Although the street will be thinly staffed for the next week, markets often go nuts this time of the year. The cause is the reduced number of market participants. While many individual investors are scurrying to make year end trades, most market makers are snug in their beds while visions of sugar plums dance in their heads. Notable exceptions are hedge funds. The Ebenezer Scrooges among them will not permit them to enjoy the season. They are all business. This can be a very dangerous time for small investors. It is true that volatility brings opportunity, but it also brings danger. This is alright fro traders who have large pools of capital with which to play and the ability to hedge bets, but such market environments can spell trouble for investors. There is a vast difference between a trader and an investors.
Market conditions prevalent during the past 25 years has turned many investors into traders. Market conditions have made trading relatively easy. One need only buy a portfolio of high-quality stocks and wait. If one waited long enough one experienced a profit of varying amounts. Why was this so? Because the preceding 25 years were terrible for the markets. Tax and economic policy changes, along with lower interest rates and (I hate this term) financial innovation, sparked the longest period of economic growth in U.S. history. What we witnessed was a prolonged recovery from a prolonged slump. The recovery matured in 2000. Efforts to rekindle growth created a bubble which could not be sustained. As with mature economies, mature markets are more stable, Growth and corrections will be more subdued. This had caused many investors to allocate assets outside their stated risk tolerance levels. Some may not realize they have done so.
Emerging markets have been an attractive destination for investor capital. Thus far the bet has been a good one, but it has coincided with the recovery in U.S. equity markets. This is merely a rebound from last years' crisis. The truth is that there is no decoupling. Economies around the globe are more intertwined than ever. Another problem facing investors in emerging markets is that they may be sowing the seeds of their own demise.
The influx of capital from the U.S. has begun to hurt export driven economies by strengthening their home currencies. Stronger currencies versus the U.S. dollar mean that goods produced cost more in terms of dollars. The results are higher prices, reduced profits or both. Countries such as Brazil are considering tax penalties to discourage foreign investment to keep the real week. Several other nations have acknowledged they are also considering similar moves. Then there is China.
China, being a command economy,. can add and remove stimulus at will thereby managing internal consumer demand. Banking on Chinese consumers to lift the global economy to new heights is a pipe dream at this time. China will only permit consumers to spend to meet its specific goals. If the government believes that the economy is overheating and inflation is becoming a problem it will engage in polices limiting consumer spending. The Chinese economy is likely to exhibit strong growth for the foreseeable future as the country is so far behind the West it will take many years of strong growth just to build the necessary infrastructure to make China a truly developed nation. Also, Chinese economic data are difficult to verify. The government controls the release of all data, including corporate earnings data. If China reports 8% growth one must take it at its word.
Domestically-focused investors have been placing bets on inflation. Their thinking is that low interest rates, the printing of dollars and record U.S. debt issuance will result in inflation pressures. The effect may be far less than many investors believe. Interest rates and debt issuance are just two factors influencing inflation pressure. One must also consider consumer demand, foreign exchange rates and corporations willing to erode profit margins to maintain their share of a smaller U.S. market. Allusions to the stagflation days of the late 1970s disregard the changes within the U.S. economy which have occurred since then. The U.S. economy is less insular and is no longer manufacturing-based. Back in the days of polyester leisure suits job growth (or losses) and inflation sprang forth from places such as Detroit, Pittsburgh, Cleveland and Bethlehem, PA. Now job production is scattered around the country in service industries such as technology, retailing, healthcare and financial serviced. The production of goods is primarily done overseas and these exporters would rather erode their significantly-wide profit margins than raise prices and lose valuable market share. This, combined with reduced spending as consumers live closer to their means, promise to keep inflation relatively low.
Subdued inflation make TIPs bad bets as trading vehicles. All are at premiums and have inflation indices over 1.00, some significantly so. Short-term TIPs (inside five years) could result in net losses for investors should inflation be tame. TIPs should be used as a hedging vehicles rather than speculations. The best TIP is the 1.375% due 7/15/18 as it is priced near par and has an inflation index near 1.00. Corporate inflation-protected notes are (how should I say this?) garbage. They adjust versus a year-over-year calculation of inflation. Even if inflation ran a steady 3.00% year after year there is now upward adjustment if the coupon as the rate was unchanged. If inflation declined from 3.00% to 2.50% coupons fall even though inflation was positive. This is a simplified but accurate explanation of how such bonds work.
I don't think there will be a double dip recession, but growth charts could more resemble a Nike "swoosh" as consumers rely more on income and less on borrowed fund. Also, much of the growth we have seen this year has been due to government stimulus plans. This was to be expected. However unlike in the recent past, such stimulus may not prime the economic pump, but rather give a temporary boost resulting in the economy settling back to a fundamental growth rate lower than to what we have all become accustomed during the past two decades. Recent home sales data illustrate the effect government stimulus is having. Existing home sales were surprisingly positive due to home buying benefits, but new home sales fell as the data reflects contracts to build new homes not closings. These home buyers would not be able to take advantage of government programs unless extended. Since it takes upwards of a year to bring a home from plans to completion, counting on government programs still being in effect when it is time to close is a risky proposition.
Less volatile markets present a problem to those investing via fee-based accounts. Growth rates and lack of volatility will make it difficult to justify paying management fees of two or three percent. Why pay annual fees to sit and watch a portfolio. This is especially true of fixed income accounts. The best plan is to construct a portfolio which meets your current needs consisting of appropriate securities and adjusting it only when your needs change or when an unforeseen event affecting an investment requires reallocating capital.
Enough of this talk of business. It is Christmas Eve, a time for those who observe the holiday to be with friends and family. Tonight as I sit by the fire with those I love, I will raise a glass of Old Fezziwig ( a great ale brewed by Samuel Adams) and wish a happy holiday season to all my readers and health and prosperity in the New Year. I shall be back the first week of January.
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