Taking Another Shot At Market Efficiency

The market is inefficient.

What I mean by this is that the market is always in a state of controlled chaos. Some may consider this equilibria, but it is equilibria in a very limited sense of the word. Equilibria is not the same as intrinsic or fundamental value (which is also in the eye of the beholder).

Because market prices are a function of consensus feelings, emotions, expectations and sentiment regarding earnings, interest rates, risk and the future (in other words they reflect the current zeitgeist of the day and embed some feelings for the future), they are necessarily wrong all the time. No one knows what the future holds. Of course as markets correct and swing from overvalued to undervalued and vice versa, they must by definition pass through some median or fair value point. The problem is they rarely trade at the fair value point for any steady state period of time.

Getting cyclical trend and momentum right are consequently the most important ingredients to long term active investing, while have a mean reversion contrarian disposition can help cut off the excesses of the tails. The problem is we never really know beforehand the timing, time or magnitude of any new cycle.

Therein lies the problem.

Secular Cycle vs Cyclical Forces

The secular cycle portends the positivism of growth, expansion and rising productivity. It also increasingly includes certain headwinds from changing demographics over the next 50 years.

Cyclical stimulus (monetary and fiscal) has managed to delay, defer and extend the full impact of the prior cycle's contraction. The question is whether such actions have got us over the hump or whether there will be a price to be paid? and if so, what the price will be?

The price is likely to be a rebalancing of labor/capital wealth distribution (probably through taxes) and lower growth. To some extent we have already seen some of those factors playing out: higher taxes and lower relative growth.

I'm Going To Mark This Spot For Active Management

With the release yesterday of Vanguard's funds performance relative to peers showing the pure dominance of passive over active management over whatever time frame you want to look at, I am going to put a marker in the ground, and as a good contrarian, say that marks the pinnacle of passive over active for this cycle.

I have no idea how long active vs passive relative performance cycles last, but if something can't go on forever, then it probably won't.

The irony of course is that I am launching a passive index based advisory practice just as active is likely to see a turnaround in its fortunes.

The other giveaway to the "peak passive" theory is the increasing crescendo of headlines touting the fact.

Oh well, back to basics. The principles of investing are simple. The act of investing is hard.

The Odds

The odds are that we are getting toward the end of the current upcycle. The market and the economy bottomed in 2009 and have been on an upward or a recovering trajectory ever since.

My prior thesis of a compressed market cycle because the market was not allowed to clear has proven false.

That having been said, a regular (or average) market cycle is about 5 years or so. On that basis we are therefore closer the end of the cycle than the beginning.

I don't see too many people calling for a recession or even of a decline in the economy. It seems to me that the consensus is that growth has been disappointing but that the economy will continue to heal/recover even if it is at a less than stellar rate.

The bond market is confusing the consensus because the consensus is not looking for or fearful of a recession. However, it may well be the canary in the coal mine pointing to the end of the cycle.

My heart is not fearful of an upcoming recession but my head is mulling the probabilities and cautious.

A Little Early On That Call - Now Might Be A Better Time To Brush It Off

I wrote a commentary for the SMID cap strategy at the end of 2009 talking about the likely battle to take place over the next 2-5 years between cyclical forces of recovery coming up against secular headwinds. Here is an excerpt:

"Don't get too comfortable. The economy is fragile, and both short term and long term risks abound. A legion of risks are in plain view. At some point, cyclical tailwinds will run into secular headwinds. Structurally we are in many ways worse off after the recession than before. We lack the political will to make the hard and necessary decisions to get things right. We have, once again, failed to allow the market to clear, and so are left with the burden of accumulated deferments. The lesson from this whole mess is that we haven’t learnt the lesson. There is a price to be paid for profligacy and denying the laws of economics. As a country we (many other developed countries are in the same boat) have lived beyond our means and made promises we are unlikely to keep. Those secular headwinds will be reflected in rising inflation and interest rates, lower growth, increased savings, higher taxes, more regulation, and constraints on government spending going forward."

In hindsight it looks as though I was a little early. But I stick by that general view of the forces and factors in play.

If I might be so repetitive. Now is probably a good time to brush that thesis off and deliver it again.

They say a clock is always right at least twice a day. Perhaps I'll be closer to the truth this time around.

Declaring Failure and Moving On

This is a very rough note. I think it could be fleshed out into a very meaningful article, but for right now it is just some top of mind reflections.

My underlying framework post-GFC was one where the business/investment cycles going forward was going to be more compressed (timewise) and more volatile. I was also heavily influenced by the new normal meme and how the economy was going to be stagnant as it worked through a balance sheet recession.

If I were to attribute a reason to that belief I would ascribe it to my ideological bias toward market economics and the belief that the market had not been allowed to clear properly due to significant artificial interventions. It was also heavily influenced by the recent traumatic past and the idea that modern markets/economies were more integrated, interrelated, more complex than ever before, and were consequently prone to momentum and cascade effects.

Financial marketwise this has not played out and I must declare failure and move on. I think the reason why financial markets have not reflected those beliefs is due in large part to hindsight bias and the massive trauma effected upon the psyche of market participants who endured the brutality and existential angst of a market implosion that could have gone even further. Investors have been fighting the last war. They have been overly pessimistic. They have been unwilling to give the Fed (or the govt) credit for stimulus. The market has climbed a massive wall of worry the whole way.

We are now at a point where the market is coming around to the idea that the Fed may have steered us over the canyon and to other side. The economy may be gaining sufficient strength to be self-supporting and a new cycle of more normal growth is going to ensue (even as the stimulus disappears).

That is the hope. We shall see how things pan out in practice.

Long Cycles, Business Cycles, Market Cycles...Cycles, Cycles, Cycles

We are 54 months into the upcycle (in the market) with a 160% return off the bottom.

Here is an interesting set of reference points:

Are we entering a "more normal?"

Man, have I been out of sync with this market.

"Don't fight the tape," and I've been fighting it since July 09.

Followed the good folks at PIMCO and GMO into the "new normal." Consequently stayed away from the cyclicals (big mistake) and also was way too cautious on the Financials.

With the market trudging determinedly higher, investors are slowly, but surely, convincing themselves that we are moving back to normal and are growing in confidence daily. I'm not a card carrying member of that school (yet), but I am worried that my timing could be a tad off (like years!).

The structural problems are real and unsustainable. In the absence of serious change, we know where we are heading. It is only a matter of timing (and that is the hardest part). Another part of my thesis, is that the changed dynamics of the market (new instruments, new vehicles, new players), in conjunction with the the imbalances outstanding, will lead to more compressed market cycles. So, while the historic market cycle has ranged around 5-7 years, we are now likely to experience market cycles of 3-5 years.

How Overcrowded Is The Short USD Trade?

I don't know how overcrowded the short dollar trade is, but if the seeming consensus is anything to go by, the dollar is good for nothing and heading into the bowels of hell. Does it deserve to be trashed? Probably. Is it a one-way trade you can't lose on? I wouldn't be so sure about that.

The US has certainly done its best to debase the dollar, and the outlook sure don't look too pretty. But you've got to remember that the dollar is a unit of relative value and that it tends to run in 5-7 year cycles (and we're closer the end of this cycle than the beginning). In that context, the USD doesn't look all that bad. Throw in the fact that the current account is moving in the right direction, the Fed will raise rates sometime, the Chinese will likely revalue at some point, "hard currencies" are not so hard, the Europeans and Japanese are begging for relief, and it doesn't take too much imagination to see the dollar moving higher.

On second thoughts, I think I'll keep my dollars.

1Q Earnings - A sign of hope

1Q09 earnings are providing a ray of hope.

Earnings are coming in better than expected (no surprise). But the downward revisions are slowing, pointing to a potential bottom in the earnings revision cycle.

This is important, because analyst estimates (which simply mirror management guidance) are generally lagging. And so, much in the same way that analyst estimates are behind the curve on the way up in the earnings/economic cycle, they have been behind the curve on the way down. This playing catch-up, usually meets at the top and the bottom of the earnings cycle.