The Economics of Fiscal Deficits

In the following video, Marlena Lee of Dimensional Fund Advisors (www.dfaus.com) addresses various questions about the impact of increasing fiscal deficits on economic growth and market returns.

AICPA's Financial Literacy Website Gets an Update

The American Institute for Certified Public Accountants recently relaunched its financial literacy website (www.360financialliteracy.org). The site has been streamlined for more personalized content and better integration with new social media technology. At Tarpley & Underwood Financial Advisors, we support this continued effort to provide a resource to improve Americans' financial literacy.

Bubble Bubble, Toil and Trouble

The following commentary was written by Jim Parker, Regional Director, DFA Australia Limited:

Like the witches in Macbeth, financial commentators currently claim to be divining all sorts of gloomy market outcomes from their boiling cauldrons. So shouldn't we all be getting rich taking their advice?

Chief among the prognosticators is The Economist magazine, which recently ran a cover story entitled 'Bubble Warning: Why Assets are Overvalued'.1

The argument of The Economist — and other like-minded commentators— is that risk assets currently are overly dependent on extremely lax monetary policies and unsustainable government fiscal stimulus.

The magazine argues that the US equity market is still nearly 50 per cent overvalued. And it says these excessive prices are being maintained essentially via the benefit of free money and the transference of private sector debt to the public sector.

"Investors tempted to take comfort from the fact that asset prices are still below their peaks would do well to remember that they may yet fall back a very long way," the magazine intoned in its editorial.

To be sure, there is a lot of discussion in the media and markets about new "bubbles" forming. Some speculate a messy reckoning is in store when governments and central banks begin withdrawing stimulus.

Indeed, the arguments can seem so convincing at times that you are left wondering why the individual commentators don't put some of their own money at risk and short the market. If it is so evidently a bubble, why not get rich from its inevitable implosion?

The quick answer to that question is that while these people are fairly sure their predictions will eventually be proved correct, they are not sure when.

So in the meantime what are the rest of us supposed to do?

Past Warnings

A first step for the interested is to look at history. A database search of The Economist going back to the early 1980s reveals the magazine has made around two thousand mentions of "bubbles" in that time.

This is a magazine which has a long track record of making ex-cathedra pronouncements about the unsustainable nature of market trends.

In April 1998, The Economist ran a cover story about "America's bubble economy". It cited the US share market's 65 per cent surge over the prior two years as just one symptom of a "serious asset-price bubble".2

Perhaps it was. But that didn't stop the market, as measured by the S&P-500, rising by another almost 40 per cent over the subsequent two years.

The Economist has also for many years complained that people in developed economies like the US, the UK and Australia spend too much on housing. In a leading article in 1989, amid a correction in UK house prices, the magazine speculated that changing demographics, among other factors, were likely to prevent prices bouncing back to the degree seen in the past.

UK house prices did remain stagnant for a few years, but for the decade from 1996 to 2006, prices more than trebled.3 Reflecting on this, the magazine cited research saying that while this might have been due partly to a combination of rising real incomes, lower real interest rates and keener competition between lenders, up to a half was due to outright speculation.

Defining a 'Bubble'

This notion of a self-generating speculative frenzy in asset markets — taking prices well beyond what their economic fundamentals might suggest — is what is commonly accepted as the definition of a bubble. In these cases, investors are said to buy in anticipation of further increases in price, rather than because of any belief about assets being undervalued.

The most frequently cited modern example is the technology boom of the late 1990s. In that case, there was intense investor appetite for any company with an association with the internet, regardless of the money-making prospects of the particular "dot com" businesses involved.

But the mere act of publicly identifying a run-up in a particular market as a bubble does not mean it will not inflate further. During the tech boom, plenty of people said that the internet was going to revolutionize business and that the productivity enhancements brought on by doing business over the web would lead to a permanent structural improvement in earnings.

So there was a fundamental case for higher prices. The argument was over which individual stocks would be the winners and which would be the losers from what was a technological revolution similar to the invention of rail.

Investors make decisions about these sorts of issues in real time and based on the information available at that time. In this context, there will always be disagreement about individual companies' prospects, simply because there will be differing opinions about what the future holds. The market can only work with the information it has to hand as of now.

Competing Views

And so it is in 2010. For every pessimist who thinks the rally in asset prices in the past 10 months is built on easy money and nothing more, there is an optimist who sees a fundamental under-pinning for the gains.

Australian investment bank Macquarie Group recently issued a bullish forecast for equities this year based on leading indicators for the major industrialised economies and newly emerging economies such as China, India, Russia, Brazil and Indonesia.4

A survey of global fund managers, released this month by Bank of America Merrill Lynch, found declining cash balances among money managers and a 13 percentage point rise to 52 per cent in the proportion of those surveyed who were overweight equities.5

"This survey is one of the more bullish we have seen and suggests that investors buy into the idea that this recovery has legs," a spokesman for BofA Merrill Lynch Global Research said in a release about the survey.

The point of drawing attention to such research is not to endorse its conclusions, but to point out that the market reflects many differing opinions about what the future holds — from those who think the recovery is justified by fundamentals to those who think it is a speculative bubble.

These opinions can change as stuff happens and as new information becomes available, influencing individual investors' views of future cash flows and the returns they expect to receive from risking their capital.

Managing Uncertainty

So feeling certain that prices are overvalued (or undervalued) is a natural human tendency. But betting against the market and basing one's strategy on identifying mistakes is a dangerous occupation. Even if you are "right", what is to say the market will not go on being "wrong"?

Better instead to start by assuming that prices are a fair representation, based on current information, about future business conditions.

This liberates the individual investor from having to try to time the market and rely on forecasts — even from reputable publications like The Economist.

Instead, the focus can be on elements within one's own control — like building a diverse portfolio of assets matching one's individual appetite for risk, current life circumstances and long-term goals. It also includes being mindful of costs and taxes and occasionally rebalancing the portfolio to manage risk.

There will always be uncertainty in investing. That is the nature of risk - not knowing what will happen next. But this can be managed without having to rely on seers and soothsayers, no matter how credible their reasoning.

1The Economist magazine, Jan 9, 2010

2'America's Bubble Economy', The Economist, April 18, 1998

3Nationwide House price data, UK

4'Strong 2010: Macquarie', Australian Financial Review, Jan 20, 2010

5'Survey Says Managers Bullish on Equities, Recovery', Pensions & Investments, Jan 19, 2010

This material may refer to resident trusts offered by DFA Australia Limited. These resident trusts are only available in Australia. Nothing in this material is an offer or solicitation to invest in these resident trusts or any other financial products or securities. All figures in this material are in Australian dollars unless otherwise stated.

Dimensional Fund Advisors ("Dimensional") is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

© 2010 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.

Avoiding Online Scams

I was referred to a nice article from Lifehacker.com that describes how to avoid getting trapped by some of the more common online scams. The article can be found at http://bit.ly/7XrjVI.

Shooting Stars

The following commentary was written by Jim Parker, Regional Director, DFA Australia Limited

It is not often appreciated by ordinary investors, but there is a cosy relationship between the media and the brokerage industry. They both want you to believe that certain individuals have uncanny powers of divination.

For stock analysts, promoting the illusion of omnipotence is helpful because it justifies their fees and keeps people trading. For the media, the myth that certain remarkable individuals can reliably forecast stock prices is helpful because it provides endless "gee whiz" stories to keep the ads apart.

Just look at The Australian Financial Review's recent annual supplement on the StarMine Awards¹. StarMine is a research company that measures the performance of stock analysts based on the returns of their buy/sell recommendations and the accuracy of their earnings estimates.

Every 12 months, the newspaper publishes lots of colourful league tables and profiles of that year's "guru" analysts, interwoven of course with paid advertisements helpfully placed by the winning institutions.

Never mentioned is what the league tables showed last year or the year before — because to do so would be to recognise that the accuracy record of the forecasters rarely extends beyond a 12-month period.

For instance, in the 2009 list of top 10 stock pickers, only one individual was also in the 2008 roll of honour. Likewise, in the 2008 list, there was only one name that appeared the year before.

The question arising from all this is just what are investors supposed to do with these league tables? Building portfolios around the stock calls of this year's shooting stars would appear to be a hazardous business given the limited chance of them appearing on the following year's top 10.

Indeed, even the AFR appears to be becoming sceptical about the worth of these annual awards. In an article accompanying this year's supplement, the paper quotes fund managers as saying that sell-side stock analysts had failed to prove their worth in the global financial crisis.

"For most of the past year, the analysts have all been chasing their tails," the paper quotes one fund manager as saying. "They were all trying to be as bearish as possible until March. And then people suddenly started to chase the market up."

Another fund manager was more forthcoming in his criticism: "Generally, analysts have collectively been totally useless during the past 12 months," he told the AFR. "As a payer of institutional brokerage, you do wonder some days what you are paying for."

An interesting theory emerges in the article about why stock forecasters are becoming less useful to long-term investors. Apparently, an increasing chunk of their commission revenue is coming from hedge funds, whose horizon rarely extends beyond the next three to six months.

This extreme short-term focus causes them to make increasingly poor calls, often second and third guessing themselves as fresh information comes to light. In volatile times, as we have seen in the past year or two, this behaviour leads analysts to end up playing catch-up with the market. So why bother?

And that's really the point. No matter how smart individual stock analysts may be, no matter how much they know about the companies and sectors they follow, no matter how much shoe leather they wear out trudging from briefing to briefing, they are in the end hostage to unforseen events:

The government changes the rules around telecommunications, global steel prices collapse, the discovery of new technology renders a previously innovative IT solution obsolete, a breakdown in an obscure area of the mortgage market unleashes a global firestorm in the banking industry...

Making investment forecasts is a haphazard business, and an unnecessary one. Good investment management is not about making forecasts or being on first name terms with the CEOs of listed companies. Good investment management is about understanding and managing risk.

It is about building diverse portfolios around risk factors that have a long-term relationship to return. It is about being mindful about costs and taxes — two things within the control of the investor.

Most of all, it is about recognising what we don't know and managing for that. The bad news is none of us knows what the future will hold. The good news is we don't need to in order to have a successful investment experience.

---

¹StarMine Awards, The Australian Financial Review, Nov 27, 2009

This material may refer to resident trusts offered by DFA Australia Limited. These resident trusts are only available in Australia. Nothing in this material is an offer or solicitation to invest in these resident trusts or any other financial products or securities. All figures in this material are in Australian dollars unless otherwise stated.

Dimensional Fund Advisors ("Dimensional") is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

© 2009 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.

A Thanksgiving Proclamation

Lincoln's Thanksgiving Proclamation issued in 1863:

By the President of the United States of America.

A Proclamation.

The year that is drawing towards its close, has been filled with the blessings of fruitful fields and healthful skies. To these bounties, which are so constantly enjoyed that we are prone to forget the source from which they come, others have been added, which are of so extraordinary a nature, that they cannot fail to penetrate and soften even the heart which is habitually insensible to the ever watchful providence of Almighty God. In the midst of a civil war of unequaled magnitude and severity, which has sometimes seemed to foreign States to invite and to provoke their aggression, peace has been preserved with all nations, order has been maintained, the laws have been respected and obeyed, and harmony has prevailed everywhere except in the theatre of military conflict; while that theatre has been greatly contracted by the advancing armies and navies of the Union. Needful diversions of wealth and of strength from the fields of peaceful industry to the national defence, have not arrested the plough, the shuttle or the ship; the axe has enlarged the borders of our settlements, and the mines, as well of iron and coal as of the precious metals, have yielded even more abundantly than heretofore. Population has steadily increased, notwithstanding the waste that has been made in the camp, the siege and the battle-field; and the country, rejoicing in the consiousness of augmented strength and vigor, is permitted to expect continuance of years with large increase of freedom. No human counsel hath devised nor hath any mortal hand worked out these great things. They are the gracious gifts of the Most High God, who, while dealing with us in anger for our sins, hath nevertheless remembered mercy. It has seemed to me fit and proper that they should be solemnly, reverently and gratefully acknowledged as with one heart and one voice by the whole American People. I do therefore invite my fellow citizens in every part of the United States, and also those who are at sea and those who are sojourning in foreign lands, to set apart and observe the last Thursday of November next, as a day of Thanksgiving and Praise to our beneficent Father who dwelleth in the Heavens. And I recommend to them that while offering up the ascriptions justly due to Him for such singular deliverances and blessings, they do also, with humble penitence for our national perverseness and disobedience, commend to His tender care all those who have become widows, orphans, mourners or sufferers in the lamentable civil strife in which we are unavoidably engaged, and fervently implore the interposition of the Almighty Hand to heal the wounds of the nation and to restore it as soon as may be consistent with the Divine purposes to the full enjoyment of peace, harmony, tranquillity and Union.

In testimony whereof, I have hereunto set my hand and caused the Seal of the United States to be affixed.

Done at the City of Washington, this Third day of October, in the year of our Lord one thousand eight hundred and sixty-three, and of the Independence of the Unites States the Eighty-eighth.

By the President: Abraham Lincoln

William H. Seward,
Secretary of State

Stop the Noise

Jim Parker of DFA offers an interesting anecdote about how the financial press and the press in general spin the facts to meet the story that has occurred. If you look hard enough, you can find examples of this type of "analysis" through out the various US media sources commenting on why the market has acted a certain way in response to news.

October 2009

From Cacophony to Symphony

Jim Parker, Regional Director, DFA Australia Limited

Sometimes it's hard to make sense of day-to-day noise in stock prices, particularly when news is thin on the ground. But that doesn't stop lots of people from trying to discern predictable patterns in the racket.

Building coherent narratives out of random stock price moves, often under the pressure of constant deadlines is the job of journalists and research analysts. The most successful ones make it all seem perfectly rational and predictable.

This ability to communicate the idea that 'this happened in the market because that happened' is most brilliantly demonstrated when circumstances change two or three times in the space of a day or two.

Let's take a look at a recent example. In the week beginning October 5, the media reported that markets were anxiously awaiting a policy meeting that week of the Reserve Bank of Australia's board.

While there was disagreement about the timing of the move (most thought it would come in November), there was a strong feeling that the RBA was on the brink of raising interest rates, becoming the first 'Group of 20' central bank to do so in the wake of the global financial crisis.

On the Monday ahead of the RBA meeting, the Australian share market fell by 0.6 per cent. One journalist quoted dealers as saying there was a fear that an early rate hike could shake market confidence and curb the recovery.¹

Sure enough, newspapers on the morning of the bank's meeting were full of dire warnings of what would happen to asset markets if the Australian central bank broke from the pack and started to withdraw stimulus too early.²

As it turned out, the RBA did raise its cash rate that day, by a quarter of a percentage point to 3.25 per cent, and a month earlier than most expected.

And what did the Australian market do? It closed higher. The benchmark S&P/ASX 200 index ended up 0.4 per cent, albeit off its intraday peak. According to an analyst quoted by Dow Jones, the rate rise could actually be seen as confirmation of the strength and resilience of the Aussie economy.

But the story didn't end there. Not only did the RBA's "surprise" rate move fail to derail the Australian market, it actually triggered a global rally. The Wall Street Journal: "A surprise interest rate increase in Australia reignited confidence that the global economy is recovering from recession, sparking stock market rallies around the world and lifting gold prices to record highs."³

You see how these rolling interpretations work? You keep changing the narrative to suit the changing circumstances. The trick is to make it all seem perfectly obvious after the fact. "This happened because that happened."

The fact is stock prices move for all sorts of reasons, and trying to provide neat and immediate explanations is a treacherous business for young players. Sometimes a price changes because of news related to the individual stock. But even then, just as with economic news, the reaction is not always what the media say it will be, usually because the market has already priced it in and is looking one step ahead.

Back in mid-September, the Australian government created a stir when it announced that it would force the nation's largest phone company, Telstra, to split into separate wholesale and retail businesses.

On the day of the announcement, Telstra shares slid more than 5 per cent. The government's break-up order, according to one wire service report⁴, represented a "giant kick in the teeth" for the company's shareholders.

The next day, though, the story changed. Telstra shares regained all of their losses. Analysts had now reviewed the break-up plan and decided it would help position Telstra to secure part of a lucrative national broadband deal.⁵

So the narrative of why stock prices rise and fall on any day changes because new information is always coming into the market. No sooner has the journalist carefully crafted a water-tight story out of one development, than something else happens and the whole edifice springs a leak.

Stocks often move because of investors' views of equities as an asset class, not for any reason related to the individual stock. The market may move higher or lower and individual stocks will shift up and down by a certain amount in sympathy, depending on how sensitive they are to market risk.

Stock prices also can move for apparently no reason at all, or at least for no reason that the media takes notice of. It could be because a large institution is liquidating a portfolio or because of arbitrage activity between the physical and futures market or because of options expiries. It may just be because someone is selling a large parcel of one stock to fund a purchase of something else. None of this is particularly interesting or significant in the big scheme of things. It's like watching rush-hour traffic.

The bad news for harried journalists and market analysts is that they have to try and orchestrate all the random noise that constitutes messy day-to-day reality into a fascinating, elegant and seemingly pre-ordained symphony. And every day, they have to start all over again.

The good news for the rest of us is that there is no compunction to listen.

---

¹'Australian shares fall 0.6%, banks skid on rate talk', Reuters, Oct 5, 2009

²'Housing disaster looms if rates rise', The Australian, Oct 5, 2009

³'Australian rate rise spurs stock, commodity rallies,' The Wall Street Journal, Oct 7, 2009

⁴'Shareholders say not one good thing in Telstra proposal', Australian Associated Press, Sept 15, 2009

⁵'Australian shares up 2.4%, banks surge', Reuters, Sept 16, 2009

This material may refer to resident trusts offered by DFA Australia Limited. These resident trusts are only available in Australia. Nothing in this material is an offer or solicitation to invest in these resident trusts or any other financial products or securities. All figures in this material are in Australian dollars unless otherwise stated.

Dimensional Fund Advisors ("Dimensional") is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

© 2009 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.