The Tao of Recovery

The run-up to our peculiar national holiday wherein much of the populace is compelled to pretend that it is Irish for a day finds us very pleased to be managing for absolute rather than relative returns. (An aside: I recently had the pleasure of reading the Confession, i.e. testimony, of that great saint who was Patrick, bishop of Ireland. Along with the one other document we have from him, his letter excoriating a corrupt official by the name of Coroticus, it provides a fascinating picture of a great man meeting and overcoming extraordinary difficulties in the twilight of an empire.) By this, I mean that it is good to have the luxury of raising cash into a Market that looks tactically vulnerable but strategically very exciting. In the past month or so, I have raised my cash position by another 5%, to about 16% of investable assets.

Tactically speaking, the Market looks vulnerable, up 30% or so in not quite six months. Gasoline prices have levitated to “sticker shock” levels, though one gets the sense that someone has alerted the Administration that a lot of voters are out of sorts about this. If so, we can expect desperate measures to try to restrain these prices, at least until after the election. The good news on job creation is being played up for all its worth, even if the figures are still pathetically anemic by past standards. Our election year skepticism is further aroused by Gallup data that indicates that employment is actually weakening (the difference being that Gallup does not make the same seasonal adjustments that the BLS makes). Then there is the fact that we are but a few weeks away from when all those articles about “Sell in May and Go Away” will make their appearance. This was pretty good advice in each of the past two years, as the middle months of both 2010 and 2011 saw sharp corrections of -17% and -20%. Even in 2009, it was pretty good advice, despite the Market being in its initial decompression stage.

I think that to make sense of why the economy seems to be all of a sudden outperforming and why there is a very good case that in its current bullish state the Market could be on to something that is too big for any of us to see, we need to consider the ancient Tao. It is noted that “Every extreme condition contains the seeds of it opposite.” Booms are born out of busts, and vice versa. In the moment, I think we are experiencing the fruition of “seeds” that started to be planted this time last year. From the time the price of sweet crude started to soar along with the Arab Spring, but in earnest when earthquake and tsunami did unknowable damage to who-knew-what links in the global supply chain (which caused legions of businesses to elect to err on the side of caution), the recovery got dicey. This spooked investors, but more importantly set them up for revulsion when the gruesome spectacle of Congress wrangling over a debt limit was visited upon us. I will never forget the heartbreak of seeing that underlying our “best minds” projections as to an eventual balancing of the US Budget was an assumption that the economy would grow at an average of 5%! That sense of doom and despair was not helped when September brought the prospect of another global supply chain disruption, this time in the form of monsoon rains and singularly inept flood control in Thailand. But then like so many other low moments we have lived through (albeit, low moments that cannot begin to compare with those met and overcome by the aforementioned St. Patrick), things just kind of stopped getting worse and then started to get a little better. A whole lot of buying and hiring that got put on hold while we lived through all that (Oh, and did I mention the unremitting headlines about the imminent collapse of the Euro project?) has started to happen. There is a whole lot of “hurry up and wait” in the economy. After a six or so month wait, it seems to want to hurry up right now.

The same Tao applies to what could over the next few years take the Market a whole lot higher than any of us are thinking right now. Extreme condition #1: After being extremely unkind to investors for half of the 1960s and all of the 1970s, the Market was very good to investors in the 1980s and 90s. This set the stage for the past decade-plus. Analogous to the “celebration” of unemployment ticking down to 8.3% four-plus off the bottom, we find ourselves this week celebrating the NASDAQ closing above 3000, only forty percent below where it was twelve years ago. With respect to the American investing public, the tide is very, very out right now. Now couple that with Extreme condition #2: the taxation and regulatory environment. As noted in the prior Musings, there are no doubt millions of business decisions that have been put on hold because of the added uncertainties attendant with an intrusive, redistributive government. There is a whole lot of potential investing and hiring that is waiting for an outcome in November. A new Administration, one that understands business and economics at a higher level than comic books and Cliff notes, will unleash this activity, along with a good bit of M&A activity that has been similarly set aside. The Market acts as if it is buying into this actually coming to pass. As someone old enough to remember how in March 1980 “Reagan Trails Ford, Carter”, I am inclined to read into the Market’s newfound ebullience the expectation that the business climate of the US will improve dramatically in 2013. Throw in echos of 1997 around the reception of a new crop of IPOs (predominately Tech, but then there’s Spanx), a willingness on the part of at least some investors to open their mouths, close their eyes and believe the executive summary of the Prospectus, and a raging Bull Market becomes a real possibility.

Even if this scenario of economic recovery finding its way past first gear in 2013 plays out, it seems unlikely that the Market can go up another 20% without first seeing another correction on the order of what the past two summers wrought. 1980 was a watershed election for capital if ever there was one, but two years later we were still wondering if things would ever get better, and two years after that the Bond Market’s reassessment of future inflation was barely getting started. We don’t have Dr. Volcker’s medicine to swallow this time, but we do have a vast number of government programs, which are indeed economic activities in the schema of GDP = C+I+G, that will fail to pass the new boss’ “Is this worth borrowing money from China to keep doing?” test. My sense at the moment is that Market returns for the next five years will be such that being 80% or even 70% invested most of the time will yield a better return than being 100% invested did for you over the past ten years.