Tuesday, January 31, 2012

Don't Fight the Last War

In November, I wrote that Stock and Bond markets around the world were then what I called “Fraidy Cat Markets” where every possible threat was thought by many to surely lead to economic catastrophe. On the other hand, there was fear that perhaps the pessimism was overdone and many had inordinate fear of “missing out” on a massive upturn. As I have said, “Mr. Market” suffers hopelessly from manic-depressive syndrome.  After a pretty disappointing 2011 where the only certainty was uncertainty, January’s “recovery from the depths” was being called a “rally”.  Then on January 25th, worry took over and markets started to head down a little, again.

To put things in perspective, the S&P500 is around 4% LOWER than it’s 2011 peak, and it would have to rise 20% to reach it’s “all time high” last set in 2007, more than four years ago.

To many, the market is grossly undervalued.  To others, looking at the same data, the market is set for a fall.  My take on this is that we are in an age of pessimism, much like the 1970’s.  Bad, unexpected things have happened to us. Many of us fear that more bad things are coming…again.   Also, the whole world is still recovering from a huge “debt hangover”. History teaches such times when debts need to be repaid or excess capacity absorbed can be pretty depressing, psychologically, if not economically.  But, for the most part, economics and markets are affected by psychology.

Negative psychology or “pessimism” is a headwind causing caution and an undervalued market.  Anything bad that happens may make it worse—in the short run.  This is always a risk for investors. Anything bad that happens can make investments fall in value—in the short run.

I’m clearly one that believes markets are currently grossly undervalued.  Other than in the US, almost every country in the world has been fighting inflation. (Most governments and many investors tend use strategies of the “last war” until they realize they are wrong.)  Governments had been “tightening” by raising interest rates and/or restricting credit, and/or by raising bank capital requirements.  In late 2011, this situation completely reversed with now almost every country in the world “stimulating” by cutting interest rates and encouraging credit expansion. It’s as if the entire world took their foot off the brake and mashed the throttle down to wide open. 

For many years investors have been warned against “fighting the Fed” meaning, that when governments “stimulate” their money supply, economies tend to grow faster, not slower.  Assets tend to go up in value. The risk is not usually small growth, but rather big inflation.  Today the “Fed” is being joined by almost every other central bank in the whole world.

Only God knows the future. So be prepared for the unexpected. Be cautious and stay diversified. But, wisdom and history teaches us that asset prices and interest rates are probably headed up not down in the longer run—especially when government central banks are easing to this extent.  True, borrowing and printing money have ramifications---usually the biggest ramification is inflation.

For the long term investor, this time will probably prove to be an above average opportunity for growth in stock markets. The biggest risk I see being is what few are telling us about—namely inflation.  

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.