The World Economy: A Time of Transition

It seems as if “Macro” forces are dominating movements in the financial markets these days. The latest call to attention of this fact is the article by Tom Lauricella and Gregory Zuckerman on the front page of the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704190704575489743387052652.html?mod=wsjproe_hps_TopLeftWhatsNews). The “big” picture appears to be driving things and not the performance of individual investment opportunities.

Specific attention is given to a statistic called “correlation” which measures “the tendency of investments to move together in a consistent way.”

The article reports that in the 2000-2006 period the correlation of stocks in the Standard & Poor’s 500 Index was 27%, on average. However, during the events that led up to the Iraq war, correlations were near 60%. At the height of the financial crisis, October 2008 to February 2009, correlations were around 80%. They were around 80% during the sovereign debt dislocations in Europe earlier this year. In mid-August correlations dropped to 74% and now reside in the 65%-70% range.

When the prices of many or most stocks move together, individual stock picking is not the optimal investment strategy. This is why many investors have been moving to mutual funds that focus more on “macro” issues rather than on individual companies.

One of the most interesting statements in the article was this: “Prior to the financial crisis, such high correlation levels were seen previously only during the Great Depression, according to data compiled by market-strategy firm Empirical Research Partners.”

I pick up on this statement because of my belief that we are going through a tremendous period of transition. The world is changing. And, it is changing in ways that we don’t fully comprehend. As a consequence, individual “bets” are extremely risky, much more risky than “bets” that tend to aggregate outcomes.

The period of the Great Depression represented another period of major transition. During the Great Recession of the 2000s people were constantly referring back to the 1930s for “lessons learned” with respect to monetary and fiscal policies that could be applied to the current situation so as to avoid falling into as deep a hole as occurred at the earlier time.

However, the major lesson we may have to learn from the era of the Great Depression is that economies have to go through transition periods as they move from one kind of societal structure to another. In many ways, the American economy, and much of the rest of the developed world, still operated on an agricultural foundation in the 1920s. Yes, the industrial base was developing, labor unions were coming into existence, and cities were coming to dominate the rural areas but, in many ways, agriculture still dominated economic policy making.

The government in the United States supported and subsidized the agriculture sector in a way that was unsustainable relative to the emerging industrial cities. When this unsustainable effort collapsed, the economy fell apart and the 1930s through the 1940s saw America restructure from a rural society to one where prosperity resided in the cities and suburbs.

During this transition, it was not easy to pick out winning investments because no one really knew what the future was going to look like. Thus, the correlations of stock prices were high because success depended more upon how the whole economy re-structured and, consequently, how the whole economy recovered.

I believe that there are strong parallels in this respect between the current situation and that which existed in the 1930s.

Whereas America supported the farms and farmers in an earlier age because farming was “the American Way,” in the post-World War II period America supported owning a home in or near cities because it was believed that owning a home was, more or less, the right of all Americans.

Now, something else is happening. The industrial base in the United States is deteriorating, capacity utilization is around 75%, underemployment of individuals of working age is around 25%, and income inequality has become quite large. Labor unions are becoming like the dinosaurs, their species is dying. Center cities do not seem to be the wave of the future as they once were seen. And, home ownership for everyone may not fit into the future of society.

The United States government supported and subsidized the housing industry for fifty years, putting GIs into homes after World War II, financing the suburbs, rehabbing the cities, and so forth. Well, the bubble burst, just like it did for the agricultural sector.

What’s next?

That’s the interesting thing about transitions…you never know exactly where they are going to end up.

There are lots of changes taking place. Before the 1930s, the Industrial Age began: the late 19th century was just the spectacular beginning although agricultural still dominated the scene. The late 20th century saw the beginnings of an Information Age even as the cities and industrial concerns remained in the headlines.

What will an Information Age look like? That is still up to the science fiction writers.

What I am sure of is that information will continue to spread and cause changes worldwide that we cannot even imagine at this point in time. Information markets are going to become ubiquitous and innovation with respect to “Information Goods” is going to extend far beyond the field of finance.

But, there are other changes taking place that are going to “rock” the world. One of these is the political makeup of the world. There is the rise of China and the other BRIC nations. Power collected in the G-7 has been transferred to the G-20. The IMF is changing and will have to change a lot more, moving from European and American dominance to include greater roles for South America and Africa. These changes are going to have massive impacts on the way things are going to get done.

Furthermore, the emerging markets seem to be the place to invest these days. The economies of the United States and western Europe are the sluggards as they go through their needed transitions. These emerging nations are now dealing with one another because the allocation of commodities in the world is crucial for the continued progress of these areas. All these movements are “macro” in nature.

As the transition takes place, the “old” is not going to work in the way it used to. Stock investing will be different, at least for a while. The “old” political philosophies are not going to be very effective as we are finding out in the United States and in western Europe. But, this is a part of the whole process. We must adjust and find out what works and what doesn’t work.

Those that try to force things back into the “old” boxes are not going to survive!