Big EZ's QE Fail

The stock market climbed last week in anticipation of the European Central Bank's announcement of its program to purchase more bonds. The US press has dubbed it the ECB's quantitative easing, or QE. As with the several versions of QE in the US, the ECB's purpose is to reduce interest rates enough to persuade businesses to borrow and expand and consumers to borrow and buy cars and houses. Also, the bank hopes it will ramp up price inflation that will reduce debt.

The bank's QE effort will fail to achieve the goal as did those of Japan and the US. ECB president Mario Draghi admitted as much when he told politicians that credit expansion alone will not rescue Europe without "structural" changes by governments. In other words, Europe's problems are microeconomic, not macro. The structural changes needed include reducing taxes and rolling back regulations, especially rigid labor regulations that make it almost impossible for businesses to divorce employees. Businesses are not investing in the US because of high taxes and job-killing regulations, but the problem is much worse in Europe.

Ghost of Ricardo Haunts Europe and Japan

The ghost of David Ricardo must be sending chills up the spines of the economists of Europe and Japan. They may not understand what causes those chills because of the poverty of their education. The US may soon experience a similar visit. Here is how the Wall Street Journal put it in email newsletter:

Can the U.S. go it alone? All of a sudden, economic data from around the world is looking decidedly worrisome. China on Thursday showed stark, sudden slowdown in lending and home buying in July, while Europe’s second-quarter results confirmed everyone’s worst fears, with Germany registering a contraction for the quarter and the euro zone as a whole failing to grow. This comes after a very big slowdown in the same quarter for Japan, the world’s second-biggest economy.

Escape from Mass Opinion

L. Albert Hahn, a great economist in the decades after WWII wrote Common Sense Economics because he thought that most mainstream economics had drifted into fantasy land as a result of the rise of Keynesian economics. I like the cover picture that shows a piggy bank sinking under water, which is what conventional investment wisdom will cause.

In section five on the stock market, Hahn wrote this:

 “As every experienced market operator knows, success on the stock market depends decisively on the ability to go against the prevailing tendency, i.e., against mass opinion, at the very moment when its correctness is least in doubt. The ability to go against the prevailing tendency, however, presupposes in the first instance that the individual remains conscious of the persuasive influence of mass opinion on his own opinion. This, in turn, presupposes a correct assessment of its force. Everyday observation shows the strength of mass opinion to be very great indeed. It engulfs not only those who easily succumb to foreign influences but even those with normally detached views and sober judgment. An almost superhuman effort is needed to evade the influence of mass opinion-particularly in the United States, where price movements and thus the opinions of others are continuously reported to the farthest corners of the country by the ticker. The ticker assembles, as it were, all the buyers and sellers in one room. The ticker influences speculation as the flag influences troops. As long as the flag is carried forward, every single man knows that the others still have the courage and strength to go on, and this knowledge sustains his own courage and strength. Once the flag retreats, every man concludes that the others' courage and strength is waning. As he knows that he cannot advance alone, he, too, retreats, even though he would not himself be forced to.

 “There is, of course, no general rule on how to counteract the influence of foreign opinion on one's own opinion. One of the most important aids for emancipation from mass opinion and its influence is to bear in mind that all prices are almost always necessarily wrong. It is further important to remember that mass suggestion wields its strongest influence when only one opinion is stated and discussion is prohibited. An experienced stock market operator will always listen with special attention to any arguments in opposition to the prevailing opinion.”

It’s old, but still good advice for investors. The time to follow the crowd is the period after the bull market starts until just before it ends. The crowd won't get out of the market until long after they have lost close to half their nest egg. Most individual investors don't get into the market until it has reached close to its top. The market is near its top today so successful investors will start rebalancing into cash or gold, but those who do will get a lot of criticism from most other investors. Being a good investor means learning to enjoy solitude. 

                                                                                                                                         

From Common Sense Economics by L. Albert Hahn, London: Abelard-Schumann Ltd., 1956, 213-214.

Markov Confirms ABCT

Greg Davies and Arnaud de Servigny offer a different take on diversification in their book Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory. Chapter 6, “Representing Asset Return Dynamics in an Uncertain Environment was the most interesting chapter to me, and the one that adds confirmation to using the ABCT as a guide to timing the market. 

Modern portfolio theory tells investors to diversify their portfolios at least between two asset classes, stocks and bonds. A simplistic summary of the method is to use the statistical measure called standard deviation to assess the risks of asset classes and diversify according to risk. But in reality, advisers have found that a fixed ratio, say 70% stocks and 30% bonds, often works better without requiring as much work.