Knowing Your Portfolio Limits
The markets can surprise us to the upside and the downside. In spite of the market setting new lows, and now down about 57% from its October 2007 high, the AI 75-50 Portfolio is accepting more downside risks while ready to change course and re-short Beta risks.
Although we expect lower lows before this bear market ends, AI 75-50 knows its limits. The portfolio has met its downside objective of experiencing no more than half of the S&P's bear market loss. We have about 26% to spare, which gives us bullets to fire.
Our "Clint Eastwood Moment"
Our aim is to hit some upside targets and then run for cover. Before turning our focus on our long/short ETF portfolio, we will define what's good, bad and ugly for stocks, the economy and asset classes.
The Good (For Stocks As A Discounting Mechanism)
Since the Great Depression, our nation is less dependent upon manufacturing. We are a service economy with less than 8% of GDP derived from making products. The foreign emerging economies now produce the world's goods. Manufacturing requires more labor than our service-based economy, heavy equipment and inventories. Although emerging economies grow much faster than our own, they are prone to bigger booms and busts, much like our experience from 1850 to 1968. These factors are being more heavily discounted in foreign equity markets today than they were during the Great Depression. Consequently, U.S. markets may be close to fully discounting a lesser great depression, which historically bottomed near current levels.
The Bad (For The Economy)
Many investors know the worst bear market in the U.S. was an 86% decline in nominal and a 76% decline in real terms (net of deflation), which took place during the calendar years 1929-1931. Few investors realize that during these years, a composite of global stock markets was down less than the U.S., -64% nominally and -54% after deflation. Globally the current bear is much worse than the one experienced during the Great Depression in real terms. Global stocks, excluding those in the U.S., are down about 61% nominally and 64% in real terms, while the S&P 500 is down 57% and about 60% after inflation (see Figure 11, last column for exchange-traded fund equivalents).
From the above, it is reasonable to say that global markets are pricing in a Great Depression. While anything is possible, it is probable that Mr. Market is correctly pricing a 19th century-style depression. Lesser great depressions have experienced negative real gross domestic product (RGDP) growth steeper than 10% but less than 20%. If so, a 12%-or-higher unemployment rate may result. This rate would be equivalent to an unemployment rate near 16% if calculated in the same manner as in 1982, which was the last time unemployment neared 12%. We are approaching economic conditions that rival past depressions.
The Ugly (For Asset Prices Not Lifted By High Inflation)
The current production-consumption structure also makes it likely that our flirtation with deflation will be brief, if at all. Our nation's dependency on foreign capital will result in high inflation and slow economic growth. The powers that be will do everything they can to lighten private, public and consumer debt loads with cheaper dollars. Long ago, the economist Milton Friedman posited that inflation is always a consequence of government policy. Federal Reserve Chairman Bernanke is the expert on the Great Depression.
His playbook for avoiding another Great Depression borrows much from Mr. Friedman. However, their defense against deflation also relies upon their ability to rein in their expansionary monetary policies after economic growth improves. Bernanke and the Friedman crowd (including Greenspan) are on record saying that bubbles (in stocks, credit and homes) can only be seen after they burst.
Many in 1999 and 2006 saw and warned of the wreckage to come from the wakes of bursting bubbles. The Fed could have read these works and acted prudently by first talking down exuberance, and if needed, raising investment margin and then if needed, the Federal funds rate. How then will they know when conditions are right for reining in $10 trillion in stimulus? Their task is impeded by a world swimming in U.S. dollars at a time when our nation is too dependent upon foreign capital.
Eric Janszen of www.itulip.com taught me that as a nation's GDP and Federal funds rates approach zero, the cost of their goods and services either deflate or inflate. Like Japan since 1989, deflation is the outcome only if the nation can internally finance its deficits (stimulus & debts). Contrarily, nations like the U.S., when faced with the same circumstance, will most likely experience high inflation and subpar (or worse) growth.
Why? Foreign creditors are in a global crisis that requires them to stimulate their domestic consumption and to diversify sovereign wealth where they can harvest the highest real returns. They tried a Financial sector lead world order. They recognize its instability. They will shelter themselves from it by building a stronger domestic consumer-based economy. Our nation will eventually do the inverse: We will produce more and consume less.
Investors can read additional research for details on this view. Nouriel Roubini, Chris Whalen and Martin Feldstein are good sources of information.
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