Investing seems overly complex. The table below is called the periodic table of investment returns and is widely used in the investment industry as grounding for the notion of diversification. The table shows annual returns from 1995-2014 for multiple asset classes (stocks versus bonds), investment styles (growth versus value), capitalizations (large versus small) and equity market locations (US versus international.)
Investment “experts” use the table to highlight the uncertainty inherent in capital markets. Since the ranking changes often and the spread between the top and bottom asset is often wide, experts push the case for diversification. “Just own a little bit of everything at all times. After all, the investment universe is too complex and difficult to understand for mere mortal investors like yourselves to have a chance at getting things right.”
But what if investing wasn’t as difficult and complex as the buy and hold diversifiers lead you to believe?
Successful investing is, in fact, difficult. What makes it difficult is that many investors use the wrong lenses to view the world and then become bogged down in confusion. We prefer to simplify things. One way we do that is by using government economic policy as the lens.
Investing can be made quite simple by getting a “snapshot” that tells us if a country’s economic policies are attracting or repelling capital. To get that “snapshot” we need to know the recent trajectory of a currency’s value priced in real, gold terms. If a country’s currency is strong and stable then it is likely attracting capital. If a country’s currency is weak and volatile then it is likely repelling capital. Since government economic policies tend to be durable and rarely shift on a dime, then the policies in place creating the currency market dynamic can be artfully extrapolated into the future. Good policy tends to stay good and attract capital until it is undone. Let’s take a different look at that “complex and confusing” periodic table of asset returns, but this time we will view it using a policy lens.
The following chart takes the best performing asset class from the periodic table above and overlays the value of the US$ over time. Since the value of the US$ is a broad measure of the “goodness” or “badness” of the government economic policies in place, we can begin to see the link between policy and asset returns. To measure the value of the currency we use the price of gold in US dollars. We use a trended long-term average to smooth things out and reduce noise. When the average price of gold is flat or falling, the US$ is strong and signaling a capital attracting set of government economic policies. When the average price of gold is rising, the US$ is weak and signaling a capital repelling set of government economic policies. The results are powerful.
From 1995-2001 the US$ was stable and strong evidenced by average gold prices that fell from $400/oz to $275/oz. US equities were the top performing asset class 6 of 7 years. The average annual return was 30%.
From 2002-2012 the US$ was weak evidenced by average gold prices that rose from $300/oz to $1700/oz. Emerging market equities were the top performing asset class 7 of 11 years. Further, if we exclude three geopolitical outlier years from that subset when bonds were the top performing assert class (2002 Gulf War, 2008 Financial Crisis, 2011 European debt crisis) then emerging markets were the top performer 7 of 8 years. The average annual return was 41%.
From 2013-present the US$ has been strong, evidenced by average gold prices that fell from $1700/oz to $1200/ounce. US equities were the top performing asset class 2 of 2 years. The average annual return was 29%.
Strong US$ periods cause capital to flow into the US and propel US equities to be a top performing asset class. Weak US$ periods cause capital to be repelled from the US. This capital is often drawn into emerging market countries, many of which are linked to rising commodity prices. Investors need to use a policy lens to simplify the world. The following article by Brian Domitrovic is a must read. He makes clear the bountiful benefit of using a “classical monetary policy” to achieve a strong/stable US$.
The best part is that his most recent audience was Janet Yellen, chair of the Federal Reserve. If the Fed starts listening to ideas like the ones Domitrovic outlines, then a great period of sustained prosperity lies ahead of us, not behind us. The recent US$ strengthening just began in 2013 after a decade of weak US$ policy. If the US, led by Federal Reserve monetary policy, can continue down this path then there will be no need for “alternative, inflation hedging” investments. Future US equity returns will cluster near the top of the periodic table and investors can easily and cheaply get on board for the bull market. An investment universe like that is not complex or difficult to navigate. Just like in the prosperous 1980s and 1990s, it merely calls for owning US equities until the policy green zone ends. If we are lucky, that end is far away. Keep it simple.
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