Stimulus-tightening boom-bust cycles
The global economy had an enormous accident in 2008 and thereafter. The monetary and fiscal authorities managed to patch things up, though not necessarily in the right way. The level of risk has therefore risen considerably. We are now running on our spare tires and another growth pothole (Chinese slowdown, European sovereign debt crisis, US municipal bond implosion, etc.) could send us back into another global recession and imperil the health of the banking system.
Given the weakened state of the global economy, we are likely to see a series of stimulus-tightening boom-bust cycles, much like the Japanese experience of the last two decades.
Japan's Lost Decades
The market was weak last week over the Libyan unrest spreading to the rest of the Middle East. Minor supply disruptions like that can scare the markets but they resolve themselves over time. Any possible new regime will need the oil revenues and turn the taps back on. What I was more concerned about were the broader macro risks, such as the results of the Irish election and risks posed to the European banking system.
Shades of 2007/8?
In the intermediate term, the backdrop is ominous. The current environment reminds me of late 2007 and early 2008. Then, we had a commodity blowoff, equity overvaluation and looming macro risks. Today, we have a commodity blowoff, equity overvaluation and looming macro risks.
Barry Ritholz pointed out an analysis from Alain Bokobza of Société Générale indicating that forecasts have become overly optimistic and asset prices are poised for a tumble.
Société Générale's Economic Surprise Indicator
In the short run, it appears that the Fed is determined to throw a party with QE2 by targeting asset prices. In the event that the Tunisian-Egyptian-Libyan contagion were to spread rising oil prices began to create risks to economic growth and employment, then who doesn't expect QE3. That way, short-term problems are papered over but somewhere between QE3 and QE33, the medicine stops working and then we all get into big trouble.
Navigating the boom-bust cycles
Given this kind of volatile macro backdrop, I have opted to use an intermediate term trend following model like the Inflation-Deflation Timer Model to trade the boom and bust cycles.
For now, my technical, sentiment and industry indicators are all pointed up. Nevertheless, I am terrified of the macro risks. I am relying on the risk control discipline of the Timer Model to limit losses while allowing winners to run.
In other words, I am thinking bearishly but trading bullishly.