Guessing What the Other Beauty Contest Judges Are Thinking

The common wisdom of late 1999 is different from that of 1998 ... and the future. But through osmosis, it is now on the way there.
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Lord Keynes

is famously reported to have remarked that picking stocks is like judging beauty contests: The key to success is to pick the contestant that the majority of the panel will choose.

Today, with instant executions, this guidance reduces to "know what's in the market."

It is not possible to "know" exactly what vision of the future is discounted into today's prices because markets, like beauty contests, involve a high element of subjectivity. But it is possible to get a sense, also subjective, of how that discounted future is changing.

A savvy manager I know likes to say that while you're unlikely to be the first to get the word, you're probably not going to be the last. Information diffuses through a community of interest by a process akin to osmosis. As new information becomes available, it bleeds into public awareness at rates that are often unpredictable. Once the new data are known widely enough, it has the effect of changing the common view, the consensus.

My sense, admittedly subjective, is that the consensus is shifting toward a better understanding of the risks now facing U.S. markets and living standards. The deep change in perception that is underway in the second half of 1999, which is likely to develop into the compelling consensus of 2000, is that our markets and lifestyles have become exposed and vulnerable to the judgments and whims of foreigners.

Most Americans are not particularly sensitive to overseas developments in the way that citizens of smaller countries have had to be. With our historic and blessed degree of remove from the huddled masses of nations on crowded continents, with our two-ocean elbow room and continental economy, most of us don't closely monitor the risks from abroad. When the rest of the world gets into the sort of trouble it did in the financial panics and economic meltdowns of 1997-98 -- and it not only doesn't hurt but actually seems to help us -- the national sense of invulnerability approaches bulletproof.

I think that's changing. Again, it's subjective, but I get a chance to monitor a lot of the thinking of Wall Street opinion leaders, the strategists, economists, analysts, and investment gurus whose views tend to osmose into wider circulation. My perception of the changes in the views of these other beauty contest judges is not a scholarly study or a quantitatively replicable research effort. It is more like an impression, a residue left behind after reading lost forests of material on a weekly basis.

Six months ago, the common wisdom on economic conditions was that Japan was hopeless, Europe was weak, Asia had a chance and Latin America was in big trouble. Three months ago, conventional wisdom had shifted: Japan had a chance, European results might prove better than we had thought, Asia showed a bounce-back that might have legs, and Latin America was in trouble. Today, Japan's recovery is real, if fragile, Europe's growth outlook is quite good, perhaps even better than ours. Asia is booming. Latin America is stabilizing.

Six months ago, inflation was dead. Period. Three months ago, inflation still seemed dead. Today, well, due diligence requires that we give a polite hearing to hand-wringing worrywarts who have seen too many vampire movies. They can scrape together a credible case from such facts as this year's trends in the prices of oil, or houses, or labor, as well as the demand implications of the global economic renaissance that have sprung up, mushroom-like.

Six months ago, the threat to the dollar of a strong euro had been put thoroughly to rout. Challenge the almighty buck, will you? Europe's new unit took a 10% whupping right out of the box and sagged from there, while the yen vacillated around 120 per dollar until midyear.

But then, about three months ago, yen rallied strongly and euro bounced part of the way back. Today, it is neither polite nor diligent to wave off any risk of dollar depreciation. Yes,

Treasury's

mantra remains the same: A strong currency is in the national interest. Exactly what might have to be done in order to maintain its strength has not yet come up as a matter of general discussion. But it might.

The bond market's trend is unbroken this year: Six months ago, three months ago, last week -- yields were headed north. The fact that inflation was taken for dead six months ago didn't deflect this trend. Six months ago the

Federal Reserve's

last move had been to ease and the blue-chip consensus held, by a margin of 58% to 42%, that its next move would be to ease. Today, the Fed's last two decisions have been to tighten and the current debate is whether it will do so again, maybe once, maybe twice, this year. Bonds lead the Fed, in the common wisdom at least.

The forward earnings outlook today is remarkably robust. A year ago, analysts were slashing their numbers and yodeling in alarm about the hit to profits that global depression would bring. Six months ago, they were trying to expunge that record. Today, they're playing leap frog trying to top the next guy's best guess.

But even with low double-digit gains for this year and next, the forward earnings yield on U.S. equities pales against current bond yields. Valuation has been a terrible timing tool, so bears have given up citing it as a problem, but the more bullish strategists and asset allocators today are beginning to raise the issue of the stocks vs. bonds trade, but mind you, only as a "risk factor."

Last week's earnings reports were uneven, with deep torpedoes mixed among the blowout quarters. The market's reception of these reports was at least as uneven as the numbers themselves: Stock price gains did not correlate particularly well with earnings gains, nor haircuts with losses. The

Consumer Price Index

came in about as expected and the broad indexes surged. This may have been causal, but may also have been coincidental: Any excuse to go up after the worst week in a decade left the market technically oversold. The September trade report showed another deep deficit, but one just a bit less deep than the prior month, so it didn't seem to move the market.

But the consensus is shifting. There is more and more discussion of the current account deficit: what it is, what it means, what risks to domestic tranquility it might contain, how might it be addressed. I can report that earnest explanations of the current account can leave even sophisticated audiences of brokers and planners gasping for air. The X's and M's of balance of payments and national income accounting fall far short on the fascination scale of the X's and O's of football season.

But when the point is made that a current account deficit is like a national margin account, the fidgeting tends to diminish. Most investors, I'll guess, don't feel confident that they have a grasp of the balance of payments, of current and capital accounts and their influence on foreign exchange trends. But most have a firm grasp of the up- and down-sides of a big margin position. You pay especially close attention when you have a big margin position.

The current account deficit represents foreign borrowing by U.S. residents. Just as with a margin account, the extra leverage allows us to run bigger positions, in equities or bonds; or, since money is fungible, in houses or cars or vacation trips; or, in business formation and job creation. All of these are doing better, riding higher, than would have been the case had not "other peoples' money" been available. And all of these are exposed to changes in perception, or judgment, or whim, on the part of our overseas bankers.

The consensus of late 1999 is not the same as the conventional wisdom of 1998, not even close. Nor is it the same as the common wisdom of, say, midyear 2000. But through a process of osmosis, it is now on the way there. Keep in mind that success in this particular beauty contest comes from guessing what the other judges are going to do.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at

GriffinJ@aeltus.com.