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Shouldn't the stock market track the real economy?

2012 turned out to be a very different year than most had expected. Personally, I was very negative coming into the year, especially towards the European economies, and was more or less right in my predictions on that account. However, I was also very sceptical of the rising stock markets. It turned out I was right on the real economy, but wrong on the stock markets. But shouldn't the stock market track or follow the real economy?

With 25 years of experience as a trader, market maker and fund manager, I should have known better! The stock market and the economy are, of course, linked but rarely on a strict day-to-day or even month-to-month basis. Most often it is a mismatch between expectations and the current reality, both amplified by the critical element of monetary policy, that produces sentiment and market pricing that diverge from the real economy. This is very evident today in Europe with the seemingly illogical combination of historical highs in both unemployment and stock markets. Stock markets have reached the pre-crisis highs of 2007/2008.

History shows that such divergence has its limits and expiration dates - either the economy improves dramatically or markets will need to adjust their expectations lower. To grasp such divergences in a historical perspective, it is useful to look at the difference between broad stock indices like the MSCI World and the German IFO. In 2013, the divergence between the underlying weak economic performance as measured by this survey and the stock market has reached the extremes of levels prevailing before markets crashed in 2000. Hardly a good sign, but remember that the difference can be reduced two ways: stocks dropping or the economy improving.

Fundamentally, the stock market is a "sub-component" of the entire economy, or GDP. Therefore, stocks must correspond to some degree with the rise and fall of the economy and relative to other economic factors like inflation and productivity. A long-term bull market in stocks usually coincides not only with economic growth, but increased productivity and risk premiums. Even more importantly, a real bull market makes everyone benefit, rich and poor, through lower unemployment, productivity and investment - all of which are failing in this present run-up in prices.

So how do investors deal with such an investment conundrum? Ironically, to the well-placed investor all the above technical economic understanding does not really matter. Experience shows that an investor willing to risk holding illiquid assets is rewarded with a risk premium for taking on that risk. The risk premium fluctuates based on inflation, current interest rates and income through dividends from a given stock. Stocks must give a higher yield than bonds to compensate for their inferior liquidity.

When European Central Bank president Mario Draghi in July 2012 ensured the world that he would do "whatever it takes" to keep the Euro alive, he created a massive move into more illiquid assets by removing the presumed negative potential in bonds and hence indirectly fuelling stocks. But again - as investors, we do not need to understand this. If we follow simple rules, we do not need to mix our analysis of the real economy with stock pricing. We can be economic agnostics.

In the 1970s, the American investor Harry Browne crafted the so-called Permanent Portfolio. Its logic is very simple. Invest 25 percent in each of four different assets: stocks, long government bonds, metals and cash. Sounds boring? From 1972 to 2011, the yield from such an allocation has been 9.5 percent. In real terms, no less than 4.9 percent. A much higher yield than the stock market and with a significantly lower risk! An investment of USD 10,000 in 1972 would have grown to USD 377,193 by 2012.

This does not mean that active trading does not pay off, but works to illustrate that it wise to always have a "dumb model" as a backstop or frame of reference. Extra risk or changes in allocation should only be taken when one has an "edge" or strong indicators of being right! The famous hedge fund manager Ray Dalio from Bridgewater has expanded the idea into his All Weather Model. As the name suggests, it is designed to handle any economic condition. The results have been very convincing. Since 1996, the annual yield has been approximately 12 percent, turning Bridgewater into the world's largest fund with USD 141 billion under management.

The difference between the two is that Harry Brown allocates assets while Ray Dalio and Bridgewater allocate risk. What they hold in common is a total agnostic attitude towards the market. They accept the very important premises of trading: we do not know what tomorrow brings; we do not know where we are going and we will get our yield primarily from extracting the risk premium from assets. The beauty of all this is that we do not have to understand the relationship between the economy and stock markets to invest efficiently. Considering the current unpredictable macroeconomic interventions, such an approach should offer a huge relief from trying to understand everything that is going on, and possibly an advantage to any investor who does not have direct access to the minds of powerful policymakers and central bankers.

As I mentioned above, an investor should only depart from this route if he has a very strong feeling or belief that something is going to happen. Personally, I allocate 70 percent in an All Weather Model. That helped me to get a decent yield in 2012 even though I was almost 100 percent wrong in my very conservative stock market predictions. I used the remaining 30 percent to insure against Black Swan events or place opportunistic investments. I am presently long-term bullish on Sub-Saharan Africa investments. The answer to the title's question is that the stock market may diverge from the real economy for a limited period, but this has no impact on the rationally placed investor. Investing is about logic and rationality - not genius. And that's a good thing for all of u

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Publication:CPI Financial
Date:Feb 26, 2013
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