Ok, I promise this will be my last rant on this subject. At least for now.

In the 1990s we enjoyed the so-called “Goldilocks” economy: rapid economic growth, improving productivity, full employment, and low inflation. The stock market loved it and went through the roof. The markets especially loved the tech companies who were powering the growth. We know how all that ended.

Today, we’re living in the “Little Red Riding Hood” economy. The stock market loves it and is going through the roof. In the Little Red Riding Hood economy it’s possible that Little Red Riding Hood will get all the way to Grandmother’s house and back unscathed. It’s also possible that she’ll run into the Big Bad Wolf somewhere along the way, possibly when she least expects it: “But Grandmother Yellen, what big teeth you have!”

The Armageddonists believe the Big Bad Wolf is just around the corner. Central bankers, say these guys, think they’re in the business of taming the business cycle, setting the price of money, and singlehandedly defeating the Financial Crisis. But actually, the Fed is in the business of creating asset bubbles. In the 1990s the Fed kept rates too low for too long and created the Tech Bubble and the 2000 – 2002 market crash. In the 2000s the Fed kept rates too low for too long and created the Financial Crisis and the market crash of 2008. Now the Fed is doing it all over again, keeping rates too low for too long, and this time when the bubble bursts it will be worse than all the other bubbles put together.

The Delusionists, meanwhile, believe that the Big Bad Wolf has been domesticated into a lapdog and they insist that All Is Well. Sure, PE ratios have ballooned this year, but the economy is showing signs of life and will soon kick into overdrive. Central bankers are acting with unprecedented genius, not just in the US but also in Europe and Japan. The stock market is at an all-time high, to be sure, but stock prices are at barely at long-term norms. Dow 16,000? Pfft. We’re looking at Dow 25,000!

As usual, the truth of the matter is elusive. Maybe the Armageddonists are right and maybe the Delusionists are right. Maybe, in the Little Red Riding Hood economy, they’re both right!

But the important point is, we don’t know and we can’t know. We can’t know because only two things matter:

  • The first is what the central bankers are going to do. But we can’t get inside the heads of the professors, one of whom hasn’t even assumed her chairmanship yet. We don’t even know who the new voting members of the FOMC will be. Most important, the professors themselves don’t know what they’re going to do. As Stanley Fischer, the likely new Fed Vice Chair, put it back in September, “You can’t expect the Fed to spell out what’s it’s going to do. Why? Because it doesn’t know.”(1)
  • The second thing that matters is the consequence of what the central bankers do. And we can’t know what the consequences will be, in good part because the professors don’t know, either. The most important aspect of unconventional policies is that, since they’ve never been tried before, no one really knows how they will work out.

This puts investors in the unhappy position we found ourselves in in 2005 – 2006, and before that in 1998 – 2000. In other words, the markets are skyrocketing and we’re all making lots of money, but we’re getting more nervous every day.

When we listen to the Armageddonists our fear level rises and we’re tempted to take our profits and go to cash. If we’d had the good sense to do that in 1998 and 2005, we’d be a lot wealthier now – but (and it’s a big “but”) only if we’d had the courage to reinvest in late 2002 and early 2009. How many of us have the patience to sit in cash for four years and then plunge back in while there’s still fresh blood in the streets?(2)

On the other hand, when we listen to the Delusionists our greed level rises and we’re tempted to go all-in. Dow 25,000? We could all retire to Bimini!

As users of the Moneybags© mobile financial app know, Moneybags has doggedly adhered to its risk targets since the app was launched, despite the frayed nerves of its creator.(3) That seemed like the best policy, given lower-than-normal and then near-normal stock pricing and a Fed determined to give us all a put.

What Moneybags has specifically done is to allow its risk assets to rise until they reached the upper limit of the bands established for each portfolio. When the upper limit has been breached, Moneybags rebalances back to the target. Moneybags would have made a lot more money by allowing its stocks to run untethered, but it would have taken on massively more risk by doing so.

But if stock prices continue to rise, what then? Since I happen to be able to get inside the head of Moneybags’ creator, my guess is that Moneybags will proceed as follows: Once prices have exceed their long-term norms (which they’re starting to do now in the US, given a bit of wiggle room), Moneybags will rebalance back to its minimum risk targets, then let its stocks run until they reach their targets, then rebalance back to the minimum again.

That isn’t the most tax-efficient way to invest, but controlling risk is more important than saving a few bucks on taxes. If the Fed screws up and the markets crash, Moneybags will get hurt, but not nearly as much as if it had ignored its risk limits and let the portfolio run.

When you don’t know what to do, and can’t know what to do, that’s the best you can do.

 

(1) As reported in the New York Times, 12/11/13.

(2) For the benefit of my younger readers, the phrase “blood in the streets” refers to that least-observed of investment rules: Buy when investors are flinging themselves out their office windows into the street below because they’ve just been wiped out in a market cataclysm.

(3) The Moneybags© mobile financial app is available as a free download at the Apple App Store or at www.MoneybagsApp.com. The sample portfolio is just that – a sample. It’s not designed to be an appropriate portfolio for any particular investor.

 

Next up (but not until January 3: Happy holidays!): How Social Policy Gets Made: The Hyman-Curtis Project

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.