John Gorlow
| Nov 23, 2012
This Time Is Not Different
Lasting 18 months, the recession of 2007-2009 was the longest and deepest U.S. contraction in the post-World War II era. Though recovery started in the summer of 2009, it is widely considered to be the weakest in the postwar period in terms of both output and employment growth.
And partially as a result of this sluggish recovery, the U.S. economy remains fragile and it is at risk of slipping into yet another contraction. Economists and market participants point to tax increases and reductions in government spending that will go into effect at the beginning of 2013, as two events that could have a large enough negative impact on economic activity to drive the U.S. back into recession, unless policy makers reach an agreement to put the finances of the U.S. on a more sustainable path.
Harvard Professors Reinhart and Rogoff, the co-authors of the 2009 book titled “This Time is Different: Eight Centuries of Financial Folly”, recently wrote that “five years after the start of the 2007 recession, U.S. per capita gross domestic output (GDP) remains below its initial level and unemployment, though down from its peak, [it] is still around 8 percent”.
Increasingly evidence suggests that the U.S. has come out of the financial crisis of 2008 in better shape than its peers. But rather than a V-shaped recovery that many economists expected, the U.S is actually bumping along in a stop and go fashion.
According to Reinhart and Rogoff (2009), this rocky performance is not surprising. The slow and halting U.S. economic recovery is typical of recessions caused by severe financial crises. For example, after the panic of 1907, real per capita GDP did not return to its 1996 level until 6 years later and the unemployment rate did not return to the pre-crisis level until 1918.
Granted, both per capita economic output and the unemployment rate will eventually regain their pre-crisis levels, nonetheless Reinhardt and Rogoff remind us that a full recovery is invariably accompanied by a massive increase in the real value of government debt. And this time it is no different.
As Pulitzer Prize winning author Thomas Friedman put it in the NY Times last week, “it’s good to see that the budget talks between Obama and the Republicans are getting off to a good start, but we know there will be plenty of partisan politics before any grand bargain is struck”. Friedman also quoted Mohamed El Erian, the C.E.O. of Pimco as saying “if we can just get this grand bargain done we can restore economic dynamism, ensure financial soundness, and overcome political dysfunction to really unlock growth again”. And Friedman added, “not to punish but to solve, not to sock it to the successful but to create more abundance for all and the right mix of tax increases, spending cuts and investment incentives, will spur more start-ups, lead to more risk taking, inspire more entrepreneurs and create more jobs”.
In “Down with Super Committees”, published in the NY Times on November 19, Nobel Prize recipient Peter Diamond wrote about the debt trajectory: “even if a grand bargain is achieved, there’s reason for pessimism because any bargain is likely to side-step, or even enshrine, many of the root causes driving inefficiencies in our nations spending and taxes. And congress with its eyes on 2014 and beyond can’t afford to take risks involved with genuine reform”.
In the next few weeks, the true outlines of the real economic program currently under development in Washington will become increasingly clear. Until then, markets remain volatile, and investors continue to express anxiety over the debt ceiling and fiscal cliff negotiations. And as often is the case, during periods of economic uncertainty, investors are contemplating what changes, if any, they should make to their investment plans.
Economic theory explains that expected returns should increase in bad times and decrease in good times. But can investors use information about the state of the economy to tactically time their allocations to equities or sectors of equities to outperform the market? In a well-constructed 2008 research paper (Business Cycles and Risk Premiums, DFA), co-authors Lee, Repetto and Rodriguez answered the question very well: They explained that “the expansion or contraction of the economy is often measured by the rate of change in output or gross domestic product. Changes in the pace or course of economic output have historically triggered performance shifts within the stock market. There is some evidence that expected returns are different in and around peak and trough months of the business cycle: they tend to be high during troughs and low during peaks. In theory, investors could use information about the state of the economy to increase expected returns by tactically timing their allocation to stocks over the business cycle in a countercyclical manner: increasing risk in bad times and decreasing it in good times. In other words what is now up, may go down and vice-versa. But the speed at which markets incorporate information about fundamental value into stock prices, and the huge variation in the duration of economic expansion and contraction periods makes identifying in advance, and accurately timing turning points in stock prices, sectors of the market, or the business cycle virtually impossible”.
For example, the latest S&P report shows that almost 90% of all U.S. active equity funds (the kind that seek to provide a return that exceeds a benchmark and the type that most advisors and fund houses recommend) under-performed their benchmarks for the 12 months ending June 30th, 2012. Further, evidence supports that the persistence of the winners is shown to be no more likely than the flip of a coin.
Empirical evidence clearly demonstrates that the traditional active investment process fails to deliver on its promise to help investors profit from its so-called "insight". Adding insult to injury, numerous advisors, brokers, fund houses, and the media who clearly all survive on commissions, revenue sharing and add sales will not hesitate to distort facts, stretch the truth and thus fuel short-term thinking all in the hope that investors will make frequent changes in their investment strategies that will invariably generate profit for the advisors but not the investors.
It is imperative to remember, that during uncertain times, it is more crucial than ever to maintain a long-term view and not to try and time the market. It can be challenging at times to stay the course. Nonetheless, even in the best of times, it is impossible to know when to get in or out. Buying and selling at the wrong time can be as dangerous to your financial health as chasing mavericks (see the film) is to your life.
The key to long-term investment success is a smart investment plan based on sound passive and index investment philosophy coupled with a strategy appropriately tied to your risk tolerance, time horizon, and investment objectives, along with diversification and rebalancing, rather than investing faith in faulty signals and forecasts that nobody can guarantee to deliver on.
Bear in mind that if your personal or financial circumstances have changed, it is important that you contact me. You might qualify for rebalancing. Otherwise, avoid costly missteps and remain committed to your plan.