Investment philosophy, process and outcomes

In some regards investing is like dieting. It only works if you have a good philosophy, good plan, and you stick to it over the long term. So what is our investment philosophy at the Suburban Economic Investor?

Investment philosophy

We are strategic, top-down investors. This means we invest according to macro-economic trends. We select relatively few investment asset classes, we abore excessive diversification and the notion of buy and hold for the long term. We don't trade; our ideal is 1-2 major investment decisions per year if that. Our heroes' are sage investors like Jim Rogers and Marc Faber who correctly picked commodities and China as boom investments (and the US as a poor one), and we smart enough manage those investments to protect downside. Our economist heroes' include Nouriel Roubini (RGE) and Paul Kasriel (NTRS).

So how does it work. Four simple steps based on foundation knowledge of financial and economic concepts.

1. Monitor and understand the global economic situation
2. Select asset classes likely to benefit (high positive economic value) over the medium term
3. Select individual investments within these asset classes
4. Manage entry, risk and exit to investments

For example. In 1999 our sage heroes' Rogers and Faber identified commodities as a group where at two decade generation lows. They also understood the central banks were printing excess money and that real rates would become negative which was bullish for commodities, and bearish for the USD. In 2003 they recognised China's entry to the WTO would spark a huge boom in that country. In 2006 these sage's went short financials recognising the imminent US housing bust. In 2007 they went long agriculture stocks. We don't pretend to be able to match this performance, but we do intend to 1) understand the fundamentals, 2) follow the global economy, 3) follow the sages by selecting good asset classes, 4) manage risk in our investments carefully.

Investment process versus outcomes

Investing is a probabilistic field in which both the likelihood and payoff for a decision in important (more on this later). In these fields the long-term investment philosophy and process are more important than short-term outcomes. We can control our investment philosophy, but we can't control short-term outcomes. Consider that in the following matrix:

We can't control the market, but we are aiming for an investment process which will deliver either deserved success or unlucky outcomes. We don't want to confuse blind luck with investing genius on our behalf. This 2 dimension by 2 dimension (2 x 2) matrix introduces both game theory and expected value concepts which are highly important to financial and life decision making. At its simplest we consider the performance what we can control (our investment process), with that which we can't control (market outcome). A useful concept for making all sorts of decisions with imperfect information.

Money supply, bonds, property, equity and the Great Moderation

In this big post I try to pull together a theme to describe the last 20-30 years of investing.

One of the principle characteristics of this was the so-called 'great moderation' in inflation. This can be seen in the chart left since the early 1980s (courtesy of the US Cleverland Fed.)

In the next chart we see that inflation is reasonably reflected in in the US 10 yr Treasury yield. Notice how yield rose from 1960s lows to peak in the early 1980s then fall through to now. Note also the price of a notional 10 yr US Treasury bond works in reverse and we had large bond rises. In fact bonds, particularly zero-coupon long bonds have been a great investment.

We'll come to why at the end, but for now note in the chart below how bond prices have been rising as yields/inflation fall.
With inflation falling, shares increase in value. Why? Well a share price can be considered the current value (CV) of future cash flows from dividends over the long term. With falling inflation the discount rate (IR) falls, and the share CV becomes worth more. This is explained in 'What is NPV?' and the bond basics post. For now not that the S&P500 really took of when inflation started moderating as shown below:
Proof that much of the expansion in the S&P500 index was price to earning expansion is seen in the following long-term PE chart from Bob Bronson. Note Bob's forecast into 2012.
The next asset class is housing and this two has boomed relative to fundamentals (rents). The chart below shows US and Australian prices in real terms, in nominal the price gains are greater. Since 2006-7 we have seen house prices globally correct (US, UK, Spain, New Zealand, Ireland, Canada and now Australia).
The last major asset class is commodities. The chart below is from Martin Pring and shows commodity prices back to 1800. Martin suggests in a presentation that as of July 08, commodities are close to peaking (if not already).
So over the last 20 years we have had every major asset class (bonds, equities, housing and commodities) boom and peak (possibly for commodities). Why?

The answer seems to be an amalgam of reasons as listed below, followed by commentary on whether it is likely to continue.

1. Excess money supply (M0-M3). Not likely to continue with high inflation (M0) and commercial banks repairing balance sheets from massive credit losses (M1-M3). See posts on money here.
   
2. Further interest rate falls. Not likely as inflation rises and bond holders demand higher returns (discount rates) and bid lower prices for bonds.
3. Globalisation benefits. The growth of China Inc. was responsible lower prices everywhere on account of lower wages. However with China inflation rampant, and the Yuan appreciating against the US, China import prices are rising.
4. Low commodity prices. Commodities rose out of mid-80s lows to the current high levels. Whilst they may correct, it will take significant global demand destruction to do so (and this only occurs in a global recession/depression).
5. Inventory management gains. The smoothing of supply chains was responsible for reducing economic volatility. These gains have been made.
6. Reduced wage bargaining power. The late 80s and 90s where eras of conservative pro-business/anti-worker global governments in which workers lost bargaining power. The swing has been back to the worker so there are no more wage gains to be made.
   

In short, I believe the inflationary aspects of excess money supply where masked by items 2-6 above allowing the great moderation. However, that excess money supply found it's was sequentially into bonds (lower interest rates), equities (2000 peak), property (2006 peak), and now commodities (2008 peak).

Consumers everywhere are maxed out. In the developed world consumers borrow costs, access to credit and higher living costs are forcing a dramatic reduction in spending amist falling housing prices. In the developing world high commodities dramatically affect the cost of living which is the major purchase item, killing any discretionary spending that may have existed.

What can turn the global economy? BRIC nations (Brazil, Russia, India, China) spending on infrastructure as part of nation building? Maybe, but these nations export economies will suffer the in the global downturn so at best nation-building will offset this.

Be sure to check the SEI global review for more information as events unfold.

When to invest. The cycle of market emotions

When to invest?
Here is a useful tool that works in pretty much any market.

Investing involves a lot of group behaviour, especially when the asset class is real estate or dot-com equitites. Think of the NASDAQ in 1999, and US/global real estate from 2001-2006.

By reviewing the market emotions by talking to investors or listening to the media you can get a sense of where on the roller coaster we are. Enjoy!