality, let's consider the year-to-date price performance of 4 key assets: the S&P 500, the Hang Seng, oil, and copper. Together, they provide a pretty good indication of what's happening in the world economy.

Since 12/31/08, copper has outperformed the other three assets. Its price has risen 65%. Oil comes in at #2, up roughly 50% (with gasoline prices following suit). Of the two stock indices, the strongest by far has been the Hang Seng, which has climbed over 30%. As for the S&P, even taking into account this morning's surge, it's only gained 3% since the beginning of the year.

The fact that all these assets are up tells us that the liquidity that has been injected into the world economy is having an effect. But while no asset remains untouched by this liquidity, the assets which are leveraged to real growth and real things are getting the lion's share of the pie.

The recovery taking place in China is actually a recovery in demand for resources. Resources make the Chinese economy grow, and growth in China cannot proceed without higher resource consumption. That's why oil and copper have risen along with Chinese stocks.

Another asset class which has not benefited from this resource-based recovery is bonds. Since the beginning of the year, one measure of government bond prices has dropped almost 25% (and today, it's falling roughly as much as the market is rising).

Bond prices are falling because Chinese stocks and resource prices now lead the world. Rising resource prices will eventually lead to higher inflation in the U.S., whether it is demand-led or supply-led, and that affects the value of U.S. bonds.