POWER OF INFORMATION.
"True genius resides in the capacity for evaluation of uncertain, hazardous, and conflicting information." - Winston Churchill
"Getting information off the Internet is like taking a drink from a fire hydrant." - Mitchell Kapor
Our ability to obtain any kind of information from all ends of the earth is more powerful today than it has ever been in the history of humankind.
Within seconds, someone in Wellington can know what is happening in Washington and trade on that information. When you get accustomed to this level of information, being cut off from it can make you feel completely out of control.
This was noticeable when Crackberry, sorry Blackberry, addicts recently lost email for a few days and their much cherished smartphones became, shockingly, just phones. There was a noticeable rise in finger anxiety as flashing red LED lights around the world went dark. I believe there was also a significant rise in Apple iPhone sales - isn't it interesting that the recent 4GS model launch occurred around the same time as the RIMM outage?
I'd argue many of us are suffering diminishing rates of return from our increasing flow of information. Speaking personally, I could spend 24 hours a day, 7 days a week, reading interesting articles from news sites, blogs, books, magazines, and broker reports, and not get through even a small percentage of what is at my disposal. I'm trying to stop my information flow from becoming prioritized by the latest headline, or the most recent email in my inbox. Following this system can lead to consensus thinking and herd following behavior.
Due to the phenomenal computing power available, the market is discounting information flow into forward expectations faster than it has ever done before. However, the diminishing quality and increasing quantity of information means that markets start trading on a lot more noise and a lot less fact. It is no surprise that this increases volatility when there are many ongoing unresolved events happening around the world. As an investor you have to accept a higher degree of loss tolerance in this environment to hold your positions through this volatility. This means your position size should be smaller and your leverage a lot more conservative (despite the very low interest rates).
Unless new regulation caps high speed trading, we should get used to the fact we are going swing between a very high volatility and low volatility environment for the foreseeable future. At some point one of these high volatility environments will probably result in some major technical crash, not unlike the flash crash, which will bankrupt and take a lot of the poorly capitalized risk seeking traders out of the market.
The flipside is that when the global outlook looks more constructive, positive trends will be magnified by traders and create a self-fulfilling bull market that reduces volatility and overshoots what value managers argue are the "fundamentals". This may have been what happened earlier this year.
The consequence of all this is that the duration of bull and bear markets may become much shorter than what we have become used to in the past.
Most high net worth and retail investors are very frustrated with this market. They have lower allocations to equities than they had in the pre-2008 crash period. Instead they have higher allocations to cash, bonds, gold and other precious metals, and carry currencies and related structured notes. This is particularly the case in countries, which have experienced prolonged bear markets in equities. Until the average investor regains confidence in stocks, it is unlikely that we can see the start of a new sustainable bull market.
Take China for example, the Shanghai composite is still almost 60 per cent below the 2007 peak. Many Chinese investors became disillusioned with Chinese stocks following the spectacular 2007 crash. On the other hand, following the stock market crash, Chinese tier 1 property markets experienced a tremendous run and may now be in a bubble (as measured by price to income ratios).
This is not unlike what happened with US housing from 2002-07 following the 2000-01 stock market crash.
In a crash, some liquidity evaporates but the rest just moves around the system from one asset to another. Liquidity is particularly attracted to markets where regulators or banks distort market conditions with low interest rates and easy credit. After all everyone needs to park their wealth somewhere. We are currently seeing risk seeking behavior in developed market government bonds, commodities, and property in emerging markets.
One strategy is to avoid markets where credit is being tightened and enter markets where credit is being loosened. In China, I would not be surprised to see restrictions on stock market investing being relaxed again. What better way to recapitalize Chinese companies than by encouraging Chinese citizens back into the stock market. The government may start focusing on developing more social security and pension fund instruments to help prevent the social tension that has been seen in the Middle East. This institutional liquidity will also find its way into domestic stocks or bonds.
In the US, the Fed is desperately trying to lay the seeds for a stock market rally but it is just not working. Bernanke has given us his credit card to go buy risky assets at a 0.25 per cent rate through 2013. It may take another year or two to fix US banks and get this credit transmission mechanism working again.
Instead of just flooding the market with liquidity, US policymakers should introduce incentives to encourage domestic corporate investment, for example by reducing the tax on repatriating corporate profits. We need resolution on the problems, which are holding up property foreclosures. And, we need bold action to encourage the development of alternative conventional and non-conventional energy sources. We may see some policy traction after the next election.
In general, stocks are not dirt cheap, so it's hard to make a value argument for buying stocks. Sure, stocks may not be expensive, as many stocks remain within a 10 year trading range and have not made new highs since 2000. Yet, many companies may be coming off what could be record margins, due to a period of cost cutting and inventory rebuilding following a crisis.
Many investment advisors recommend buying dividend yielding stocks. I don't think dividend yields on quality companies are attractive enough to go out and buy equities. They only look interesting in context of distorted low government bond yields.
If a stock in this environment offers a very high dividend, it may be an indicator of trouble, or the dividend may even be cut in following quarters. I buy stocks because they offer the outlook for capital growth. If I wanted just a yield, I'd go for a carefully selected portfolio of corporate or junk bonds. Interest rates are low for the foreseeable future and bonds have come off record tight yields in the recent market correction.
Right now, it is hard to make a growth argument to buy stocks in this kind of macro environment. Looking at micro level earnings estimates suggests analysts may be too optimistic about earnings growth in 2012.
On a macro level, analysts expect US growth of 2 per cent, Japanese growth of 2.5 per cent, Eurozone growth of one per cent, and Chinese growth of 8.7 per cent in 2012 (according to composite economic forecasts in Bloomberg). Sure sentiment may be negative right now but expectations are not low. They are reasonable, or possibly optimistic, given current conditions. The risk in my opinion is that growth expectations for 2012 are too high rather than too low.
For a medium to long term investor, there is no trend or technical argument to buy stocks either. This may improve as moving averages converge towards current index and stock levels. In this environment it may only take a few large risk loving hedge fund managers, hoping for a pay check in 2012, to push stocks up to levels that could bring in the trend traders. But, for the investor it will take more than just penetrating a few recent highs to make a convincing case that a new bull market in equities has started.
In summary, sideways or declining markets are more likely than a new bull market at this current juncture. While sentiment for equities remains poor and investors may under-own equities as an asset class, expectations are not low and there is not a convincing value, growth, or technical argument to buy stocks. Sure you could pick up companies you particularly like that have a particular catalyst which could move the stock. But, I would not go for a dividend driven strategy, except as a short term trading play on improving risk sentiment.
In the short-term, it is easy to paint a bearish picture. The large unsolved problems still remain unsolved. The Europeans have not even proposed a credible solution yet, let alone had these solutions endorsed by their domestic populations. Households may be coming towards the end of their deleveraging cycle but governments are just beginning. Various important elections will take place in 2012, which could postpone major policy decisions until the end of 2012. Populations are feeling the impact of austerity and unemployment, so populist regimes that are anti-trade and integration may rise in prominence. The risk of trade wars and protectionism is growing. Perhaps, regimes, which advocate fiscal tightening and responsibility, may also gain ground but their platforms may also be short-sighted. At the same time, I'd like to believe we are near the end of a bear cycle. Emerging markets have the capability to stimulate their domestic economies which could brighten the global growth outlook.
However, as we have seen in China, they will have to be prudent in how they do this to prevent massive credit fuelled bubbles. The developing market consumer is underleveraged relative to the developed market consumer, so if we do enter a lower inflation environment and interest rates come down across the world, it may lay the seeds for the next bull run.