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Martin Barnes

Martin Barnes is Managing Editor of The Bank Credit Analyst. He has almost 30 years of experience in analyzing and writing about global economic and financial market developments. In recent years, he has written extensively about new technologies and long-wave cycles, the financial market implications of low inflation and trends in corporate profitability.

General principles and the role of liquidity

1. Know when to be a contrarian.

The crowd is often correct for long periods of time, so it does not always pay to be a contrarian. The time to bet against the crowd is when market prices deviate significantly from underlying fundamentals. For example, gold has been in a bear market for years and it has been correct to stay negative toward the market given the falling trend of inflation. Contrarian strategies have not worked. On the other hand, the surge in technology stocks in 1999/2000 in the face of suspect earnings trends clearly provided an excellent opportunity to take a contrarian stance and this paid huge dividends when the bubble inevitably burst.

2. Don’t use yesterday’s news to forecast tomorrow’s markets.

Many people make the mistake of forecasting the stock market on the basis of current economic data (which usually relate to developments of at least a month ago). This is a mistake because the stock market leads rather than follows the economy. It makes more sense to use the stock market as an indication of what the economy is likely to do in the future. By the time that the economic data has confirmed a trend, the market is often discounting the next phase of the cycle. The market is forward looking while economic data are backward looking.

3. Liquidity is key.

All great bull markets are rooted in easy money. Stimulative monetary conditions mean low interest rates that, in turn, encourage investors to take on more risk. Buoyant liquidity will always find its way into asset markets, pushing prices higher. The corollary is that a bull market cannot persist in the face of tightening liquidity. Thus, investors must pay close attention to the factors that drive monetary policy.

4. Understanding the inflation trend is critical to success.

Following on from the previous rule, inflation is the single most important economic variable when it comes to predicting the trends in financial markets. Rising inflation is toxic for both bonds and stocks because it points to tighter monetary policy and rising interest rates. On the other hand, falling inflation is extremely bullish for the opposite reasons. Most bear markets have occurred in response to rising inflation pressures. Correspondingly, falling inflation was the single most important force behind the powerful bull markets in bonds and stocks during the 1980s and 1990s.

5. Take a long-run view.

An increased focus on the short run has become one of the scourges of modern life. Companies are often more obsessed with propping up near-term earnings than with taking long-term strategic decisions, while investors are often looking for quick gratification when they buy stocks. The day-trading mania was the most extreme manifestation of this. Patience is a virtue when investing because even the best ideas sometimes take a while to play out. By all means abandon ship when fundamental conditions deteriorate. However, if you are confident that you have a purchased a good company, then don’t despair just because the price does not rise right away – as long as the fundamentals remain positive.

6. Allocate a small part of your portfolio to ‘play’ with.

It is okay to take speculative risks with some of your investments. However, don’t bet the ranch on a long shot. A good strategy is to have the vast bulk of your portfolio in a diversified group of blue-chip investments, and to leave a small amount for higher-risk opportunities. That way, you get the best of both worlds. The bulk of your assets is relatively protected, but you can still have some ‘fun’ chasing some hot ideas.

7. The stock market rises most of the time.

Bear markets are the exception rather than the rule. The market rises about two-thirds of the time. This means you should avoid being trapped in a bear market psychology for long periods of time. There are always reasons to be gloomy about the outlook, whether it relates to valuations, economic conditions or structural concerns such as debt levels. The U.S. economy is extremely resilient and it has generally paid to err on the side of bullishness. There have been long bear markets in the past, but these have usually occurred in the context of disastrous economic environments such as deflation (the 1930s) or high inflation (the 1970s). Neither environment is likely for the foreseeable future.

8. Know when you are speculating.

You invest in a company when you are buying shares in order to participate in its long-run growth. You are speculating when you are buying shares only because you expect to sell them at a higher price to someone else, and you are not even looking at the company’s fundamentals. It is okay to do both, but you must understand the difference. For example, the internet mania was all speculation because few companies were making profits and few investors were holding the shares for long enough to benefit from the discovery of the next Microsoft. When you know that you are speculating, then you will be more ready to bail out quickly when market conditions turn sour.

9. Have realistic expectations.

Between 1982 and 2000, Wall Street enjoyed its most powerful bull market of all time with average annual returns of about 15% a year after inflation. This was close to twice its historical average. The exceptional returns reflected falling inflation, a revival in corporate profitability and a revaluation of the market from cheap to expensive. Those forces have now been fully exploited and long-run returns are likely to average less than 6% a year after inflation in the next decade. Investor expectations are for much higher returns according to various surveys, and that can only lead to disappointment and increased risk taking.

‘Research suggests we tend to become more confident and less accurate as we process increasing amounts of information. As most people can handle no more than seven pieces of information at once, it is wise to employ no more than seven criteria for choosing each stock.’

Paul Melton