Thursday, August 25, 2011

Trahan and Krantz, The Era of Uncertainty

The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground by Fran├žois Trahan and Katherine Krantz (Wiley, 2011) is a thoughtful, thoroughly researched book. Its main thesis is that macro matters—a thesis that has been amply demonstrated in recent market movement. An investor can be right in his bottom-up analysis, but if he gets the macro picture wrong he’s most likely doomed: historically 71% of equity returns are explained by macro trends.

“Macro,” of course, covers a wide array of forces “that dictate how the world unfolds around us.” The authors identify ten major macro themes that will matter for investors: globalization, the internet and the technology revolution, the implications of the credit bubble, the rise of China and its emerging consumer class, a change in worldwide demographic trends, Americans’ evolving relationships with credit and debt, fiscal crises in the developed world, troubles for the euro and/or the dollar, the Federal Reserve’s dual mandate and its shortcomings, and the changing face of “greed” on Wall Street. (p. 4)

The authors pay particular attention to the business cycle and how it can be understood using leading economic indicators—those with shorter lead times (e.g., Philly Fed index and ISM new orders/inventories ratio), those that are intermediate-term (e.g., consumer prices and emerging Asia equity markets), and those with longer lead times (e.g., changes in global short interest rates and the yield curve). For the investor it is critical to know where we are in the cycle, whether LEIs are accelerating or decelerating. Data from 1950 to 2009 make this clear. During this period annualized equity returns during the early expansionary phase were 34.5%, in late expansion 15.8%, in early contraction, 1.2%, and in late contraction -14.3%. The investor can further improve his returns by choosing those sectors that outperform the broader market in any given phase.

Another mandate for the savvy investor is to recognize and stay clear of bursting bubbles—“with little help from either Wall Street or Washington, D.C.” (p. 50) Trahan, who was chief investment strategist at Bear Stearns and one of the first on Wall Street to sound the alarm on the housing bubble (he left Bear Stearns before its untimely demise), shares some of his research that showed that “the housing bubble was predictable and avoidable.” (p. 67) For instance, home sales prices were far more stretched than rental prices, the ratio of the value of new homes for sale to employee compensation was at a level not seen since the late 1970s, the housing boom was geographically widespread, and the supply of new houses was skyrocketing while “the rate of home non-ownership—in other words, potential demand—was declining sharply.” (p. 70)

Where are we now? And where are we going? The authors are no fans of the policies of the Bernanke Fed. Their criticisms are laid out carefully, with special emphasis on dollar weakness, high commodity prices, and income disparity. And although there are too many variables to predict exactly where we’re headed, the authors suggest that “the global inflationary pressures resulting from the Fed’s weak-dollar policy will likely result in a growth slowdown and a future disinflationary, if not deflationary, period.” (p. 134)

After presenting a detailed account of inflation in the United States and a summary of some of the global economic tensions, the authors offer strategies for investing in both inflationary and deflationary environments complete with supporting charts and figures. The book concludes with some policy suggestions for a better economic future.

The Era of Uncertainty is a model of strategic thinking and often imaginative research. It is well written, its charts are based on the proprietary work of Wolfe Trahan & Co., and its theses are thought-provoking. It’s one of those books to which I’m sure readers will return as events unfold down the road.

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