I am a director of several funds and often – along with some other board members – I am also responsible for the investment strategy of these funds. Usually, board members and advisors have very little to say in terms of the how the funds invest because it is the investment manager’s responsibility to perform and, therefore, it is very difficult for a board member to interfere in the investment decisions of the fund manager. However, in the case of some funds the board members or the advisory board are responsible for a fund’s asset allocation. In other words the board members will decide at periodic meetings – usually quarterly - how much of a fund is invested in equities, bonds and cash. Of course, board members will seldom agree with each other, what percentages should be allocated to these different asset classes and so, a compromise will be reached, which will, therefore, neither turn out to be “right” nor totally “wrong”. However, the consensus decision will never be entirely satisfactory. In addition, it has been my observation that board members and the funds’ investment managers become very optimistic after an extended period of stock market strength and very pessimistic after a period of extended weakness. When the market has been strong for a while these “experts” will find hundreds of fundamental reasons why the market is strong whereas when the markets has declined for a while they will list hundreds of reasons for caution and for reducing the exposure to the market.

In the 1970s, the most admired technical analyst was Joe Granville. As incredible as this may sound, Granville caught every stock market move of more than 10% up or down within a few days of the turning points from up to down or from down to up. The result was that at the end of the 1970s, the entire world was watching Granville’s buy and sell signals. In fact, for a brief period of time Granville’s buy and sell signals would move the US stock market - at least temporary. Granville’s demise as a market guru then followed. In 1982, he failed to realize that a secular bull market in bonds and stocks had begun and remained bearish. So, in the early 1980s he totally lost his credibility and his following. Still, to Granville’s credit, I must point out, that he turned extremely bullish on the stock market after it had collapsed by 40% between August and October 1987 culminating in the famous October 19^th, 1987 crash during which the Dow dropped by over 21% in one day! Also, whereas Granville fell on hard times after the 1970s and is, today, hardly known among the investment community, his books on technical analysis are outstanding, in terms of his insights into what factors move markets. They are also entertaining, and easy to digest. In my opinion, one of his most important words of wisdom is that markets will always move ahead of the news. When a stock or any market begins to act well, while the news is extremely bleak, the market may be indicating that some improvement is around the corner. Conversely, when a stock or a market begins act badly, while the news is still extremely bright, the market more often than not is telling you that the fundamentals may be about to deteriorate. Basically, Granville’s view is that “news” is bunk and that the market will have responded to favorable or unfavorable news long before the news comes out into the open. In other words, you should invest when everything looks horrible and when nobody can see how fundamentals could improve, while selling is advisable when the sun is out and everything looks rosy. As Granville pointed out, an investor should basically stand on his head!

 I am mentioning the fact that news will always lag investment markets for a number of reasons. First of all when I look at today’s inflated asset markets, the late 1970s and early 1980s come to my mind when all investment markets were - with the exception of the commodity markets - extremely depressed. After the experience of high wage inflation in the 1960s and accelerating consumer price inflation in the 1970s, stocks and especially bonds were extremely inexpensive in the early 1980s. In 1981, long term US government bond yields rose to over 15% and 3-months deposit rates were above 20%. Therefore, nobody in his right mind wanted to touch bonds – not even with a barge pole since higher yields were available on short term deposits than on bonds. Also, the common view was that bonds were “certificates of confiscation” as consumer price inflation was here to stay and that it would continue to erode the value of bonds. Most of my clients argued “why buy bonds at 15% yield when one can get 20% interest on riskless short term bank deposits”??? In addition, with the Dow Jones hovering around 800 – no higher than in 1964 – nobody even believed that Robert Prechter might be right when he predicted in his first book on the Elliott Wave Theory, published in 1978, that the Dow would rise to 2,300 (in a subsequent edition he revised his forecast to 2,700). The preference for cash and commodities (in particular gold) was also evident from the inflows into equity mutual funds. In the 1970s - with the exception of two months - mutual funds suffered net redemption every month! Moreover, by 1982, cash positions at US mutual funds rose to over 15% compared to around 4.5% at present.

Today, on the other hand, it seems as if investors had thrown any caution into the wind. Cash returns are so low – courtesy of Greenspan’s ultra easy monetary policies that the entire world is “investment mad”. Investors all over the world are hunting for investment opportunities the way gold diggers were rushing to California during the great gold rush of the late 19^th century. Based on low inflation figures investors buy bonds, due to the incremental demand from China they buy commodities, because of record S&P earnings, an expanding global economy, and the belief that stocks go up anyway by about 10% per annum in the long run they pile into stocks, and finally because “you cannot lose on real estate over time” they rush into properties all over the world. 

So, what I am thinking is that while the early 1980s represented a lifetime buying opportunity for financial assets and real estate, today, we may be at a lifetime selling opportunity for financial assets and real estate (not necessarily in Asia). The reason for the strong performance of asset prices over the last 20 years or so is that, in the early 1980s, consumer price inflation shifted to asset inflation, which changed the rules of the investment game whereby investors were not alerted by this change of rules. So, if in the early eighties, consumer price inflation could, out of the blue, begin to shift from consumer price inflation into asset inflation without investors actually perceiving this shift to become a permanent feature of the following two decades, why could, now, or in the near future, asset inflation not begin to shift back into consumer price inflation – this against all expectations???

Figure 1: Misrepresentation of Consumer Price Inflation

Source: tmcmanus@bofasecurities.com www.bofasecurities.com and Bill King kingreport@ramkingsec.com

Figure 2:

As a side, I may add that I have always been skeptical about buying inflation adjusted bonds (TIPS), simply because the yield on inflation adjusted fixed income securities is pegged to the CPI. Since the government will always understate the true rate of inflation the buyer of the TIPS will eternally be shorthanded. Moreover, I think that one day in future, the bond market will finally wake up to the fact that inflation has been understated and sell-off very badly. In fact, you would have to be the world’s greatest optimist (a la Abby Cohen or Larry Kudlow) to buy a US 30-years government bond in US dollars and with a yield of just 4.5% with the view to hold these bonds to maturity. You would have to assume that US inflation will never rise above 4.5% within the next 30 years and that the US dollar’s purchasing power will be maintained. Not a likely scenario, in my opinion (short term, however, bonds could rally somewhat more as the economy weakens).

But there is another reason why I started out by talking about markets moving ahead of news. Recently a board member of one of the asset allocation funds, for which I am also an advisor, wanted to double the equity allocation of the said fund based on an economic study he circulated (naturally produced by a self serving investment bank), which showed that the global economy was strengthening and that profit growth would remain strong. Now, I am not necessarily arguing here that the study is wrong. Who knows?? But, a strengthening global economy may be “old news” as far as the US stock market is concerned and not lead to rising stock prices. The market may have already discounted this good news through its rise since April.

Moreover, if I look at the recent performance of important stocks in terms of their market capitalization, such as Wal-Mart, GE, IBM, Citigroup, Dell, and financial stocks in general, which are all weak, the stock market seems to say the opposite from what the bullish economic study is suggesting….

And quite frankly, if I have to make a choice between who to trust more – the market action or the forecasts by strategists, economists and analyst, I take the market’s forecasting ability any time. I should also like to add that recent weakness in sub-prime lenders and homebuilders hardly suggests that the credit driven economy will strengthen in the next six months. Corporate profits are, therefore, likely to disappoint.

A last point: Given the devastation in the Gulf of Mexico, the “always easy” and disastrously interventionist Fed is likely to stop raising interest rates soon. This will be reflected in the US dollar resuming its downtrend and gold rising further.

© 2005 Marc Faber, Ph.D.
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