John Maynard Keynes was a big believer that government should use tools to stabilize an economy.  Over time, the Federal Reserve (“Fed”) has become more and more Keynesian in its approach to monetary policy.  The Fed has used such tools at various times over the last 20 years to jump in during a crisis to stabilize the US “system”.  There certainly are times to jump in and stabilize the economy – we were and are supporters of the Fed’s first Quantitative Easing program.  There is and always will be a place for intervention, but market manipulation is a different animal.  We believe this is what is going on in Japan now and it could have major negative consequences down the road.

What did Japan do?  The Japanese Pension System (think – Social Security System here in the US) today decided to change the allocation of its $1.2 trillion fund as follows:

• Domestic stocks raised to 25% from 12%
• Japan bonds cut to 35% from 60%
• Overseas shares raised to 25% from 12%
• Foreign debt raised to 15% from 11%

Naturally, Japanese stocks are up 4.8% today as a result of $156 billion more of Japanese stocks being purchased by the pension fund.  Another $156 billion is going to foreign stocks and that is why world stock prices jumped this morning.  On the flip side, $300 billion in government bonds are being sold.  In the “normal” world, that would cause bond yields to spike.  Contemporaneously, the Bank of Japan decided to increase its asset purchases by buying 60% more Japanese Government Bonds and tripling the pace of its purchases of stock and property funds.  Yes, you read that right, the Bank of Japan is investing directly in the Japanese stock market.  With that kind of investing, it comes as no surprise that the Yen is down 3% versus the US dollar today and more than 30% over the past year and a half.

If the Japanese Pension System can buy stocks, why can’t our Social Security system and the Fed?  Sounds ludicrous doesn’t it, but for a politician or government bureaucrat who is looking to stabilize the economy, why not consider it?  Because long-term that would cause market manipulation.  In the short-term, it is like putting their “finger in the dike’ to stop the immediate problem.  Down the road, however, this will cause bigger problems as pressure mounts on other weak parts of the dam.  Governments have unlimited money with the power of the printing press and using that power to distort asset prices by buying stocks is never a good idea.  It is a slippery slope that Japan has started down.   Hopefully, others will not follow.

What does this mean for investors?

The market has done a 180 degree turn in the last two weeks – just in time for the mid-term elections.  In our last market update, we referenced areas of the market we see as good investments as this time.  We continue to believe emerging markets are priced attractively at this point.  When making an investment, we look at the expected gains over a 3-5 year time horizon.  Using this analysis, emerging markets offer an attractive risk/return profile.  Other parts of the equity market are still extended in price.  When markets are manipulated – like the real estate market was in 2006-2007 as a result of Fannie Mae mortgage easing – the “true value” of an asset is distorted in the short-term.  In the long-run, valuation does matter and that is why real estate prices came down in 2008-2009.  Diversification is still appropriate at this time.  With QE3 ending and market volatility returning, we continue to believe there will be good investment opportunities in the months ahead.

Book of the Month –  Keynes Hayek: The Clash that Defined Modern Economics

This is a fantastic book that highlights the two main views of economics and how they differ and their impact on the world.  Keynes became famous for his work “Economic Consequences of the Peace” written after World War I.  This work rightly forecasted turmoil in Europe because of the desire to make Germany pay war reparations.  Hayek grew up in Austria and saw the ravages of inflation after World War I and was actually left of Keynes.  He was an understudy of Ludwig von Mises and became a true believer in Austrian economics.  The main difference is that Austrian economics believes that central planning “deprives individuals of their unique contribution to society – to express, through their willingness to pay a price, their opinion of the worth of an object or service” – Japan is doing just that with the actions they announced today.  Roosevelt was a true believer in Keynesian economics and Reagan/Thatcher was of the Austrian persuasion.  All in all, it gives a great historical perspective on each theory and each theories impact on our economy.

Sincerely,

Your THOR Team

THOR Investment Management, Inc. is a registered Investment Adviser with its principal place of business in the State of Ohio.  The commentary contained in this market update is limited to the dissemination of general information pertaining to THOR’s wealth management services.