December 18, 2006
NEW ERAS & OLD WORRIES
In search of reasons for why all the major asset classes have been on an extended bull run, Justin Lahart in today's Wall Street Journal (subscription required) raises the possibility that smoother, kinder and increasingly gentler economic cycles are the source of the good times.
"The economy doesn't rock 'n' roll the way it used to," he wrote. And indeed it doesn't. Recessions are less frequent intrusions, and when they do arrive they tend to be less severe compared with the contractions of generations past.
A forthcoming paper in The Review of Financial Studies explains that declining macroeconomic risk, or the volatility of the economy, may account for a lower equity risk premium. In other words, stock prices are higher than they otherwise would be if recessions were more common and took a bigger bite out of the economy.
The idea that things have fundamentally changed is hardly new, especially when it comes to finding cause for predicting that bull markets will run longer. Unfortunately, the advice is often tainted with failure. One of the more infamous examples came on the eve of the 1929 stock market crash, when Professor Irving Fisher of Yale counseled that equities had reached a "permanently high plateau."
Fisher's new era turned out to be a crock, and most (all?) theories for why bull markets don't have to end have suffered similar fates. The enduring constant, so far, is that markets rise and fall.
That doesn't mean that the economy of late isn't smoother and gentler. Nonetheless, there are some who question if there's such a thing as a free lunch paid for with the so-called repeal of the business cycle. In the late-1990s, financial journalist James Grant gave a thorough and informed airing to this strain of skepticism in his book The Trouble With Prosperity: A Contrarian's Tale of Boom, Bust, and Speculation.
As to the question of whether the current progress in managing economic cycles affects investing cycles, we regret to inform readers that we don't have a definitive answer. But we've got plenty of reasons to wonder if a new new era has truly dawned. The Federal Reserve and its counterparts around the world may be wiser than before, but investors are still investors.
Fear and greed, in other words, still haunt the canyons of Wall Street, infecting otherwise lucid minds with visions of grandeur and, when the time comes, worries that the unsightly gains will be forever lost and that prices will never again rise. Bernanke and company are an intelligent lot, to be sure. But investors in the aggregate aren't necessarily any wiser when it comes to exploiting peaks and troughs in asset prices.
Yes, we can argue about whether the various asset classes are now overvalued, fairly priced or even underpriced given the smooth economic sailing that presumably awaits for as far as the eye can see. The latter view has plenty of support, according to Lahart's article, which cites research from a Hong Kong research outfit, GaveKal, which observed that reduced economic volatility has boosted the demand for financial risk. The question before the house: is the higher demand warranted?
There are many views about fundamental drivers at work in the 21st century economy, although as Lahart notes, a source for the smoother cycles may be plain old luck.
This much, however, is clear: the major asset classes are enjoying a multi-year bull run, as we noted a few weeks back. It's rare to see so many asset classes emitting optimism, at the same time, and for so long. Perhaps it's warranted, perhaps not. We'll take what comes and rebalance accordingly. Timing, of course, is the great unknown.
With everything rallying, raising cash is easy: throw a dart at an investment and sell. Odds are, you're bound to have a profit. Rather, deciding where to redeploy the cash with a modicum of prudence is the conundrum du jour. Usually, there's always something hurting on the asset class level. But based on trailing returns of recent vintage, there are no obvious candidates wallowing in pessimism, which tends to make for attractive pricing for strategic buyers.
Alas, the only thing to do is sit tight, wear a pair of flame-retardant pants to keep the cash from burning a hole in your pocket, and wait for clearer opportunities.
Posted by jp at December 18, 2006 9:40 AM
The recent recession was short-circuited by Fed creating enough money to depress interest rates to 1%. We'll pay a price in the fullness of time.
Posted by: algernon at December 19, 2006 9:29 PM