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Investors Follow the Herd? Or Reason?

InvestorEducation / Learning to Invest Jul 08, 2009 - 10:53 AM GMT

By: Axel_Merk

InvestorEducation

Best Financial Markets Analysis ArticleKieran Osborne writes: How do you diversify when all asset classes are moving in tandem? This was a key question many faced at the height of the financial crisis, when all asset classes were plunging together, but is an issue that remains today. We have long held concerns over the increased tendency for the values of different asset classes to move in the same direction simultaneously, as was the case leading up to the crisis, throughout the crisis, and today. In fact, according to Bloomberg, the correlation coefficient that measures how closely markets rise and fall together has reached the highest level ever.


Despite recent market appreciation, investors may be concerned – in many people’s eyes increased correlations are ok when markets are rising, when everything is going well, as a rising tide floats all boats, and one turns a blind eye to the downside, but what happens when the herd gets it wrong? What happens when the herd suddenly reverses course (look at oil, which peaked at $145 only to fall to $33)? What do you do if markets should crash again? Where do you hide? We have long argued that investors should consider a diversification approach to something as mundane as cash, and it now appears that this approach may be as crucial as ever.

Market dynamics, of course, are playing out: naturally, as vast amounts of money has been pumped into the system, credit slowly thaws and money is beginning to flow again, combined with a reversal of many risk aversion trades (some money that flowed out of markets into the “safe haven” of the U.S. dollar and T-Bills has now found its way back into the markets), asset prices have reflated.

We believe a large part of the catalyst for the reversal of risk aversion trades has been a misinterpretation of economic data as “green shoots” of a recovery, however, when one digs deeper actual “hard” data do not paint such a rosy economic picture. Many economic overhangs remain and we believe we are far from the beginning of a sustainable recovery. Indeed, many in the media are now pondering whether the “green shoots” are now wilting in the summer sun (incidentally, and as a complete digression, despite tremendous market uncertainty and volatility, the old adage of “sell in May and go away” appears to be playing out).

Moreover, we believe the U.S. Administration and Fed are acting irresponsibly, both fiscally and monetarily, and many unintended consequences are likely to come home to roost over the coming months and years. We are concerned about inflation, market inefficiencies, the crowding out effect that so much government debt may have, amongst others. The market, too, has become increasingly nervous about inflation – implied inflation expectations taken from the spread between TIPS and equivalent maturity Treasuries has been rising steadily since the beginning of this year. Not to mention our view that recent market interventions and the expanded role of the Fed, have and will, compromise its independence and effectiveness.

While it is hard to distill all the market developments simply, the way we see it, many dynamics can be illustrated through an adaptation of an old children’s nursery rhyme:

“A lot of money came to the market,
Some money stayed home,
A lot of money flowed to equities, commodities, oil, emerging markets etc,
Some money was hidden under the mattress and bought none,
And some money went “wee, wee, wee” all the way to somewhere with sound monetary policy and a more fiscally responsible home”

Indeed, we are seeing trends within institutional investors who are actively mirroring the last sentence – repositioning their portfolios to hedge against the risk of a falling dollar by investing in international currencies. Combined with reflation trades and the reversal of risk aversion trades, we believe this factor has contributed to the price appreciation of many international currencies since March. We believe it may only be time before this trend proliferates to the mainstream and we see a heightened level of pressure on the U.S. dollar from domestic investors.

What about Treasuries? Can’t we hide there? Sure, but “hide” is a relative term – you’re going to have to endure the enhanced price risk that now prevails: recent market volatility did not spare the Treasuries market, which had the worst first half of the year in over three decades. Optimists point to the prior week’s auctions, which gave some hope that foreigners will continue to have an insatiable demand for U.S. government debt. Bond dealers have decried that the demand for Treasuries remains strong, that market dynamics remain favorable, but this is all predicated on continued foreign demand. Domestic investors aren’t buying any: we aren’t that benevolent. That’s the real problem we have with this view: with so much debt to be funded, at some point foreign demand will dry up too, interest rates will rise and any nascent recovery may be nipped in the bud.

There is a bigger issue here. By implication, the U.S. is now dependant on foreign countries to fund government spending. All of us in the U.S. should be worried about recent developments – as a nation we are becoming increasingly indebted to foreign countries, as a nation we are increasingly dependant on foreign countries, as a nation we will be paying boatloads in interest to foreign countries for years to come – generations will be affected. These are not just economic issues; these are social issues, and why we take such an active stance on them.

These dynamics may put the revered “reserve currency” and “safe haven” status of the U.S. dollar and U.S. government debt increasingly under pressure. We have argued that the U.S. dollar will not lose its status as the world’s reserve currency over the short-term, as, put simply, there may be no legitimate alternative at present. However, we do believe present initiatives are undermining the “safe haven” status of the U.S. dollar and U.S. government debt.

Would you loan your neighbor a thousand bucks if you know he owes hundreds of thousands to others? Oh, and by the way, he’s just told you his income will be dropping over the foreseeable future. That’s exactly the position the U.S. government is in right now – income (taxes) is going down while debt is morphing out of control. Both the government’s and Fed’s balanced sheets looked a lot healthier 12 months ago, and they are only likely to deteriorate going forward (the government balance sheet in particular). As such, we believe investors will increasingly question the “safe haven” status of the U.S. should another crisis erupt.

Kieran

Kieran Osborne
Co-Portfolio Manager, Merk Investments

Sustainable Wealth

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment product, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

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