Investing by the (Wicksellian) book
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.