The Four Horseman Racing in the Change to New Normal Stakes

Ahead of potential "black swan" events in the next few months, likely to be as much led by major political upheaveals and revelations as revealing further systemic risks, we are about to enter the "new normal" for capital markets. Having recently read the blow up in credit spreads post Lehman, as a one in a million year event according to how you calibrate your risk models, I decided to pull up my own bootstrapping techniques that have permeated from my own neural paths.

How are we going to migrate from the "old normal" consisting mainly of risk expects a return, the time value of money, markets have no memory (except for estimating risk) and markets have no emotion? 

In the "old normal", Central Banks and Governments would have us believe that the actions they have taken in the last year or so could have been employed at any time in the last forty years to select a higher level of growth and deliver full employment. You will have your own views on that.

The "old normal" also assumes that a few trillion (or 30 trillion of guarantees for housing healthand welfare) of borrowed money (or a few 100 billion in 1990 borrowed dollars) is appropriate to maintain the overall level of economic activity at current levels. The "new normal" of course, does not have to reflect this "old normal" assumption at all, in fact, reality bites will eventually assert themselves and parody the actions of Central Banks and Governments as modern day equivalent of King Canute.

So what is the "new normal" and what will markets look like while we get there? 

Let's migrate the "old normal" through a change process and arrive at the "new normal". It is clear (while intervention persists at the Central Bank level and whilst our current democratic process allows Government with dubious qualifications to attempt outcomes by burning through future tax payers incomes) that a period of anarchy will exist which we can label the "change process". The "change process" will be characterised by markets that exhibit the following characteristics.

First, risk will no longer expect a return. Probabilities can no longer be relied upon to guide asset allocation decisions. Fundamental research can provide comfort but quality is as valid as scrap as a determinant of return. Coupled with this, the outcomes usually represented by a bell curve with return outcomes clustering around the mean are no longer valid. You can draw an inverted bell curve for outcomes (very fat tails) or a flat bell curve (equal outcome of any return) and be just as likely to be right for future return outcomes.

Second, there is no time value of money. You put money in the bank, it earns nothing. So you can forget that one. Central banks will hold rates at zero, as Japan has done for decades. Maybe you want to construct a yield curve based on forward yields of consecutive 90-day rolls, thats up to you.

Third, markets now have memory. You can predict the future price of assets, not by a coin toss, but by looking at the behaviour of past prices over any time frame, either using the time honoured techniques of technical analysis such as mean reversion, pre-open and closing trading volumes, or any other method that looks like it works.

Fourth, markets will be extremely emotional. Players with large long or short positions will remain emotionally attached to them, regardless of results. Future prices will be as much determined by the proponents of such disciplines as behavioural finance, chat rooms and other herd behaviour (start a herd, lead a band-wagon and make money).

So this is how market will behave during the "change process". The "new normal" will arrive when the four horseman listed above go back to whatever stable they came from. For this to happen, we need desirable outcomes. Politicians will by their very nature snake oil to say they know what these are, but in the modern age, it really gets down to a few key choices to be made from diminishing natural resources, such as minerals, clean air and water. I do not have the resources to construct a model of this, but it seems we need to move from "produce whatever you can sell anywhere" mentality to a "produce what is needed to maintain or improve a minimum standard of living". This means not building expensive houses with no proper buyer, not providing health that no-one can afford and not allowing current generations to squander precious resources on wars and pork barrel politics.

I have an enquiry in to the SF Fed that asks them to size the economy based on the size of GDP relative to what can be sustained from median incomes and what the savings rate should be to get there. I put two key propositions, one that the average house price should equate to around 3 times household income (in order to be affordable and paid off) and secondly, that in order to retire, individuals need to have accumulated a pot of around 13 times their current annual income (assuming a 5% annuity rate and a healthy ability to live off 2/3 of current income). Capital markets can reduce these rather scary numbers, but not while Central Banks and Governments are borrowing future taxes at the current alarming rate.

I estimate that the savings rate would have to be increased to around 25% for ten years, to achieve the "new normal" of repaying current over leverage in the household sector, buy a "right priced" house and provide for a healthy retirement.

I did some back of the envelope calculations to come out with a, still to come, reduction to around 100,000 in house prices and a contraction in GDP of around 40% (taken at once or spread over ten years) in order to arrive at a "new normal" of properly funded GDP. 

On a more utopian note, the scale of the "health and welfare" aspect of retirement is not something that should be solved using actuarial assumptions about life expentancy and the distasteful extension of retirement age to 70 or 90 years old. The Governments role in the "new normal" will be to provide the economic environment for confidence in the future and to demonstrate its ability to govern by reducing the retirement age until we don't have to work at all and exist in rude health.

This could be achieved by investing capital and people in BRIC or emerging markets/countries, by other than military means, so that we can derive income in other ways. I follow what China and Norway do to recycle their wealth in order to improve living standards. Not very much by the looks of it.

So the "new normal" has a basis in building houses that people can afford given their incomes and by saving 25% for ten years so they have a healthy retirement.

Ten years of change, on this basis is the new normal. During this time, the four horseman will do their thing. Of course these horses can run for a lot longer than that, as they have in Japan. I suspect that the American psyche is not in tune with the highly structured Japanese one.