Disciplined Investment Suggests Caution

The world’s financial markets have entered the New Year just as they left the last – weighed down by myriad negative influences that threaten to send asset prices into a tailspin.  Reasons to be bearish are not hard to find, yet the bulls remain undeterred and continue to argue, albeit unconvincingly, that risk assets will deliver healthy returns in 2012.

The list of potential catastrophes or ‘black swan’ events is unusually high and urges caution.  First, the seemingly never-ending crisis in the euro-zone refuses to ease and could well gather in intensity – if not come to a head – in the near future, as a deepening recession is set to test the capital markets’ ability to absorb the large, scheduled supply of new debt issues from the monetary union’s shaky sovereigns.

It is already quite clear that the euro-zone’s monetary union is not viable in its current form and, further market stress would almost certainly increase fears of an eventual euro break-up – a potentially devastating event – with a concomitant rise in the return premium required on all risk assets.

Second, China’s stellar growth rates are now an historical artefact and, the demise of the Middle Kingdom’s notorious property bubble, in concert with the damaging side-effects of ill-advised credit creation – not to mention the downward pressure on the export sector reflecting the euro-zone’s economic malaise – could well provoke a hard landing.  The potential adverse impact on worldwide economic activity should not be under-estimated given the large share of global growth captured by the Chinese in recent years.

Last but not least, tension in the Persian Gulf continues to mount, as Iran flexes its naval muscles in the Strait of Hormuz, the world’s most important oil transit chokepoint with flows through the strait amounting to more than one-third of all seaborne traded oil.  The Iranian actions have been taken in response to tougher trade sanctions imposed by the West, who have grown increasingly concerned over the Islamic Republic’s nuclear enrichment programme.

The stand-off looks set to continue given the strong rhetoric on both sides and, could well result in an unwelcome incident that precipitates a surge in oil prices and plunges the global economy into recession.

Indeed, Intrade, the world’s largest prediction market, has seen the odds of an overt air strike by the US and/or Israel against Iran before the end of the year, rise to more than one-in-four in recent weeks.  The probability of a strike can hardly be viewed as trivial at this juncture and, and the potential for a ‘black swan’ event originating in the Persian Gulf is a very real possibility.

The bulls dismiss the worst outcomes in all of the above as hyperbole and, believe that disaster will be averted in each case simply because policymakers cannot – and therefore, will not – allow the worst to happen given the economic carnage that would result.  Recent history however, suggests that confidence in officialdom’s ability to deliver favourable outcomes is misplaced.

One need look back no further than three to four years to observe how American policymakers failed to prevent a supposedly containable problem in an inconsequential segment of the said country’s residential mortgage market from morphing into a full-blown global financial crisis.

More recently, Europe’s leadership did not demonstrate any greater wherewithal to insulate the euro-zone’s core from the difficulties that beset the periphery.  As for the foreign policy arena, America’s historical record suggests the less said the better.

Given historical fact, it is clear that the potential worst-case scenarios cannot and should not be excluded from the decision-making process.  Unfortunately, advocates of high allocations to risk assets do not concur and, are quite obviously, gambling on the most probable rather than probability-weighted expected outcomes.

The year ahead could well prove kind to the employers of such faulty decision-making but, should that prove to be the case, the favourable outcome should be considered a function of good luck rather than a solid investment process.

The bulls will undoubtedly counter that valuations are already cheap and, have thus discounted most of the potential bad news.  However, the measures of value employed are clearly flawed given that reliable valuation indicators such as the cyclically-adjusted price/earnings ratio or Tobin’s Q, which have historically demonstrated a statistically meaningful ability to predict future returns, suggest that most of the world’s major stock markets are far from cheap.

The investment world’s perennial bulls continue to expect risk assets to generate solid returns in the year ahead and, appear oblivious to the vast array of potential negative scenarios that threatens to undermine their asset allocations.  As Warren Buffett once quipped, “Forecasts tell you little about the future but a lot about the forecaster.”

The astute investor will know to emphasise a disciplined investment process over the most probable outcomes.  Indeed, the sub-standard investment performance delivered by many investment professionals over the past ten years or more confirms that good luck cannot outdo sound decision-making indefinitely.

Previously posted on www.charliefell.com


Print Friendly

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>