Secrets Of Success: It's the cost of a pair of shoes, stupid

One of the most surprising discoveries newcomers to stock market investment have to make is how little time the best practitioners in the field spend making decisions based on what is happening to the economy at an aggregate level.

One of the most surprising discoveries newcomers to stock market investment have to make is how little time the best practitioners in the field spend making decisions based on what is happening to the economy at an aggregate level.

Open the newspaper, listen to the news on TV, or study the latest batch of brokers' circulars, and you will see no shortage of reports about the latest economic data, and what it means for financial markets. Bill Clinton, famously, said to his political peers: "It's the economy, stupid."

Yet virtually all the most famous investors, from Warren Buffett down - none of whom could remotely be described as stupid - insist that they spend hardly any time fretting over the fate of the economy. In his books about stock market investing, Peter Lynch, the American fund manager, urges us all to spend, at most, 10 minutes on macroeconomic statistics.

What matters to investors, says Lynch, is not the latest reported trend in GDP or the RPI, but "what is happening to the price of sneakers". His argument is that stockpicking investors, at least, buy shares in companies, not in whole economies, and it is the performance of company-specific variables, such as shoe prices, that are most important for the investor to understand.

However important they may be to politicians seeking re-election, the truth is that economic runes are not afforded the same importance by many professional investors. The reason is not that there is no link between the economic performance of a country and the performance of its financial markets. Rather, the problem is twofold: nobody can ever be perfectly sure at the time what is happening in the economy; and the investment implications of economic developments are never as clear cut at the time as they turn out to be in retrospect.

The case of the US current account is a good example. Most people assume the size of the deficit is a potential problem for the world's most powerful economy, with important implications for the value of the dollar and other global financial assets. So it probably is, but you do not need to spend much time shifting through the mountains of investment research that crosses most professionals' desk to be told the reality may not be quite as simple as it appears.

For a start, if you add together all the world's balance of payments figures, the figures quickly show that the world appears to be trading at a deficit with itself, to the tune of some $300 billion every year. This is the amount that has simply gone missing from the world's economic database.

Opinions differ over how big the real US deficit would be if it were possible to measure trade and capital flows more accurately. But it is certainly not unreasonable to think, given the size and dynamism of the US economy, a good deal of the US shortfall is made up by surpluses on services that have simply not been recorded in the statistics. Nobody really knows.

Then there is an interesting phenomenon, pointed out two months ago by Bill Miller, of Legg Mason, among others. While the US clearly has the largest current account deficit in absolute terms, as a percentage of GDP, its current account is actually smaller than it is in a number of other countries. In some of these countries, currencies (unlike the dollar) have been rising, not falling, and financial markets have been leading the global markets forward strongly for the past two years.

Australia is a good example. If there is a correlation between current account deficits and currency movements, in other words, it is not a simple one-way correlation.

As far as investors are concerned, at different times different factors may become more important than you first thought. With currencies, one such factor is clearly the comparable level of interest rates in different countries.

A general problem is that market prices are in practice set not by changes in fundamental economic data, but by how those relate to what the market was expecting. Hence the paradox that if every investor appears to think that the dollar must fall (as happened towards the end of last year), the chances are that it will rise, simply because there are no sellers left in the market.

Every week some new piece of research is published that appears to show things may not be the quite the way we all thought they were. Several examples of this have crossed my desk in the past few days. One is a piece of research from the iconoclastic consultant Andrew Smithers. His latest report makes the point that the UK's saving rate, though widely held to be not as low as that of the US, is actually lower if you standardise the way that dividends and receipts from overseas direct investment are accounted for between the two countries.

To recap, count one against the idea of basing investment decisions on the basis of perceived economic performance is simply that the figures may be so wildly wrong as to be an unreliable basis for forming any sort of investment judgement. In just this way, the terrible balance of payments figures that are always held to have been a cause of Harold Wilson's shock election defeat in 1970 turned out to be a myth, once the final revised figures came to be counted some time later.

The second difficulty is that even if you can lay hands on reliable economic data, you cannot be certain, with something so inherently volatile and unpredictable, what the implications for investment will be. You can be certain that many authoritative opinions will be given about each new development, but few will turn out to be right. The decline of the euro after its launch in 2002 is a perfect example of how wrong universal opinion and superficial analysis can be.

At the moment, the markets have clearly entered a period in which those of a bearish tendency have regained the upper hand. Conventional indicators suggest that the world economy is slowing down and that liquidity is tightening: in times gone by, the pundits would have been talking about the threat of an imminent recession.

That, in theory, should be bad news for equities and property, as well as riskier asset classes such as smaller companies and emerging markets. That may well be how it pans out over the summer, but that does not mean it is a good time to be unloading things that you bought for a good reason. Good investments are not as sensitive to macroeconomic movements as everyone assumes.

jd@intelligent-investor.co.uk

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