Tuesday, 25 March 2014

The Fed, Luck and Skill, History of Money

Three interesting articles with some snippets (for the full articles, please click on the links):

Jeremy Grantham: The Fed is killing the recovery

It's quite likely that the recovery has been slowed down because of the Fed's actions. Of course, we're dealing with anecdotal evidence here because there is no control. But go back to the 1980s and the U.S. had an aggregate debt level of about 1.3 times GDP. Then we had a massive spike over the next two decades to about 3.3 times debt. And GDP over that time period has been slowed. There isn't any room in that data for the belief that more debt creates growth.

The Bernanke put -- the market belief that if anything goes bad the Fed will come to the rescue -- has had a profound impact on people and how they act.

Yes, I agree that the Fed can manipulate stock prices. That's perhaps the only thing they can do. But why would you want to get an advantage from the wealth effect when you know you are going to have to give it all back when the Fed reverses course. At the same time, the Fed encourages steady increasing leverage and more asset bubbles. It's clear to most investing professionals that they can benefit from an asymmetric bet here. The Fed gives them very cheap leverage on the upside, and then bails them out on the downside. And you should have more confidence of that now. The only ones who have really benefited from QE are hedge fund managers.

So are you putting your client's money into the market?

No. You asked me where the market is headed from here. But to invest our clients' money on the basis of speculation being driven by the Fed's misguided policies doesn't seem like the best thing to do with our clients' money.

We invest our clients' money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other centrals banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That's how we will pay for this. It's going to be very painful for investors.

Luck and Skill Untangled: The Science of Success

It turns out that investors earn dollar-weighted returns that are less than the average return of mutual funds. Over the last 20 years through 2011, for instance, the S&P 500 has returned about 8 percent annually, the average mutual fund about 6 to 7 percent (fees and other costs represent the difference), but the average investor has earned less than 5 percent. At first blush it seems hard to see how investors can do worse than the funds they invest in. The insight is that investors tend to buy after the market has gone up — ignoring reversion to the mean — and sell after the market has gone down — again, ignoring reversion to the mean. The practice of buying high and selling low is what drives the dollar-weighted returns to be less than the average returns. This pattern is so well documented that academics call it the “dumb money effect.”

A Brief History of Money

If the entire history of Homo sapiens was represented by a 24-hour clock, money would only have been around for the last 18 minutes. Because it connects people, it is arguably humankind's most important invention, up there with the printing press and the internet.

But, as George Goodman (a.k.a."Adam Smith") points out, “The trouble with paper money is that it rewards the minority that can manipulate money and makes fools of the generation that has worked and saved.”  Under a fiat money system, higher inflation slowly confiscates savings. Wall Street and the financial sector have been viewed with scorn in the aftermath of the 2008 global financial crisis, but one positive development in the world of finance is that we no longer have a “minority” that can use money to their advantage—anyone can do it. For a long time, only the privileged rich could access global market opportunities, but thanks to innovations like exchange-traded funds and low-cost online trading accounts, participation in the global stock market is cheap and easy.  Because of the now low barriers to entry, all investors can protect themselves from inflation and grow their wealth.

Born after 1980, millennials are the first complete generation of Americans born into a world of dollars without an anchor. No anchor means no check on inflation, no check on money printing, and therefore no check on the value of our U.S. dollar.  With inflation eating away our purchasing power, we should invest in assets that grow at the highest real rate (after-inflation) over time. 

Over the long run stocks have outperformed bonds and bills, usually by wide margins[xi].  And while U.S. bills and bonds did provide slightly positive returns after inflation during this period, bonds and bills in other countries lost money between 1900 and 2012.  Investments in supposedly “safe” short term bills lost purchasing power in Germany, Japan, France, Italy, Belgium, Finland and Austria. In the U.S. and in countries abroad, bills and bonds have failed to help investors build wealth.

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