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1. Spend as much time analysing supply as you do demand
Demand is much more interesting than supply. Supply is much more difficult to estimate. If ties with China were severed, it would be the biggest supply shock in human history, bigger than the World Wars. The biggest surprise was how fast China grew and how fast they took over supply chains to satisfy global demand. It would be an inflationary shock, but could be good for the sunset industries, like steel, shipbuilding. etc. Mitsubishi Heavy Industries is up 150% this year, so something is happening.
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2. There is no relationship between GDP growth and return on equities.
There is 123 years of data and if you plot GDP growth with equity growth there is no relationship between the two. It's mainly because "Price is what you pay and value is what you get". Japan's stock market has recently creeped over its last high reached in 1989, after 35 years, although its GDP has definitely grown in that period - because of the acute over valuation in 1989. There are many Asian countries whose stock markets are now getting back to where they were before the Asian Crisis of 1994 - although the countries' GDP has been growing year on year. In India, 20% of GDP comes from Infrastructure and allied activities and yet it is hardly represented in the equity markets.
By any account the US markets are expensive, although there are some value stocks. Interest rates were so low that most things did go into a bubble. But around the world there are a lot of pockets of valuation and unloved areas.
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3. Pepper's Law - to work out when the upside or downside will stop
Use every analytical power you have, to assess when the market move will stop, then double that period and deduct a month, says Gorden Peppers. "The market can remain irrational for much longer than you can remain solvent." Keynes. Difficult to know when things will return to value, but when it does it will be swift.
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4. Charlie Munger: "Never think about anything - consider incentives."
Economics considers that we have one incentive and that is to get richer, but that is not always true. If you cannot forecast the incentive, you cannot forecast the outcome. One person's incentive matters to us and that is that of Xi Jinping. He controls the banking system, interest rates and exchange rates in China, the world's 2nd largest economy. It is not possible to control the quantity of money, interest rates and exchange rates indefinitely and at some time you have to let go of one of the pillars for the others to function. We must work out which one of the 3 he will be incentivized to let go control of - because that is inevitable. It is much easier to forecast a million people than one person. An educated guess is that he will get rid of the exchange rate control. Although it is embarrassing when your currency weakens, it is a lot less dangerous than not being able to control the price of money.
In 1994 a different Chinese President allowed the Yuan to devalue 33% and then along with exponential growth, with Mass mobilisation of labour, Mass mobilisation of capital, that changed the world. It depressed inflation, it depressed US interest rates because China bought a lot of its treasuries. So that Political decision changed the world and now again China is at the crossroads and we should see what Xi Jinping does.
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5. Governments like markets only when they deliver the prices they want
With Reagan and Margaret Thatcher, the Governments made the ideological choice that markets are better suited to allocate resources. And it did get them the outcome they wanted. However, that is not where we are today. It started with Quantitative Easing - and it is still continuing. Inequality of wealth is one outcome, which the Government is clearly not going to allow the markets to work out. Governments are just supposed to be a referee - but if the outcome is something they don’t like they will interfere. The Government can get the money for this from the Savers (more likely) or by printing the same (which will cause hyperinflation). That would mean capital flow controls.
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6. The Ratio of Corporate Profits to GDP must revert to the mean in a free society
This can happen by profits falling, or markets falling or by the Government actions. Eisenhower, a Republican President, was the most active ever to try and break up large corporations. He thought "BIG" business was a danger to liberty. In the US the Market Capitalization to GDP is at an all-time high of over 200%.
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7. To assess the appropriateness of Monetary Policy, asses the price and quantity of money
Interest rates alone do not constitute the monetary policy; it is the volume of the money. Interest rate is the accelerator, the economy runs on the engine which is the money supply. By money supply we mean credit. From 2009 to 2019, interest rates went down to virtually zero, but growth was very slow. 80% of all money supply is created by banks - hence credit growth is crucial. The period of growth in the US between 1945 and 1979 (which ended in high inflation) was by the Government telling the banks how much to lend and where to lend because Europe had to be rebuilt and the money could not go to speculation or buying property. Massive investment is needed now and the Government will have to direct where it goes.
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8. The most dangerous form of speculation is the search for yield
The lower the interest rates, the more risk the person will be willing to take to get - at least 5% returns is needed.
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9. The real danger for investors depends on the strength of the Constitution and the Rule of Law
Investors have to depend on the rule of law and that is why it is dangerous to invest in China and Russia. The US Constitution is strong and likely to hold even if there are contentious Presidential elections.
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10. The countries most likely to default on their debt are those which have already defaulted
So, history is a guide to the future. Most of the lenders are foreigners and instead of putting the citizens through difficulty, devaluation, grinding deflation, it is easier to default and get elected. e.g. Argentina, Egypt, Greece, Turkey. India has never defaulted, even when it was in difficulty in 1991.
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11. High Equity valuations fall slowly when there is inflation and quickly when there is deflation
1901 to 1921 and 1966 to 1982 where there was a period of inflation, there was a long slow grind to a new low, with short bounce backs in between. A period of deflation caused the crash between 1929 and 1932. Inflation results in interest rates going up which affects corporations over time. Economic collapse threatens the solvency of corporations instantly. What can happen now as valuations are high is that prices move sideways for a long period of time, whereas corporates go on earning and hence valuations go down over maybe decades. There can be other places where equity valuations will be more attractive.
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12. Never buy Emerging Markets equities if the exchange rate is overvalued
If the exchange rate is overvalued, it forces the country to buy back their currency or raise interest rates - in other words run a tight Monetary policy. There is definitely a link between liquidity and the stock markets and with an undervalued currency there is a current account surplus. The valuations of the equity markets, because of the exchange rate management, gets totally delinked from reality. At the end of 1989, the Taiwanese markets were at 65 times earnings - and the Hangseng in 1998 came down to 10 times earnings just because of the focus on exchange rate. The Chinese exchange rate looks overvalued now. Foreign investors in China are selling out more than there are inflows for the first time. That is why they are heading into deflation.
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13. Tourism is the best guide to whether a country's exchange rate is overvalued or undervalued
Any country, where the citizens can afford to travel - the currency is overvalued. Nowadays it is Italy.
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14. Always buy equities below 10 times cap unless there the future holds communism, war, or currency is overvalued.
10 times cap refers to earnings divided by book value and if the company is at that valuation then it is extremely cheap. Price is what you pay and value is what you get and if you get a good stock at such a low valuation it is safe to buy. It would not have worked with Greece in 2008 because many of the companies went bust. This is because Greece did not have an independent Central Bank and had to work within EU rules.
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15. Democracy is more suited to the operation of capital controls than the free movement of capital
Democracy is a new phenomenon - in the UK they did not have it until women got the vote in 1928. Capital controls are likely to be coming back by restricting the amount of savings you can hold outside your country and that is a way to keep interest rates low.
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16. The Governments can use savings to reduce debt and do not need hyperinflation for the same
They can change the rules and manage your savings to fund their debt - so therefore no real worry of hyperinflation but instead worry of financial oppression
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17. Technology never defeats inflation
It worked for many years - where Amazon managed to control the prices with technological advances - but the end is near. Inflation is a Monetary phenomenon and over the decades there have been periods of technological advancement - but that did not control inflation.
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18. Monetary systems fail about every 30 years
China is likely to stop pegging its currency to the dollar. The Euro is unlikely to be sustainable. Japan is going to start repatriating its capital to fund its Government. If only one forecast happened it would be profound and all are likely to happen. The old system would have imbalances which would have to correct
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19. Money is almost always in dis-equilibrium
That is when money can be made. The biggest dis-equilibrium comes when the state tries to fix something. Managing exchange rates is one area.
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20. Never trust a forecast with a decimal point
It is difficult enough to forecast a direction and a trend. When a forecast is given with a decimal point it implies confidence - and actually it is trying to sell something with that forecast. Precision of a story is dangerous. The most dangerous thing is when you mis-sell to yourself.
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21. Extrapolation is the opium of the people
At this time of structural change extrapolation cannot work.
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