The Goldilocks Paradox

As a child I was always frightened by fairy tales. Indeed, the justification for that fear became obvious when I took a European literature course in college. The genre is for children in only the most superficial sense: the anthropomorphic beings and make-believe human characters are sketched in such a way as to hold even the most fidgety child in thrall. Underneath it all lurks murder and mayhem (Bambi and The Three Pigs), familial dysfunction (Cinderella) and genocide (The Walrus and the Carpenter). Then there are the classics, courtesy of the Brothers Grimm, Lewis Carroll and even C.S. Lewis, which contain vast helpings of violence, death and psychedelia. The worst part may have been the implicit moral lessons, black vs. white, good vs. evil—choose the right side or you will end up like them!

So it is with undeniable trepidation that I regard the current consensus of the financial environment, which more than one pundit has called the “Goldilocks” economy. You remember: Goldilocks enters the Three Bears’ house (breaking and entering), tries their porridge (petit larceny) and deduces that one of the soups is “neither too hot nor too cold—just right”.

This economic scenario is very tempting to believe—we have so far survived a major hedge fund collapse (Amaranth), a housing crash in the U.S., and a huge run up in the price of oil (where $50 a barrel is now deemed “cheap”). These are not insignificant shocks to the economic system. The Amaranth blow-up alone cost investors $6.4 billion, while the Long Term Capital liquidation of 1998 cost investors “only” $4.6 billion, but it tied up banks and regulators for years. Consumers and manufacturers seem to be shrugging off the hefty run-up in gasoline and oil prices, and capital investment appears to be on the rise.

Inflation, while still persistent in certain industries and commodities, appears to have moderated (not too hot); economic growth, which has begun to slow down, has produced numerous pockets of continuing success scattered about the global economy (not too cold). U.S. investors who continue to exclude foreign equities in their asset allocations are missing some of the best growth opportunities in recent times. Other signs of stability abound — in 2006, the U.S. Fed has paused after 17 straight interest rate increases and foreign governments and companies still find America a safe place to invest. Looking at the various pieces of data seems to suggest decent stock price returns ahead. But like the fairy tales, what lurks beneath? At the start of 2007, there appear to be some basic questions that no one can answer right now: where is U.S. housing headed, and what are the implications; will manufacturing continue to be robust; and, when will volatility, which accompanies major market moves, reappear?

U.S. housing is no doubt a big driver of future economic results, and here is one aspect:

I like this indicator because builders and homeowners need permits in most areas from everything from building a house to adding a bathroom. Was the turn-up in December real? The answer will have implications for consumer spending, commodities and interest rates. How about manufacturing—has the decline in 2006 begun to reverse?

The answer to that has implications for wage growth, employment, which, like housing will eventually impact interest rates and inflation. Given the ongoing problems for U.S auto companies (which continue to lose market share to competitors), modest improvement would be regarded by economists as “just right”.

Since this is not a fairy tale, I would not pretend to have answers to any of these questions right now. I will say that the one piece of data that “scares” me the most is the so-called volatility index, which measures investors’ confidence that asset prices will remain stable. Most major market moves are characterized by sharp increases in volatility, and we have had a long stretch of complacency:

If you believe that all economic events are cyclical, then this may be an excellent time to do a risk assessment of your portfolio, much as I suggested in the October note. The Bears did finally come home and find Goldilocks sleeping in Little Bear’s bed. But that was only a fairy tale, right?

My best to all,

John III