October 14th, 2013
In chess, a stalemate is a drawn game. Chess players study endgames, where small advantages become big wins. Computers have now solved these endgames – all of them! Some require dozens of precise moves. A mistake converts a draw into a win or a loss. Humans make mistakes.
Political processes are inherently human. It is possible to estimate the outcomes, but there is plenty of room for surprises along the way. I have been analyzing public policy issues for forty years, including the study of hundreds of actual decisions as part of my dissertation – the original research required to get your "professor credentials." I do not have any exaggerated illusions about the predictive power of academic research, but at least for me, the research has helped to identify investment implications.
There are certain principles that hold up with amazing frequency in the US political process, and more generally in democratic systems:
- If a particular outcome is clearly beneficial to nearly everyone, that result will usually be achieved.
- The process of bargaining and compromise is always messy. It looks terrible to observers who have never personally experienced it.
- Compromise does not yield the best possible result. Instead, it generates the best result possible. Outsider each have an idea of the perfect solution. The problem is that there are many differing and inconsistent "perfect" solutions.
- No one really loves the result of a compromise.
- Every political issue is subject to compromise, even those that seem to involve strict rules.
Why dwell upon this in a blog dedicated to successful investing?
For the last three weeks I have accurately highlighted the political debate as a major concern for investors. Investors who read last week's post saw that while I did not see a specific outcome in the week ahead, there were five things to watch:
- A temporary extension of the debt limit. This will be criticized by the punditry as "kicking the can" but it will serve the function of buying some needed time. The market will respond to the progress, not to the political wails of some pundits.
- Minimally, an agreement that provides some tweaking of sequestration and provides Speaker Boehner a chance to claim some credit.
- Maximally, a broader compromise on some entitlement and debt issues – less likely and taking longer.
- The agreement could be reached overnight or on a weekend, without much notice.
- The resulting pop in stocks (just like the fiscal cliff resolution) will leave many chasing the market, waiting for a pullback.
This proved to be a fairly accurate assessment. As I write this, the situation is changing almost by the hour. Yesterday the emphasis was on the Senate. Today it is on the most recent proposals from Republicans in the House.
The biggest element missing from the five points listed above is the political cover for Speaker Boehner. Poll results showing blame falling mostly on Republicans seem to have stiffened the resolve of Democrats. They are now asking for higher spending levels, easing the sequestration rules. The principle highlighted by the administration is not to allow the debt limit threat as the foundation for policy negotiations. The principle highlighted by Republicans is the need to use maximum leverage to achieve goals viewed as important.
An Important Distinction about Politics
Regular readers know that I strongly recommend separating your political viewpoints from your investing. You should join me in being politically agnostic—willing to invest successfully no matter who is in power.
It is fine to have an opinion about ObamaCare, about debt, about European leadership, or about the Fed. Feel free to express your viewpoints in personal discussions or in the ballot box. Stop there. Confusing what you hope will happen with what probably will happen is the fast track to investment losses!
When I discuss policy issues, I am helping you to predict what will probably happen and also the investment consequences. I have been extremely accurate on every important policy decision for many years – Europe, 2011 debt ceiling, fiscal cliff, etc. – often in disagreement with the majority of pundits. I have never expressed personal preferences, but instead emphasize how to profit from likely outcomes. I regularly cite sources covering a wide political spectrum. Discerning readers might note that I find the viewpoints of extremists of all types to be market-unfriendly. Mainstream thought, from whichever party, is better for investments, whatever your personal views.
The implication for investors is that gridlock leading to a default on U.S. debt is bad. This is an investment conclusion, not a vote on ObamaCare.
A New Theme: Earnings
In the absence of fresh economic data, the discussions will start early. The best and most recent update comes from earnings expert Brian Gilmartin. Brian explains why we should watch earnings closely, and especially monitor the forward 4-quarter estimate. He writes as follows:
In a nutshell, the reason we track the forward estimate growth rate and y/y change is that (in my opinion) it is the one metric that validates or "explains" an expansion (or contraction) in the SP 500′s p.e ratio, or what is otherwise known as P.E expansion. Although I can't prove it mathematically, it seems intuitive that if the growth rate of the forward estimate is increasing, then the SP 500′s p.e ratio can "expand" to keep pace with the presumed acceleration in "earnings expectations" or contraction as the forward growth rate slows.
Just like the bond market and the Federal Reserve are more concerned with "inflation expectations" than actual inflation that we can see in the data, I think the one component missed by strategists and the CNBC community is "earnings expectations" and the growth therein, and the one metric that quantifies this expectation is forward earnings, and yet we hear about it so very little.
I expect us all to be seriously focused on earnings by the end of this week.
I also have some thoughts on how the debt limit endgame will play out. I'll report on that in the conclusion. First, let us do our regular update of last week's news and data.
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