Permanent Value

Weekly Update: November 15-19, 2010

Bruce Doole
November 24th, 2010

THE MARKETS

Among the many economic differences between China and the United States, one of the most glaring is that China is trying to slow down its inflation rate, while the United States is trying to ignite it.

Unlike in the U.S., China’s economy is growing rapidly. Its voracious appetite for goods and services is rippling through the country and led to the inflation rate rising to 4.4% in October from a year earlier. That was China’s highest level in more than two years, according to Reuters. Strong demand from China is also affecting worldwide commodity prices, which have risen 41% since March 11, 2009, according to data from the DJ-UBS Commodity Index.

In response to the growth, China raised banks’ required reserves by 0.5% last week, which was the fifth increase this year. It also raised interest rates back in October, according to CNBC. Both moves are designed to put a lid on inflation and prevent the economy for overheating.

The U.S. has the opposite problem.

Sluggish growth and deleveraging have kept our economy stuck in neutral and inflation nearly non-existent. Last week, the Labor Department reported that the core Consumer Price Index, which strips out the volatile food and energy sector, rose a modest 0.6% for the one-year period ending in October. That was the smallest increase since records began in 1957, according to Reuters.

In response to our weak growth, a concerned Federal Reserve is now pumping hundreds of billions of dollars of fresh liquidity into our economy to try and revive our “animal spirits,” according to MarketWatch.

What’s interesting about this split is that the U.S. and China are the two largest economies in the world, according to Bloomberg, yet their economic trajectories are vastly different. For investors, this has investment implications.

For more than 100 years, the phrase, “Go West, Young Man,” has guided folks seeking their fortune. Given growth in China and other developing Asian economies, it may be time to change direction.

LITTLE DID WE KNOW THAT…

…MR. MIYAGI, OF KARATE KID FAME, was way ahead of his time when he instructed his student Daniel in the art of “wax on, wax off.” Never mind the fact that Mr. Miyagi was talking about how to wash a car; his phrase has become a popular way to describe the nature of our present day financial markets.

There was a time, not long ago, when many investors would call themselves a “bottom-up investor,” which meant they analyzed individual investments based on the specific merits of that investment. Little emphasis was given to how “macro issues” — such as the overall economy, interest rates, geopolitical issues, or other big picture items — could potentially affect that investment. The thought was a “good” investment would do fine regardless of what happens at the macro level.

Ah, but times change.

Today, the concept of wax on, wax off, which is also referred to as, “risk on, risk off,” has grabbed the headlines and pushed bottom-up investing off to the side. Instead of referring to washing a car, the current concept of wax on, wax off refers to days in the financial markets when investors act as a herd and pile into or out of asset classes without much regard to the specific merits of any particular investment within that asset class, according to a September 22 article by BNY ConvergEx as published by zerohedge.com.

For example, on “wax on” days, “The mood of investors is confident and they flood into stocks and other investments perceived as risky such as junk bonds, emerging markets, and commodities,” according to The Wall Street Journal. Conversely, on “wax off” days, “Money comes sloshing out of those investments and into so-called safe-haven investments such as U.S. Treasuries, the U.S. dollar, or Japanese yen.” 

Why the shift? BNY ConvergEx cites several reasons including the rise of index investing, artificially low interest rates, globalization, and high-frequency trading.

Ultimately, a “good” investment is still a good investment, but as long as wax on, wax off remains a prevailing characteristic of financial markets, we should expect higher volatility and a potentially longer time frame for these “good” investments to pay off.

Market Returns

  This Week Year to Date Last 12 Months Last 5 Years
S&P 500 0.0% 7.6 % 9.9% -0.9%
Dow Jones Industrial Average .1% 7.44% 9.09% 4.84%