Virtually everyone in the investment business today grew up in a world where fundamentals dominated the markets. But from the collapse of Lehman Brothers in the fall of 2008 right up until today, markets have been driven not by fundamentals but by geopolitical events and central banker policies. Unless we can somehow get inside the heads of, say Ben Bernanke and Angela Merkel, we can only speculate about what’s going to happen. And one thing investors should never do is speculate about unknowable things.Here's an executive summary of the Reinhart paper and here is the paper itself (66 page PDF), both via the IMF from our post "Rabobank on Financial Repression and What Bernanke is Up To"
By “fundamentals” we mean the common sense ideas that underpin any understanding of the investment world that we can make sense out of:
Investors will demand – and, in general, receive – greater returns to invest in a more risky security than in a less risky security. Yet the riskiest securities – emerging markets stocks, for example – have significantly underperformed less risky securities – US large cap stocks, for example.
Diversification reduces risk, and thoughtful diversification reduces risk faster than it reduces return. Yet as we all know, when markets have melted down virtually all sectors have moved in lockstep, leading investors to complain that “Diversification only works when you don’t need it.”
Finally, hard work distinguishing value from price is how investors add value and outperform other investors. Yet active managers have overwhelmingly underperformed since 2007, and some of the best managers have underperformed the most – especially value investors in 2008.
Investors complain that they have bought assets that seemed clearly undervalued by long-term norms and have been hurt when a geopolitical event came out of nowhere. Meanwhile, other investors are eagerly buying assets that seem clearly overvalued by the same norms, but central banker policies keep prices of those assets rising.
For example, legendary investor Louis M. Bacon, founder of Moore Capital Management, recently decided to return $2 billion to his investors. According to the New York Times, Mr. Bacon “has been stumped by the current debt crisis in Europe.” Said Bacon, “The political involvement [in markets] has been so extreme… What they are doing is trying to thwart natural market outcomes.”
Geopolitical events, sovereign actions and central banker policies have always been important market movers. But rarely – and certainly not in our investment lifetimes – have macro events so completely dominated markets for so long.
The problem arises because the world’s developed economies are not slogging through a typical economic recession, but a full-blown financial crisis, which is a very different animal. As we know from reading Reinhart & Rogoff,2 financial crises arise from different causes than recessions, tend to last much longer and tend to have more repercussions for the economies in crisis. The current crisis, for example, can be said to have started in the US in mid-2007 with the credit crunch, but it’s still raging in Europe five years later, with no end in sight. And if we really want to take a long look back at the distortions and bubbles that led up to the crisis, note that as this paper is being written the S&P Index is hovering around 1330. But the index first hit 1330 in April of 1999, 13 long years – and a lot of breathtaking volatility – ago.
As a result, central banker intervention has been more massive, of much longer duration, and more unconventional (quantitative easing, Operation Twist) than we’ve ever seen before.
Consequences for Investors
One issue to keep firmly in mind is that central bankers and sovereign nations aren’t especially concerned about the plight of investors. They are trying to preserve the global financial system and to stimulate moribund economies, and if investors happen to be in the way, that’s too bad. For example, the Fed has stated baldly that it wishes to create a mini-bubble in assets prices, presumably to increase the “animal spirits” among the public: “Our goal is to try to get the level of asset prices above their intrinsic level.” (Emphasis supplied.) Ultimately, those efforts will be in investors’ interests if they are successful, but in the meantime investors are simply pawns in a very large and momentous chess game.
Sovereign and central banker interventions distort markets in many ways, but let’s focus – just as an example – on the phenomenon known as “financial repression.” Technically, the term “financial repression” encompasses a wide variety of techniques available to sovereign nations that are designed to shift income from citizens to the sovereign. For example Reinhart and Sbrancia identify the following techniques:
Capping or controlling interest rates...MUCH MORE (7 page PDF)
*On Monday it was "Big Money: Yale vs. Norway"