There is more to what happens in the markets, than what happens in the stock market alone.
And that can be very useful.
When looking broader than thinking if the stock market will go up and down, one can start try to understand the financial markets in scenarios of what might happen, and how one can profit with different asset classes in these scenarios.
Scenario thinking
Let's move outside of the stock market, and for a few minutes think about what can happen with an economy at large.
First, let's face it. Some of the things that might very well happen during one's life time, due to ergodicity, will be quite severe.
The country we're in might cease to exist. Property might be confiscated, which happens in most parts of the world at least a few times per century; remember gold in the US, not to mention Europe after the second world war. New regulation might be introduced that creates havoc with private enterprise, and so on.
This is why hardcore financial planners recommend having part of one's investments entirely abroad. And the bags packed.
Financial Seasons
But before we start to save up on the tin cans and buy a gun, let's think about what can happen before the tanks come rolling in.
The proponents (Brown, Dalio and others) that recommend asset allocations often have a model to understand what might happen in the economy, short of war on the streets.
Such a model can, for instance, break down the investment climate into fundamental dimensions.
What are those dimensions that can reasonably encompass a whole economy, we hear you ask?
One is what happens to the values produced by the economy. Does the economy fundamentally produce more goods or services that society value? Or is the economy shrinking? So the (local) economy itself is one such dimension that can either grow or shrink.
So what's left when we've considered everything in the economy? What could possibly be left? The other dimension is that which we use to trade these values that the economy produces.
When I give you something, I trust that you will pay me back, and that token of trust is often expressed as the currency used in the local economy where I have an expectation that the token will work in my next transaction with someone else. So this consists of all kind of short promises, that is, short debt that can be turned into exchangeable tokens in the economy. In broad terms, let's call this dimension the credit available in the local economy.
So now we have two dimensions:
- The Economy consisting of everything we value and we can potentially access,
- Available Credit, that can trade those values.
With the above said, let's not fool ourselves that the mental model is everything that can happen. It's a model, not the rules of the game. In the real world there are few games that really bend to rules, as the ludic fallacy reminds us.
Economy: increase or decrease
So the economy can both increase or decrease. For instance, if trade increases, or we invent new sweet things that we enjoy, or we proposer and just value new or subtle things more, then the economy increases.
If we instead screw up trade, we destroy what we value or we get depressed and don't value anything anymore, the economy decreases.
Credit: increase or decrease
All that we value in the economy, for a monetary civilization, is traded using some kind of credit.
Credit is multiplied via different mechanisms by the level of trust that currently prevails, through one kind or another of fractional banking; as money itself, or through credit cards, interbank lending, consumer credits and so on, and the basis of that multiplication is that short term promises will be honored.
When trust is high, a lot of credit can be created, far exceeding what the central banks actually puts out in the shape of money.
And on the other hand, if trust disappears or the central bank decides to remove money from circulation, the credit in the economy can evaporate rapidly, leaving only true, liquid, accessible hard cash in it's wake, and nothing much else.
Beware of theories
Now, this of course opens up tons of questions. But we are not academics. And we're wary of overly much theory, especially for theory's sake, not to mention what theory is currently in fashion. We try to stay away from that.
We know that this is a model, and not the rules of the game. And we're not going to use it to predict (don't predict!), or speculate about cause-and-effect.
It's much more like four different boxes that the economy is likely to end up in, because there are few other scenarios to go to (except war and confiscation, as said above).
The economy shrinking or growing, credit increasing or decreasing create four "seasons" and the economy will be in one or another of these seasons.
Now the important question. If we have these four fundamental seasons in an economy; how can we profit from them?
Well, different assets have different characteristics depending on the season. Let's flesh out a little more what might be going on.
1. Increasing economy, increasing credit.
This is the way "everybody" wants things to be; what we normally call growth. The stock market chums along, sometimes very impressively, and credit that can trade the values that are being created chums along with the economy.
Stocks can perform extremely well during the growth season, and long term bonds (25y+) are expected to perform very good as well.
Cash and gold are both probably at bargain prices.
A side note on cash in this season, which is a little difficult to observe because we're not used to think about cash in that way, as an investment asset: What does it mean that cash is at a bargain price? Well, price goes both ways. Something is almost always available at a bargain if one knows how to look for it.
In this season, it's precisely cash that is at a bargain price. And what should we do with an asset that we can obtain at a bargain price? Well, get it, for the bargain price of course.
2. Increasing economy, decreasing credit.
Increasing economy and decreasing credit is a season that happens when the economy grows, but a lunatic in the central bank might constrict monetary policy, or a politician might interrupt interbank-trade, or any hick-up in trust might happen, which means that credit evaporates like dry tinder in a wildfire.
This triggers the onset of a crisis. Flash sales occur.
We might be in for a quick devaluation of stock and bond values. Anyone with real cash or long term bonds in the local currency might expect to benefit, and gold sometimes also perform.
But often, if the trust evaporates quick enough, it's only cash that will work, and one can suck up tons of stocks, and also gold and bonds with the cash that one got cheaply earlier. Anyone with liquid, real, accessible cash at hand in the immediate has the opportunity to go on a shopping spree and build the fortunes of their lives in 6 or 12 months, when the other asset classes start to bounce back.
Now, the crisis can either bounce back or turn into a full-blown, protracted depression.
3. Decreasing economy, increasing credit.
Another alternative might be that the economy decreases, but someone in the government might get the good idea to solve the issue of a decreasing economy by printing more money, by calling it modern monetary theory, quantitative easing and what not. It might work if the economy is actually increasing beneath the credit. But if the economy is truly decreasing, we're in for another ride that will trigger inflation and an even worse crisis.
It might also be a a high point in the economy, and the growth has started to flatten out, but this is obscured by the trust that is still there and keeps credit expanding.
Now inflation looms, and when it strikes, then very hard assets will perform well. And the hardest asset of all is what nation states put in their vaults for bad times, the most trusted asset since Seneca's time and well before that.
Gold.
And when inflation strikes, everyone suddenly rushes after the hardest of assets, and gold prices turn explosive.
Decreasing economy, decreasing credit.
And the last season, the winter, is a protracted depression. Both credits and the economy are decreasing. The sudden fall in trust and credit has now spread and infected the whole economy.
Anyone that needs cash will be forced to sell inventory and assets at low prices, which will be reflected in the daily prices in the stock market that will spiral downwards.
The newspapers will call this a crisis and disaster with black headlines, and some bank directors (central or otherwise) will jump from skyscrapers. The newspapers will continue to call it an ongoing crisis, and as usual the news will be blind for the opportunities that now open up for those with the right assets on their books.
Cash will be useful. And perhaps even better, when there's no real trust not even in cash, gold will allow us to do the shopping.
Conclusion
By having different assets in a portfolio, one can always have at hand what the market wants.
Oh, so you're ready to sell your stocks really cheap to get cash? Lucky you, I've got cash, so just hand over some of those stocks for a really low price.
Or you value stocks at crazy levels? Sweet, I bought some a few years ago when they were at a bargain. So here you go, I can by some gold or keep some cash instead.
Oh, so you don't trust anything anymore? Lucky you, I've got some gold saved for a rainy day.
This is the beauty of having an asset allocation and rebalance from time to time, as the gentlemen Mr Dalio and Mr Brown discovered.
And if one mixes the assets in good proportions, one can build a quite powerful portfolio that will sail one's portfolio safely through any storm.
Farewell,
//lucilius&antinous
More: Can this thinking really perform and create reasonable returns? we hear you ask. And how can one mix the assets? Keep on reading about Our Crawling Road: A portfolio for accumulation part 2 or our current portfolio.
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