The burden of uncertainty

It is a well known fact that one of humankinds greatest burdens has to do with uncertainty, and just like its distant cousin, infinity, our minds have a difficult time coping with the concept. Countless studies have shown, for example, that we are much happier once something that was uncertain becomes certain, even if it happens to be something unpleasant. Apparently the mere presence of certainty removes a whole layer of tension.
Markets behave in a very similar manner and the degree of uncertainty can easily be measured by the degree of volatility. It is why in times of serious trouble, as in the second half of 2008, volatility levels can rise dramatically.
As uncertainty is perceived to be an unpleasant experience, it acts as a powerful driver that pushes us to come up with solutions to counter it. The insurance business is a perfect example of an industry that has flourished as a direct result of mankind's desire to counter uncertainty. Corporate earnings announcements is another example whereby the time frame between earnings reports have been shortened in order to reduce the degree of uncertainty regarding the health of a business. Such strategies do come at a price, however. By increasing the frequency of earnings results in a given year, the firm may be sacrificing long term objectives for short term gains.
With all this in mind, the EU's willingness to bail out Greece and Abu Dhabi's intervention on Dubai should come as no surprise. In both cases it would seem that the uncertainty of doing nothing is just too large of a burden to cope with.

A fluke or for real?

Last week's announcement that the U.S. economy had expanded in the fourth quarter (the second consecutive expansion) by a greater amount than what the market consensus expected took everyone by surprise, raising the risk that the resulting complacency may lead to a premature withdrawal of some of the more critical stimulus plans in place.

The trouble stems from the nature of the downturn which in this case is structural rather than cyclical. Historically speaking, it takes an economy significantly longer to recover from a structural downturn than a cyclical one. The combination of greater government regulation in an environment of high unemployment and weak consumption can only contribute to extending the period of slump. The stock market rally in 2009 may reflect a disconnect between expectations and the real fundamentals and, as a consequence, stocks may disappoint this year.

The tough road ahead...

According to Ibbotson Associates, a well respected data mining firm, since 1926, U.S. stocks have returned on average 9.8% per annum. This is the compounded annualized total return (i.e. including dividends that are reinvested) of the S&P 500. Over the same period, bonds, which is the other major asset class has returned 5.3%, significantly less than equities. Taking the more recent past such as the last 10 years, however, the results are -2.22% and +6% for equities and bonds respectively, in stark contrast to the longer term where the equity investor was the clear winner. These results tell us that although we can expect average returns in the order of 9.8% over the very long term, we can experience significantly long periods (a decade in this example) where average returns could turn out to be substantially below this figure.
This example illustrates well the importance of diversification amongst asset classes because although even for a diversified portfolio, correlation aberrations over shorter term periods such as in 2008 can lead to significant losses, over the longer term they are likely to be diluted somewhat.
Coming back to the 9.8% return expectations drawn from data that spans over a very long period, it is not very realistic to expect such returns into the future, particularly in an environment of weak consumption, investment and greater fiscal discipline. To make matters worse, the Ibbotson figures happen to be gross of inflation (average 3%), investment expenses (average 1-2%) and taxes (average 1-2%) which means that if we were to calculate the net expected annualized total return for equities, it would add up to between 2.8% (worst case) and 4.8% (best case). You may argue that inflation is a non issue because we haven't seen much of it over the past decade, but the future may turn out to be very different given the quantity of stimulus out there. In any case what is clear from the above is that to be able to generate a decent return over coming year is going to require a lot of skill that only true professionals can provide.

A mirror image of a year earlier?

2009 turned out to be a year in which most asset classes yielded positive returns after a rough beginning. Just about the only asset class that performed negatively were treasury securities (the only asset class that yielded positive returns a year earlier).
Just as in 2008, correlations were generally relatively high but because the move was in the opposite direction there wasn’t much to complain about (unlike in 2008 when pundits were suggesting that diversification was dead). Commodities recorded the largest gains, followed closely by equities and real estate and finally hedge funds that rose steadily throughout the year. A recent measure of home price to rent suggests that problematic markets such as that of the U.S. are now close to their historical fair market value (could that really be?). The same measure also indicates that certain European countries such as Spain, U.K. and France and bubbly places like Hong Kong are substantially overvalued which means that we can expect the slide to continue in those markets.

The Dollar Surge

I guess it is fair to say that most of us got caught by surprise with the reversal in direction in the dollar since the beginning of December. Dollar bears were citing a ballooning US deficit, remaining toxic waste and weak consumer demand as prime reasons to clobber the dollar. But then, around the beginning of December, something fundamental changed. People began to realize that Europe was not any better, neither fiscally (huge deficits and a growing risk of defaults for certain countries) nor in terms of consumption and the tides began to turn. Further support for the dollar also came in the form of employment statistics that were overall better than what the market was expecting. So there you go, the U.S. economy is not doing as bad as what we were led to believe, on a relative basis of course! I should also point out that emerging markets are not plagued by the deficit problems of developed markets and therefore their currencies should rightfully appreciate against the dollar. This is especially applicable to commodity rich countries such as Australia.

Mind you, these are long term trends that I expect. As everyone knows, the short term is notoriously difficult to forecast, especially regarding currencies that contain a lot of noise.

Another black swan?

The Dubai government's announcement that it would postpone debt repayments in its holding company sent markets roiling across the globe, triggering a sharp spike in the cost of insuring debt from a growing number of emerging and even non emerging markets including the likes of Brazil, Turkey, Hungary and Greece. The crisis, which began in the second half of 2007 with the collapse of the subprime mortgage market (as delinquencies soared), spread like wildfire into the highly leveraged banking sector, triggering a severe credit crunch which in turn prompted governments across the developed markets to instigate an unprecedented scale of intervention with an immediate aim of assuaging markets that were on the verge of complete collapse.

Until Dubai disclosed its problems, the general belief was that emerging markets had "emerged" out of the crisis relatively unscathed mainly, it was thought, as a result of the limited exposure they had to the subprime toxic waste. What pundits (once again) apparently failed to heed attention to were the implications of tighter credit standards to debt laden countries in the wake of the crisis. It basically meant that the "unscathed" emerging markets were having increasing difficulty in servicing the huge amount of sovereign debt that had been accumulated during the booming years preceding the crisis. It is difficult at this stage to asses exactly how serious the problem is, markets were certainly not expecting such a gloomy announcement from Dubai. If there is any certainty, however, it is that the crisis is still with us and probably for some time to come.

Paving the way for inflation?

It would seem a bit farfetched to expect a surge in inflation any time soon, especially given the dire economic conditions that continue to plague mainly the more developed countries. But then again it is when you least expect something to occur that it actually does materialize. Nothing could be truer in this regard than inflation expectations. The Federal Reserve or any central bank for that matter, has a dismal record when it comes to anticipating inflation. That is why most central banks actually shy away from overtly publishing their expectations.

A surge in inflation typically occurs when demand for goods and services outrun supply. Several indicators can provide a good idea of the risk of inflation in a given economy. One such example is the employment rate whereby the closer unemployment is to its "natural" rate, the greater is the probability that prices may surge (given that labor is the single most costly input in production). Another is capacity utilization which measures manufacturing ouput is to its full capacity. As with employment, the closer it is to its limit, the greater the risk of a surge in price. The problem with these measures are that they dont tell us much on their own (they need to be assessed in conjunction with other indicators) and also that they are not "forward" looking enough.

As for recent economic releases, one that drew my attention is business inventories with the latest figure signaling yet another drop, bringing stockpiles to their lowest levels since November 2005 (see chart). What this means is that if demand were to suddenly surge (unlikely if you ask me), U.S. businesses would be caught swimming naked and would have no other option than to jack up prices until enough capacity is restored to build inventory. It is indeed an inflation "red flag" but unfortunately doesnt tell us much in terms of probability of occurrence.

Emerging signs of a long period of anemic growth?

The various high octane government actions/interventions over the past two years have clearly had an impact on the global economy, namely by putting a stop on the market freefall, the worst of which occurred in 2008. Those very same markets are now pricing a very high degree of optimism regarding the future, almost as if someone had pressed on a reset button to give the economies of the world a new lease of life, as if the crisis itself was nothing more than a bad dream! Certainly there is significant variation in the health of the economies across the globe, with those of developed countries looking far more sickly than those that belong to the emerging league. No wonder, considering that most of the financial mess was not only concocted in first world countries but was also largely consumed by them. Emerging markets, on the other hand, emerge from the mess relatively unscathed with far less leverage and in a much better shape structurally than at any time in the past. So now that we know which horse to bet on, can the dizzying ascent of the global stock markets be justified in any way? It is the developed markets that worry me and although there have been a flurry of upbeat figures over the past couple of months that would suggest the worst is behind us, more recent figures on housing and prices are less comforting as they increasingly suggest that we are entering a period of anemic growth.