Monday, January 31, 2011

Economic Outlook (Part 1) -- Overview

This morning I spent some time with members of UCLA Anderson Prof. Bill Cockrum's Student Investment Fund. I believe this is the 5th or 6th year I have done this, and I always look forward to interacting with this group as they begin the difficult task each year of formulating an economic outlook and a coherent investment strategy. I thought it might be worthwhile to break down my presentation to them in several parts, with a minimum of words and a maximum of charts. Most of the charts and themes have been covered here in other posts, but I think it helps to put it all together in an illustrated, narrative form.

Formulating an investment strategy first requires an understanding of what the market is expecting. If your view of the world is the same as the market's then you can't expect to do much better than just investing passively in the market. But if you think the market is misjudging things, then that opens up opportunities for gains by over- or under-weighting different market sectors and individual stocks or bonds.

Many people use opinion polls or surveys of bullish and bearish sentiment to judge whether the market is cheap or rich. I think it's better to look at the market itself; I think there are a variety of market prices that provide good insight into the assumptions that are driving the market. The things I look at tell me that the market is still quite concerned about the future—there are lots of walls of worry, in other words. I think many of these concerns are too pessimistic, therefore I am generally optimistic and bullish.

Monetary policy is a source of great concern, since the Fed is in uncharted waters. Three years, ago, if you had told just about any economist in the world that the Fed was about to purchase well over $1 trillion worth of securities in a relatively short time span, they would have reacted with forecasts of imminent hyperinflation, but only after protesting that such a scenario was virtually impossible in the first place. But it has happened, and nobody knows yet what the endgame is going to be. So far there hasn't been any overt inflation problem, but there is a lot of action in the gold and commodity markets that might be precursors to a general rise inflation.

Fiscal policy is also a great source of concern, since federal spending relative to GDP has expanded by some 25% in just a few years, and will be as large or larger a share of the economy for the foreseeable future unless big changes are made. The problems with a surge in spending are many: higher spending, if left unchecked, sooner or later will require higher tax burdens, and higher expected tax burdens automatically depress the present value of all risky assets. Higher spending also means a weaker economy, since government spends money much less efficiently (and many times with wild abandon and rampant corruption) than the private sector.

Credit spreads have narrowed a lot, but they are still well above the levels we might expect to see in times of a normal, healthy economy.

The implied volatility of equity options (e.g., the VIX index) is still well above levels that we might expect to see during times of economic and financial tranquility.

The dollar is as weak as it has ever been. Surely that reflects great concern on the part of US and global investors over the future of the US economy.

Gold prices have soared to over $1300/oz. Surely that also reflects great concern over the political and financial future.

Commodities are up strongly, across the board. This reflects not only a strong global economy but there appears to be a significant monetary component to rising commodity prices, as investors stock up on physical assets out of fear that money may lose its value.

10-yr Treasury yields of 3.4% only make sense if the market in aggregate holds a very dim view of the US economy's ability to grow. Given the widespread belief in the Phillips Curve, a very weak growth outlook for the US economy compels one to believe that inflation is going to be very low for a considerable period. So Treasury yields are a clear sign that the market believes US growth will be sluggish for a very long time. 2-yr Treasury yields of 0.6% are an unambiguous sign that the market believes the Fed when it says that short-term interest rates will be very low for a very long time, and that will be the case only if the economy is weak for a long time.

In short, the market is generally pessimistic about a lot of things, leading me to the conclusion that equities are attractively priced if one believes that the problems facing us are not insurmountable.

The federal deficit is a big problem, but a solution is far from impossible. Just holding spending constant would balance the budget within 5 years. Social security is a big problem, but most of the problem could be addressed by raising the retirement age and indexing benefits by using the CPI instead of nominal wages. Healthcare is a big problem, but simply changing the tax code to allow everyone to deduct medical expenses would go a long way towards making the healthcare market more efficient and cost effective.

The November '10 elections made it clear that the people are demanding big changes from Congress, with the number one message being "stop the spending." Given the extreme to which the situation has gone in so many areas, the time is ripe for some fundamental and positive changes in the direction of fiscal policy.

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