During the ’80s and ’90s, ignorance was bliss. The global economy was growing nicely, and analysing it (or even paying attention to market cycles) seemed like a waste of time, as the economy came in only three flavours: good, great, and awesome.
Even if you misread the flavour, the downside was that you’d just make a little less money. Value investors prided themselves on being bottom-up-only analysts, focused on scrutinizing individual stocks, while top-down analysis — making investment decisions by looking only at the macro picture — became unfashionable, viewed as market timing. (I know the above statement may sound a bit over the top, but over the years I have read and listened to dozens of interviews with famous and successful investors who declared that they do bottom-up-only analysis and don’t pay attention to the economy.)
Prolonged and virtually uninterrupted growth brought complacency, excesses, and debt. Bottom-up-only analysis worked until it stopped working, as investors discovered during the recent crisis that the global economy can come in additional flavours: bad, horrible, and downright nasty. Today the cost of misreading the economy is much higher.
Two years ago the Great Recession waltzed in — to the great surprise of homeowners, the Fed, and the banks — and everyone discovered that house prices don’t always go up. The financial sector, the lifeblood of our economy, started to drown in the sea of bad debt. As the troubles in that sector began to spill into the real economy, the government felt it had no choice but to step in, and the bailouts and stimuli began.
Today it is hard to take a walk through our economy and not meet a friendly Uncle Sam; he is everywhere. He’s buying long-term bonds and thereby keeping long-term interest rates artificially low. Since he took over the defunct (for all practical purposes) Fannie Mae and Freddie Mac, he is the U.S. mortgage market, because those organisations account for the bulk of mortgages originated. Of course, he is also on the hook for their losses.
Our dear Uncle Sam rolls in style; he doesn’t know how to bail out or stimulate on the cheap. U.S. government debt (at least, the debt that is on the balance sheet) leapt from about 60 per cent of GDP before the Great Recession to more than 100 per cent in 2010. The party of overleveraged consumers has been crashed by an overleveraged government.
To understand the consequences of the Great Recession, consider this analogy: The U.S. economy is like a marathon runner who runs too hard and pulls a hamstring, but finds himself with another race to run. So he’s injected with some industrial-strength steroids, and away he goes. As the steroids kick in, his pace accelerates as if the injury never happened. He’s up and running, so he must be OK — this is the impression we get, judging from his speed and his progress. What we don’t see is what is behind this athlete’s terrific performance: the steroids, or, in the case of our economy, the stimulus.
Obviously, we can keep our fingers crossed and hope the runner has recovered from his injury, but there are problems with this thinking. Let’s address them one by one:
- Serious steroid intake exaggerates true performance. Economic stimulus creates an appearance of stability and growth, but a lot of it is teetering on a very weak foundation of government intervention.
- Steroids are addictive; once we get used to their effects, it is hard to give them up. When the first home-buyer tax credit expired, it was extended for anyone with the patriotic ambition to buy a house. It is hard to give up stimulus, because the immediate consequences are painful, but long-term gain has to be purchased by short-term discomfort.
- The longer we use steroids, the less effective they are. Take Japan, which was on the stimulus bandwagon for more than a decade. With the exception of tripled government debt, Japan has nothing to show for its efforts; the economy is mired in the same rut it was in when the stimulus started.
- Steroids damage the body and come with significant side effects. In the case of the economy, the side effects are higher future taxes and increased government debt, which brings on higher interest rates and thus below-average economic growth. The hopes that we’ll transition from government steroid injections back to an economy running on its own are overly optimistic.
So what does this mean for investors? When we purchase a stock, we are buying a stream of future cash flows. By doing only bottom-up analysis, investors implicitly assume that external factors (the winds and hurricanes of the global economy) have no impact on these cash flows. That is a brave and careless assumption, especially in a post-steroid world. Instead, investors should take a more holistic approach, mixing bottom-up insights with top-down analysis.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing” (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley, December 2010). To receive my future articles by email, click here. You can follow me on Twitter (http://twitter.com/vitaliyk).
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