2004: “It was a good year… a very good year”

Financial markets sometimes reward investors handsomely for contrary thinking. Like Rudyard Kipling said, “ If you can keep your head about you while others are losing theirs, you can make excellent investment returns.” Well, maybe he didn’t put it exactly that way, but that’s my recollection.

That said, the markets do not always reward investors for contrary thinking. Sometimes, figuring out what the primary trend happens to be and just going along for the ride can also be rewarding. In other words, as the famous trader Jesse Livermore once said “the trend is your friend.”

The tricky part, of course, is knowing when it pays to be a contrary thinker and when it pays to go with the flow. In my experience, contrary thinking makes the most sense when investors’ emotions are running high and when valuation and sentiment measure reflect extreme emotions. In most other circumstances, I tend to have more respect for consensus forecasts for a simple reason: They are often correct. In other words, collectively we possess a lot more information about the future than any one individual or institution can process. And that is the main reason that market mechanisms allocate capital based on collective opinions more efficiently than boards of “expert” economic planners ever could.

That doesn’t mean that the markets never get it wrong – far from it. It’s just that markets tend to do a better job at allocating scarce capital resources than other alternatives. It’s like what Winston Churchill said about democracy being the worst possible system – except for all the others.

I have made these points because my outlook for 2004 is currently pretty conventional. I see the continuation of a strong global expansion, continued upward trend in commodity prices, and inflation remaining at tame levels. Interest rates are likely to begin rising, but central bankers will probably tread gingerly so as not to derail the global expansion. Stock markets should do pretty well against this backdrop, the main driver should be profit growth.

Beware of Bonds?

Whether it is a declining dollar or rising inflations – or both – any signs of trouble would likely show up first in the global bond markets, where yields remain remarkably well behaved despite the major improvement in global growth. With bond prices having risen dramatically in recent years, with low current yields signaling low future returns, and with the volatility of yields having moved up as well, the risk-reward equation for bonds does not look particularly favourable at the moment. Accordingly, make sure that your duration is short and you have exposure to high yield corporate bonds that tend not to react as much to movement in yields.