Wednesday, October 6, 2010

Dreams of a Cyclical White Knight

And now for some more first order thinking.

At the heart of yesterday’s commentary is the issue of cyclical recoveries morphing into sustainable economic expansions. The argument by the bulls subscribing to this view is that this is precisely what will occur this time as it has every other time before. The virtuous cycle saves the day. This is about as straightforward as it gets. The argument against this thinking is equally straightforward.

When the global macro economic system is hit by an extraordinary event, the post crisis environment is anything but normal and the odds of a cyclical recovery resolving a structural crisis are very long. What is then needed is a structural solution to a structural problem. Examples of this thinking abound (not that the cyclical bulls are listening), with today’s commentary in the FT by Martin Wolf among the most cogent.

The topic of Martin’s commentary may be the emerging currency war with a particular focus on China. The essence of Martin’s commentary is, however, the more important point – structural problems require structural solutions, which in a global economy can only be solved via cooperation between the major global players. Yet, cooperation between the major global players requires leadership. Since the logical country in a position to exhibit that leadership, the US, has as its head a political manager and not a leader, the odds of someone taking the lead toward the necessary cooperative environment for structural change are very long indeed.

The Post Crisis Environment

Crises occur mainly due to structural (systemic) problems. The post crisis environment that ensues is one that rarely resolves itself via the cyclical solution. Yes, cyclical rebounds do improve things for a while but they do not get to the heart of the matter. The structural problems remain and will overwhelm the relatively meager energy of a cyclical bounce. It’s like trying to treat a patient with a life threatening disease with antibiotics. It just doesn’t work.

To use the stock market analogy in the current environment: cyclical bull markets within secular bear markets do not change the reality that the equities are in a secular bear market. Accordingly, cyclical recoveries within a structural (secular) change environment will not resolve the systemic issues at hand.

The bullish rejoinder to this is the muddle-through solution: Things are never so neat and tidy. Stuff happens, things are messy. But, fear not, we will find a way out of this mess. We always have and will do so again. This time is not different.

However, as I argued yesterday, such thinking concludes that this time IS different, for the norm in a post crisis environment is for extraordinary measures to be exerted, which includes fundamental changes in the rules of the game. Therefore, this time is not different as crises do occur and the subsequent environment requiring fundamental change is the norm.

Who will be right? The cyclical-recovery-saves-the-day crowd or the we-need-to-address-the-structural-problems club? Time will tell, which I suspect will be sooner than most think. One thing is for sure, however, someone is going to be real right and the other will be real wrong.

Investment Strategy Implications

My money is with the structural problem club. However, the cyclical dreamers are in control right now. Therefore, as an investor and investment strategist, I cannot act aggressively until the technical analysis signs that the market is ready to embrace the more worrisome view of my club. (Think, the recent vintage tech and real estate bubbles.)

Accordingly, before shifting from the currently cautiously bullish (60 to 90% in equities) posture to neutral (40 to 60% in equities) to outright bearish (<40%) clear technical analysis signs, most notably external and internal divergences, must be evident. At present, as noted last week only the internal divergences are. Therefore, cautiously bullish (the equivalent of driving with one foot on the brake) remains the advisable strategy.

As history teaches us all too well: delusional thinking rooted in old school dogmas can maintain its grip for a very long time.

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