You need to pay attention to macro analysis

Dec 12, 2014

New York, New York

Dear Diary,

No follow through on Wednesday's stock market loses. Instead, the Dow went up 63 points. Gold was flat.

A conversation in the hotel lobby...

Woman, tall, thin, attractive:

"Hey, you must be a writer. You look like a writer."

Your editor, hunched over his laptap, writing...

"Good guess."

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---------------------------

Woman, putting her arm around his shoulders...

"I'm Rebecca. What's your name?"

"Bill...'

"What are you writing about?"

"A subject so boring I wanna slit my wrists every day."

"What's that?"

"Economics."

"Oh..."

"Well, what are you doing?"

"We're here with a group of Fortune 500 business executives. We're consultants. The companies hire us to help their employees find innovative solutions to their problems."

"What kind of problems?"

"All kinds...they each have their own problems...but we don't get into that. We just show them that whatever their challenge is, the solution is within themselves."

"How do you do that?"

"Well, they meet here. They each get a backpack. In the backpack are the things they need for problem solving. We give them a map...and directions to places all over town where we have meetings. The whole idea is to get them out of their routine. Out of the box. They will have some totally new experiences...and some challenges that have nothing to do with their daily work.

"This may sound funny...but, we open their minds to new thoughts... In the summer, for instance, we encourage them to eat a peach and let the juice trickle down their chins... "

"I don't know if I would dare to eat a peach, if you know what I mean..."

"Sounds crazy, I know. But it is the realization that they don't have to always do everything the way they're 'supposed' to do it...that there are other ways...that is what opens them up to thinking differently and solving their problems."

"Oh...."

We turned back to our writing...confident that the world still turns...and still finds new and imaginative ways to separate people from their money.

Now, let us take up:

Macro Economics

Wait. Don't touch that dial. This is important. This is the context in which you will put your money to work. You send it off to do a job; you've got to know the territory.

And as is turns out 'context' is more important in investing than in just about everything. You can find a good house or a good wife in a bad neighborhood. But it's almost impossible to make money when 'the market' is bad.

Positive Beta

Broadly speaking, there are two sources of investment gains. There is alpha and beta. Beta is what you get from being 'in the market.' Say, you buy a handful of stocks at random. Then, the whole stock market goes up. Chances are, your stocks will go up too.

Alpha is what you get by out-performing your fellow investors. If most stocks go up 10% and your stocks go up 20%, you've got positive alpha.

The trouble is, alpha is hard to get. Investing is competitive. And in order for you to get positive alpha (above average performance) someone else has to get negative alpha (below average performance). We'll discuss this more when we come to our section on stock market investing. Our point today is that most of what you are likely to get from your investments is beta. That is, they are likely to go up about as much as the average...for the market.

Micro analysis (studying things in small detail) helps you pick the right stocks. But if you're going to find the right market, you need to pay attention to macro analysis.

Should you be in stocks or bonds? US stocks or Russian stocks? Real estate or cash? These are macro questions. Also known as 'asset allocation' questions. And your answers will determine how well your investments do.

We'll quote our Bonner Family Office chief researcher Chris Lowe:
    This is backed by a number of well-known academic studies. The first, by Brinson, Hood and Beebower in 1986, showed that beta decisions - the mix of assets in mutual funds' portfolios - explained 93.6% of the average fund's return variation over time.

    And in 2000, Roger Ibbotson and Paul Kaplan studied 10 years of monthly returns of 94 US balanced mutual funds and five years of quarterly returns of 58 pension funds... and found roughly the same thing. About 90% of the variability in returns of a typical fund across time was explained by beta, not alpha.
What this means is that being in the right place at the right time is far more important than trying to pick individual stocks. But how do you know which is the right market? Which market will give you positive beta?

First you should know that there are plenty of researchers - mostly academics - who claim to have 'proved' that you can't actually 'time' the markets. That is, they believe you can't successfully choose when to be in a market and when to be out. You just have to take what the markets give you, they believe. Anything better is just luck.

There are also plenty of researchers who claim you can't hope to pick better stocks than other investors. They think positive alpha is luck, too.

In our opinion, based on three decades of observation and study, they are both wrong...for reasons we outline in another installment in this series. But let's not get distracted. We're after positive beta. And the way to get it is to see as clearly as possible what is going on in the big wide world of finance so we can put our money in the market that is most likely to go up.

When you are analyzing a single company, you pay attention to details - products, profit margins, technologies, competition, management and so forth. When you analyze whole markets you need to look at other things. Some companies will innovate successfully. Others won't. Some will capture more market share; others will lose it. Some will invest their money wisely. Others will squander it on buybacks and LBOs. But looking at whole markets, you need to look at the larger context.

You need to understand, for example, that markets are cyclical. They go up and then they go down. Imagine two different stock markets, side by side. One has been going up for the last 10 years. The other has been going down for the last 10 years. Which one is likely to be the best beta choice? The winner or the loser?

The answer, of course, is that it depends. But when a market has been going in one direction for a long time, the odds increase that it will reverse direction as time goes by. "Trees do not grow to the sky," is the old expression on Wall Street.

Another way to look at it is as 'reversion to the mean.' A single company may innovate and grow for many decades. But markets tend to move in cyclical patterns, up, then down, then up again. Some markets are more cyclical than others. The 'hog cycle' for example, was identified long ago. When the price of pork rises, farmers increase their production. When it falls, they cut back. Since the gestation time for a pig to have piglets is about 9 months, there is a regular and predictable lag. Prices go up. Farmers raise more pigs. Increased supply causes prices to fall. Farmers raise fewer pigs and then prices rise again.

Almost everything in nature is cyclical in some way. You are born, you grow up, you mature, you grow old, you die. We wish it didn't have to be that way...especially the last couple of stages. But that's the way it works. The day dawns...the day ends. Winter gives way to spring...

On and on...forever. But markets also have aggregated brains and strong collective emotions. Investors look ahead. They try to anticipate the cyclical changes...and so doing they imprint their own thoughts on the market itself. If they anticipate more price increases, for example, they buy, moving the ultimate market crest forward. Then, as prices rise further it acts like the pull of the moon on tides and waves. Investors see their friends making money. They are galled and envious. Soon, they are buying too...and the markets go higher.

Finally, so many people have bought into the market that there is little money left outside of it to bid prices up further. This is the "top," when people are so bullish...and so confident that prices can't go higher. That is when investors are most likely to lose their sober perspectives, too. Yes, markets are treacherous. They appear most benign when they are at their most dangerous point.

The first secret of getting positive beta is to learn to make this psychological dimension to markets work for you, not on you.

How? You'll find out next week. You'll also learn about another treacherous adversary in your quest for 'positive beta.' And we'll tell you where we think you're most likely to get 'positive beta' in the years ahead. Stay tuned.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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