US Macro policy - the theory and the practice

We follow the macro situation to be aware of potential big problems and to guide us on asset allocation. US macro policy can be defined as follows in the last few years:- (1) Keep rates low, this will encourage capex spending (2)Buy bonds to reduce the rate, this will force the market to take on more risk, increasing asset prices and increasing wealth, this will increase consumer spending (3) Growth will reduce the debt/GDP ratio. If GDP growth is greater than the cost of debt the country can deleverage It sounds great on paper. However, QE by itself does not improve the economy. Its aim is to increase

animal spirits

- so demand is created by businesses willing to take risks by investing and consumers willing to spend. However, we have found the following happen:- (1) Low rates have decreased the income from cash deposits. With a growing elderly population who have reduced their risk profile this may mute demand. (2) Capacity utilisation has been below average why should businesses invest? Especially if consumer spending has been affected by low real wage growth, little credit availablility, and low deposit rates. The demand has not been there. So why should companies borrow to invest in capex. Better to borrow and buy back stock where earnings yields are lower than borrowing costs. However, higher asset prices only benefit those who are shareholders. This is often those with excess savings, hence the wealthy. Hence QE exacerbates the difference between the haves and have nots which can create social tension. (3) Total debt has not decreased. It has shifted from the problem of a few companies or consumers, to a problem of the whole country (i.e. the government). However, it maybe possible that a critical point is being reached in the US. Employment may be reaching a critical mass where real wages may start increasing. This will boost consumer confidence which can increase consumer spending, this may explain what seems to be the strong start to the Christmas retail season. Credit is becoming more available as US banks are now well capitalised. If this increases spending in the economy and GDP growth increases such that the US economy can start deleveraging, the economy will be improving in almost all metrics. This could even start a slow and gradual increase in rates increasing the income of low risk investors. This would be a virtuos cycle indeed and would be an important moment for central bank policyholders - who would deserve to be congratulated. However, due to the success so far relative to other countries the USD has started to appreciate. Though the trade defecit is shrinking as foreign oil demand is weakening due to large energy reserves found inhouse, it may affect the export market. For the Americans however this may be benefited by weaker commodity prices, which often have a strong correlation to the USD as they are transacted in USD.

Technical investing and risk management

I must admit a certain innocence in the use of technical investing. A close friend and respectable investor continuosly highlights its usefulness in investing. For example, this individual would buy into a stock weighting the size of the investments on the volatility of the stock. More volatility, lower initial position. I find this approach incomplete. For example, why not size positions comparing volatility of the stock price on volatility of cash flows. If cash flows are volatile and the stock price is volatile this merits a smaller initial position than a company whose cash flows are quite stable historically, and we believe they should not become considerably more volatile in the future. This way we connect market prices to company value generation. His second rule is he would buy once, buy twice, three out. Another rule is setting a limit on how much lose you would take. This seems sensible and I try to ensure no single position can suffer a more than 1% loss on the portfolio in my worst case scenario (which of course can be wrong - and has been in the single case of Tesco so far). Indeed, this viewpoint is what finally deceides the position size of a stock. However we must be careful. A long term investment philsophy based on understanding a business should not apply a trading risk management strategy - each process is built for a different strategy and combining them is likely to not be an optimal manner to manage assets.

The market is always weighting different factors differently, this leads to volatility of stock prices

The markets are a curious place because pricing at different points in time are dominated by different factors. Often macro factors dominate over sector and company specific issues. This results in higher correlation between stock prices in different sectors. Sometimes the market over emphasises quarterly results, meaning an up or down surprise can lead to violent changes in stock prices. Some investors spend considerable time understanding the mood of the market and understanding quantitatively what factors it is focusing on. I dont do that because this takes considerable time and does not suggest a clear cut investment as an output. Instead we focus on businesses we understand, and appreciate in a qualitative manner when the market mood is different by the way it values the same businesses differently. This can provide opportunity. We often find unlucky or lucky timing of events can pay a large role in market pricing. A large acquisition that perhaps was expensive can lead to the stock price of the company declining. A bad patch in the market can then exacerbate this decline followed by a bad sector issue can lead to carnage on the stock price of a company that was initially driven by a company specific event and then taken further down with market and sector issues. This can lead to mis pricing due to herd behaviour. It should be noted with ETFs taking greater market share of stock market volume this pricing momentum may increase.