Not raging bears but definitely taking on a cautious approach: Alphen

Adrian Clayton of Aphen Asset Management writes that he chuckled quietly to himself when he explored the thought earlier in January that this was going to be a difficult year with respect to market predictions because every year there is a new set of factors that potentially could drive markets lower or higher and 2010 is no different!

But if the truth be told, should asset managers be expected to make twelve month predictions on an asset class that we all know is characterized by randomness over short time periods? And if we do know better, who is the bigger fool?

Whilst positive and negative environmental factors are always present, what really should be asked by astute investors is whether there are any consistent themes that over time give us a good idea of expected equity returns in the years ahead (from where equities are priced at present)? Fortunately, we can confirm that these do exist.

Unfortunately though, only long-term and very patient investors tend to benefit from acting upon them. But before we get there, let's just quickly express the views of the two camps that dominate headlines at present.

The bulls are gung-ho about loose monetary policy that they feel will be kept intact for ages; they view higher equity P/E's as distorted by cyclically low earnings; they believe that corporate profits will normalize in the years ahead; they feel that China is well capable of managing its fiscal and monetary stimulus injections and these will not lead to asset bubbles; they feel that commodity prices will remain sustainably elevated based on Asian Tigers' and Chinese expansion and they further indicate that in real terms commodities are not expensive anyway; they see no reason why investors would back cash that yields close to zero and they are buoyed by improving economic data emanating from around the globe.

The bears are convinced that there is only one way for monetary policy and that is up/tightening; they contest that P/E's are cyclically high and will compress, they instead view P/E's as simply exaggerated and corporate profits will rebound but through technical reasons that don't represent quality profits; they view 2011's profits as a bugbear; they view China's monetary expansion, particularly private sector credit creation by banks which represents four times nominal GDP as an enormous monetary tsunami which will be impossible to diffuse; they raise the point that between 20% and 33% of this money is entering equity and property markets as ample proof of a bubble; they point to artificial stimulus and commodity ETF's which have grown from $40bn in 1999 to $1trillion in 2009 as two factors responsible for the commodity boom; they see inevitable increases in interest rates as normalizing zero yields on money in the bank; they feel that economic growth is being lifted on transitory government stimulus and other measures such as cash for clunkers and home subsidies that will not be repeated and an inevitable technical double-dip is on the cards.

Sitting from our vantage point we have no accurate way to determine which of these camps will be proven correct with respect to their economic views. In fact, both arguments are highly plausible and much depends on the management of major economies by monetary and fiscal authorities (the controllable part) as well on consumer psyche (the uncontrollable part). What we know from history is that after tectonic economic shifts such as the Great Depression and the Japanese asset bubble burst of 1989, the most difficult factor to predict is human psychology and it can become self fulfilling. Previous fall-outs have demonstrated unequivocally that if consumers and investors become downtrodden and fearful, it is nearly impossible to shake them out of it. Fortunately so far in this crisis, monetary and fiscal authorities have added happy pills to the free vino and the party rolls on.

The Alphen Angle is an electronic publication of Alphen Asset Management