Investing into uncertainty - Black Swans and Lame Ducks

Let me start with the obvious - Investing has never been more difficult or more important. I hear and read a lot on the subject and polarisation between the doomsters and the optimists is stronger today than I have ever known it to be in the past. Time to try and take out my torch and shine it in a few dark corners,

After the meltdowns of the 2008/9 period, a lot of people have been left shocked, confused and a lot poorer. The unsinkable certainties of yesteryear, the Banks, were the ones that perhaps did most damage, but even now the shocks are coming thick and fast. The disgraceful behaviour of Obama over BP did almost as much damage to that fine company as it did to the remnants of his own etiolated reputation. The feeling I picked up from all around me was that the question being asked was "is anything safe?". Savings rates and Government Bonds yielding lower than rates of inflation say it all. The first and almost the only consideration for many is the safety of their capital. Only after that fear begins to wane as a prime motivation can wealth begin to seek out future opportunities.

The Great Divide is Deflation versus Inflation. The Deflationists would point to 20 years of deflation in Japan as that nation retrenched from a Banking/Property/Shares bubble and ploughed its still mighty surplus into savings at rates far below 0.5%. With all that money going in to savings, less and less was spent on consumption, investment in buildings, plant or machinery and a general stasis was reached. I have often felt that the Japanese adopted the "Sleeping Beauty" model - sleeping for a thousand years until awakened by a kiss of economic stimulation from the rest of the world. Well the 90's saw that kiss and Sleeping Beauty failed to wake, not having the confidence to do so despite having more than enough money. This is the possible downside of economic austerity - that by cutting spending and shrinking an economy it implodes in a deflationary spiral. As yet the need to cut back (and here I am talking about most of the G20) on profligate behaviour and to get both personal and public finances on a sound footing almost certainly outweighs the deflationary risk and we have a long way to go before this and the famous "double dip" scenario it is associated with are a looming problem.

The other side of the Grand Canyon of Opinion is the Inflationist argument, and yet the symbiotic connection between the two side is rarely made clear. They are usually portrayed as opposing theories. Deflation has historically only ever been beaten by pumping money into a system to get things moving (a Keynesian stimulus as it is usually known). Roosevelt initiated the "New Deal" to combat the Great Depression of the 1930's and Hitler expanded public works in Germany, as did most European governments. It worked and we should not lose sight of the fact that Dr. Bernanke, Chairman of the US Federal Reserve, made his academic reputation through the study of the Great Depression. Pumping money into any system devalues it ( Google for Gresham's Law for that discussion) as the total value of cash seeking a finite number of goods and services competes. I still believe we are yet to fully pay the price for the stimulus after 9/11 by Bernanke's predecessor Alan Greenspan. The inflationist argument is that we will inflate our way out of trouble as money becomes worth less and asset prices such as investment and property seem to grow. Of this are bubbles made.

For my part, I see a clear synthesis of the two as the stimulus required to avoid the deflationist crisis is maintained at sufficient levels (but never more than that) to keep economic growth from at least not turning negative. At this point the prudent action is to take action by withdrawing stimulus, putting up interest rates and refinancing Government Bonds at a sufficient level to stop the artificial "boom" from running away. It can be argued that the failure to do this after the 9/11 stimulus was at the centre of the bubble which caused out current woes. A former Fed. Chairman - William McChesney Martin - famously described his job as "Taking away the Punchbowl just as the party got going". If only Greenspan and Bernanke had noticed people swinging from the chandeliers.

Of course a little inflation is usually concomitant with growth and is not to be feared too much. It is MUCH easier to choke off growth than stimulate it. Adam Smith's Invisible Hand is weaker and slower than it is often given credit for.

So - where do we go from here? While fear and risk-aversity are so high on the agenda it seems to me that for the short term the deflationist fears will ensure that rates are kept low and that saving rather than investing will be predominant. With property (the preferred form of investing in the UK, Ireland, Spain and the US in recent decades) likely to fall further or stagnate (except China which is more and more taking on the characteristics of creating its own bubbles) there are few safe havens - and paradoxically I see this as a reason for investing in shares.

Taking the UK domestic Share Index - the FTSE 100 - as an example, a current yield of around 4.5% (the re-introduction (?) of BP dividends obscures an accurate figure for this a little) for a "self-cleansing" index (i.e. weak companies are always leaving and stronger ones joining) means that for it to reflect similar total returns as a UK Government Bond yielding just under 3% it could reasonably be expected to be at least 50% higher than current levels. The FTSE index is also very international in make-up, thus providing an extra layer of smoothing to risk directly aimed at a domestic economy. A little Stop Press item here. As I write I see an article in the FT in which slightly more optimistic numbers than mine calculate prices should be 100% higher.
Discussions about risk premia and the Reverse Yield Gap are for another day if this seems simplistic (which I admit is partly is).

Stimulation of money supply (and also velocity of circulation - but that is another discussion altogether) are not, in my opinion, likely to be given up at any time in the near future. Lower rates and effective support for commerce are the left hand side of an equation that simply has "buy shares" on the right. I am talking about markets rather than stock-picking here and the opportunity to snatch defeat out of the jaws of victory will alway be with us if the wrong portfolio is chosen. Buying an Index Tracker is not sophisticated investing - but in the case under discussion works adequately.

A final word for the Gold Bugs. Actually I would prefer the final word to be just "goodbye" - but fat chance unfortunately. Gold as an investment yields nothing and is great if we implode into savagery and revert to a Mad Max scenario - but only if you have it secreted about your person. Ignoring the more extreme survivalist ravings (if they are true, forget Gold and buy bottled water, shotgun cartridges and tinned beans - all to be kept in your bunker in the Highlands). It is a "reverse bubble" built on the same psychology as the "system" it purports to eschew. If the ordure ever did hit the air conditioning that badly what good would a few bits of paper saying you own Gold be worth?

Dum Spiro Spero