— It’s been a while since we’ve heard from the ECRI, or, if you’re not up with economic jargon, the Economic Cycle Research Institute. These guys deal with leading indicators and nothing but leading indicators.
— Last year, the ECRI leading weekly index made the headlines on a number of occasions. It correctly predicted the 2010 slowdown and many observers used it to talk up the prospects of a double-dip recession. However, Lakshman Achuthan, founder and managing director of the ECRI, said a double dip would be avoided. So he has form on the board.
— Now he’s predicting a slowdown in global (not just US) economic growth, based on the plethora of leading indicators he follows. You can check out the interview here.
— So what does this mean for your investment strategy? Well, if you’re loaded to the gills with commodities you might want to consider paring back that exposure on rallies. While inflation remains a long-term threat – or more accurately a long-term certainty given authorities will simply resort to money printing to ‘assist growth’ – in the short term you probably should expect the inflation chatter to subside.
— The Aussie dollar vis-à-vis the US dollar has likely peaked for the time being. The peak was pretty much highlighted a few weeks ago when the business pages of The Australian quoted someone (an ‘expert’, can’t remember who) calling for the Aussie to reach $1.70 versus the greenback.
— The Aussie was overvalued at $1.10. The strains on the economy were evident for all to see. At $1.70 Australia’s trade-exposed sector would be gutted. And that’s before a carbon tax comes in.
— Dan Denning, who’s been in the US for the past few weeks, reckons the States is cheap compared to Australia. I’m sure he’ll be regaling you with some currency tales when he’s back on board next week.
— Getting back to the ECRI, it says we’re heading into a slowdown. The recent rally in the US dollar and correction in commodities confirms the slowdown is probably in its early phases.
— But to think we’re going back to a 2008 style meltdown is probably a mistake. As the saying goes, history rhymes but it doesn’t repeat. We’ll probably get a sizable correction that will scare the daylights out of everyone and then we’ll rally again.
— One of the mistakes most analysts make is one of extrapolation. That is, today’s good earnings will be 10 per cent higher this year and 10 per cent higher the year after and so on. The result? A pretty handsome valuation, or target price, on a stock or index.
— The method of extrapolation worked well prior to 2008. When credit markets around the world were expanding at a healthy clip, the purchasing power unleashed by this expansion flowed throughout the economy and into revenue and earnings. Nice, easy, year-on-year gains were not too hard to generate.
— But credit markets are no longer expanding, or if they are its due to central bank assistance. In Australia, credit is growing by just a few per cent per year.
— Against this backdrop you’ll find it very hard to see the type of secular expansion witnessed prior to 2008. That is why the investment landscape you should prepare for (or be prepared for) is one of volatility. Rallies will be followed by sell-offs, which will be followed by rallies.
— We’re in a bear market dressed in bulls clothing. Countless CEOs will tell you they’re waiting for the upswing or recovery or whatever. But it’s a type of thinking that is trapped in a pre-2008 world. We’ve had the upswing. It was a brief period in 2009/early 2010 when the full force of global monetary and fiscal policy pulled just about every asset price out of a heap (except housing – the asset class you target the most always fails to respond).
— Expect this type of environment to last for years while the system tries to purge the imbalances that have built up more or less since the early 1970s. It was then that the US dollar severed its link to gold and any semblance of international monetary stability was gone.
— Unwittingly, Jeremy Grantham touched on this instability in asset pricing in his latest quarterly letter:
In 1974, the U.S. market fell to seven times earnings and the U.S. value/growth spread hit what looked like a 3-sigma (700-year) event. U.S. small caps fell to their largest discount in history, yet by 1984 U.S. small caps sold at a premium for the first time ever.
By 1989, the Japanese market peaked at 65 times earnings, having never been over 25 times before that cycle!
In 1994, emerging market debt yielded 14 points above U.S. Treasuries, and by 2007 had fallen to a record low of below 2 points.
By 1999, the S&P was famously at 35 times peak earnings; in 2000, the value/growth spread equalled its incredible record of 1974 (that I, at the time, would have almost bet my life against ever happening again). Equally improbable, in 2000, the U.S. small/large spread beat its 1974 record and emerging market equities had a 12 percentage point gap over the S&P 500 on our 10-year forecast (+10.8 versus -1.1%).
Further, as the S&P 500 peaked in unattractiveness, the yield on the new TIPS (U.S. Government Inflation Protected Bonds) peaked in attractiveness at over 4.3% yield and REIT yields peaked at 9.5%. Truly bizarre.
By 2007, the whole world was reveling in a risk-taking orgy and U.S. housing had experienced its first-ever nationwide bubble, which also reached a 3-sigma, 1-in-700-year level (still missed, naturally, by “The Ben Bernank”). Perhaps something was changing in the asset world to have caused so many outliers in the last 35 years. Who knows?
— In answer to Grantham’s question, no one really knows. But we’d guess the lack of a monetary anchor in the system had a fair bit to do with it. Removing gold (officially at least) from the system puts decision making into the hands of individuals. And individuals trying to tweak a hugely complex and ever-changing organism like the market will always get it wrong.
— Your best protection against this uncertainty and volatility? Go against the crowd. Be contrarian. Buy assets when they’re cheap and out of favour.
— What’s out of favour right now? Hmmm…how about retail stocks? But you’d be mad to buy them now, surely? Precisely.
— Or – old fashioned contrarian value investing doesn’t float your boat – you might like to click here to go spear trading with Slipstream Trader Murray Dawes…
Markets and Money Australia