In­vest­ing by the (Wick­sel­lian) book

Financial Mirror (Cyprus) - - FRONT PAGE -

As reg­u­lar read­ers will know, I have spent much of the last ten years study­ing, and at­tempt­ing to en­large upon, the work of the great 19th cen­tury Swedish econ­o­mist Knut Wick­sell. My mis­sion has been two-fold: firstly to un­der­stand how Wick­sell’s writ­ings ex­plain what we see hap­pen­ing in the global econ­omy to­day, and se­condly to trans­late his the­o­ries into prac­ti­cal tools to help in­vestors make as­set al­lo­ca­tion de­ci­sions in the real world.

Ear­lier this year, I came to the con­clu­sion that in or­der to make fur­ther progress, it would be nec­es­sary for me to con­sol­i­date and sum­marise my find­ings so far so that they could serve as a foun­da­tion for fu­ture im­prove­ments. Clearly such a sum­mary could not be con­densed into a reg­u­lar col­umn. So I am pub­lish­ing the fruits of my Wick­sel­lian re­search in the form of a short book, en­ti­tled “Stag­na­tion Or Bust?” Po­ten­tial read­ers should not be in­tim­i­dated; it is a mere 56 pages long. One might think that is not much to show for ten years of in­ter­mit­tent re­search — less than a page for ev­ery two months. But read­ers can rest as­sured that for ev­ery pub­lished page, at least ten were dis­carded be­cause of their fuzzi­ness, lack of pre­ci­sion, or ab­sence of clar­ity. It has been a long and painful process...

Yet even read­ing 56 pages re­quires a cer­tain com­mit­ment, so for those who are pressed for time, I shall now cut to the chase, and out­line what my Wick­sel­lian anal­y­sis — and the Wick­sel­lian spread, in par­tic­u­lar — has to say about as­set al­lo­ca­tion in the cur­rent febrile mar­ket con­di­tions.

Over the last 12 months, the Wick­el­lian spread — the dif­fer­ence be­tween the nat­u­ral in­ter­est rate and the mar­ket in­ter­est rate — has placed the world firmly in the lower, de­fla­tion­ary, half of Gavekal’s long­stand­ing Four Quad­rants ma­trix. This im­plies that in­vestors have been fac­ing ei­ther a de­fla­tion­ary boom, or a de­fla­tion­ary bust, or both in suc­ces­sion. More­over, de­spite the re­cent rise in in­fla­tion ex­pec­ta­tions, the Wick­sel­lian Spread in­di­cates there is lit­tle prospect of an ac­cel­er­a­tion in in­fla­tion in sight, with the re­cent rise in the Baa bond rate mak­ing any such ac­cel­er­a­tion even less likely.

Now, in a de­fla­tion­ary world in­vestors have a choice: long eq­ui­ties to play a de­fla­tion­ary boom, or long US govern­ment bonds to play a de­fla­tion­ary bust. In this re­gard the sig­nals have been clear: from Novem­ber 2015 to March of this year, in­vestors should have held the bulk of their port­fo­lios in long bond po­si­tions. From March, with the Baa rate col­laps­ing, they should have held eq­ui­ties, in the form of the S&P 500.

Right now, the Wick­sel­lian spread is at -1.75pp, which means it is en­ter­ing the dan­ger zone from -1.75 to -2.25pp which sep­a­rates the boom and bust sce­nar­ios, and which there­fore also marks the bound­ary be­tween the “buy stocks, sell bonds” and the “buy bonds, sell stocks” worlds (see the chart).

To cut a long story short, any sus­tained rise in Baa bond yields from where they are to­day at 4.86% will see the risk of a re­ces­sion rise ex­po­nen­tially. As a re­sult, the higher the Baa rate goes from here, the more in­vestors should buy long bonds and sell eq­ui­ties. To put it bluntly, the move in the Baa rate from 4.3% to 4.8% was a non-event. A move from 4.8% to 5.3% would be a dis­as­ter.

For­tu­nately for in­vestors, the long bond, which as re­cently as June of­fered no value, has now moved from a low of 2.09% to 2.99%, slightly above the mid­dle of my (nonWick­sel­lian) val­u­a­tion model for the 30-year trea­sury.

The in­vest­ment con­clu­sions are sim­ple: if rates stay where they are or keep go­ing up, then in­vestors should re­in­state the clas­sic 50% long bonds, 50% eq­ui­ties al­lo­ca­tion which I have favoured for most of the last seven years.

A more ex­treme so­lu­tion — but not one for the faint­hearted — would be to start grad­u­ally sell­ing eq­ui­ties now to buy long-dated bonds over the next two months, the idea be­ing to move to a 100% bond po­si­tion just in time for the US pres­i­den­tial in­au­gu­ra­tion on Jan­uary 20, 2017.

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