How the Virtuous Circle…

Support for higher equity values is anchored in the belief that we are in a virtuous circle: a Goldilocks version of money, economies, government policy, central bank accomodation, corporate management and profitability, and the markets.

Here’s how the virtuous circle works:

The US consumer buys what emerging economies and oil-exporting countries sell, and capital flows to the emerging economies and oil-exporting countries rise. The emerging economies and oil exporting countries recycle the capital back into financial assets, primarily debt. This lowers rates (producing the so-called “conundrum”), which help provide the wherewithal for US consumers to borrow at very attractive rates to support their lifestyles. Lower rates also help support higher asset values (equities and real estate), which further helps the US consumer to spend through the wealth effect (including MEW – mortgage equity withdrawals).

Products sold by emerging economies generate internal growth, which produces demand for raw materials and infrastructure builds that help fuel global consumption and generate incremental profits for global corporations. The resultant global growth and expanded markets coupled with globalization, technological innovation, and advanced management techniques help corporations generate above average top and bottom line growth.

Corporate leaders, by “creating value” through profitability and growth above the cost of capital, are kept in check via private equity and activist investors (including hedge funds) and the threat of M&A. Traditional long-only portfolio managers and their need for short-term performance support this environment when they willingly sell their shares to the highest corporate buyer. In the absence of a hot new issues market, the equity pop they receive from an M&A deal helps goose up their performance numbers.

Lastly, central bankers stand at the ready to provide liquidity as needed so that global growth remains sustainable and consistent.

Investment Strategy Implications

Of course, there is more complexity to the story, but I think you get the picture.

The virtuous circle is a stool that stands on many interconnected legs and requires many things to go right and few to go wrong to sustain itself. Yet, despite investors' persistent low regard for what could wrong, nothing is without risk.

Tomorrow, I will describe how the virtuous circle can become the vicious cycle.