Wednesday, April 18, 2007

…Becomes the Vicious Cycle

What goes up, must come down. And what goes up in unison, will go down in unison (relative performance, notwithstanding).

Since the new millennium began, the power of the virtuous circle has enabled equities to overcome an extraordinarily number of adverse developments. However, it should be appreciated where this strength comes from. And should not be ignored that all juggernauts have a weakness(es), an Achilles heel that could bring to an end (more likely, severely limit) the benefits enjoyed by many.

In cases involving self-reinforcing features, such as the current virtuous circle, strength begets more strength. Each aspect reinforcing the other to greater heights. Like a well-oiled machine with many interlocking moving parts, motion generates movement and forward progress is the result. But, the interconnected dynamics of our well-oiled machine can shift into reverse gear and all the parts can then work together producing a negative and most unwanted result - a vicious cycle.

A disruption to the virtuous circle can occur at any point. This is a testament to the dynamics of an interconnected, interdependent world. For example, an exogenous event can alter sentiment which tip the balance the other way. However, at this time and given the abundant liquidity in the system, there are two links in the virtuous circle chain that stand out above all – the US consumer and Decoupling.

It’s easy to see how a serious contraction of US consumer spending can break the virtuous circle – lower US consumer spending begets lower capital flows to emerging economies and oil-exporting countries which lead to fewer recycled capital into debt instruments which puts upward pressure on rates which impacts the borrowing availability to US consumers. And so it goes.

The offset to this is, of course, lower US consumer spending will reduce debt demand pressures and enable the Fed to mount its white horse and come to rescue yet again. That is all possible so long as inflation does its part and moderates. And in a moderate fashion.

The other offset is Decoupling – the ability of other regions of the world economy to pick up the growth slack of a slowing US economy. However, as Steve Roach has pointed out, the real test for decoupling has not made. It is only when the US consumer and, thereby, the US economy slows substantially that the decoupling scenario will be put to the test.

An additional risk to decoupling is if growth in the US does not moderate producing a sustained global boom that overheats and results in inflationary pressures worldwide. Concurrent with that is the financial markets and its overheated potential pushing all assets to extraordinary levels, while central bankers seek to offset extreme speculation and shut down the prime engine of global growth – liquidity. (This is, by far, the greatest risk to sustainable global growth and stability as it could precipitate a vicious cycle of historic proportions.)

Investment Strategy Implications

The current bull market’s greatest strength is also its greatest weakness – interdependency. The manifestations of this interdependency can be seen on multiple levels – highly synchronized economies, markets, sectors, etc. producing high correlations and low risk aversion. The interdependency has also produced a virtuous circle of self-reinforcing positives. But, self-reinforcing trends can work in reverse. And with great suddenness.

The world has become one economy and one market with highly interdependent qualities and exponential performance features. Yet, risk exists. And some are quite substantial. To dismiss them and genuflect at the altar of market fundamentalism is to advocate the end of human nature. Greed always gives way to fear.

The best investment advice I can think of in such an environment is simply this: Don’t Drink the Kool-aid.

Nothing is forever. And when the end comes, the characteristics that drove the run-up are usually the same characteristics that drive the decline.

An appreciation of timeless principles, such as regression to the mean, may limit the upside benefits of a bull rally, but will more than offset the inevitable plunge circles and cycles generate.

1 comment:

barry said...

So you are essentially arguing that the Business Cycle has not been repealed?

Good, I'm glad I am not the only one left who still beleives that . . .