In the good old days there was a saying that if you let a million monkeys bash away randomly at typewriters they would, given enough time, eventually type out the complete works of William Shakespeare.  However this would not prove that the monkeys were educated.

In recent times it has also been opined that no matter how many bloggers publish on the web, little sensible commentary will ever emerge.

Applying the same theory of randomness to the world of investing produces the argument that if there are enough different funds & fund managers in the world then there will always be a few who produce fantastic returns in a single year, no matter how bad the market conditions in that year.  However in order for the results to be statistically significant (and not just random noise) then the generally accepted test is that the few winners should be in excess of 5% of the total sample size of funds.

Sadly last year proved that a statistically insignificantly small number of funds actually produced positive (let alone fantastic) returns.  It therefore follows that the few winners represent statistical “noise” and that claims by fund-of-fund managers to be able to select the “best of the best” hedge funds are therefore not significant (if last year’s alpha was truly just in fact statistical noise then reliably measurable alpha over multiple consecutive years does not exist in a significantly large enough size to be successfully selected by any market participant).

Randomness also ensures that next year there will be a new crop of “winners” for the marketing experts to promote – beware that next year’s winners are not guaranteed to be the same as this year’s winners though.  The wealth warning “past performance is not necessarily a guide to future performance” is put on funds for a very good reason.

It is broadly accepted that we got ourselves into this mess by allowing the banks to lend too much, too cheaply to people who were not really able to pay back the loans they shouldered.  The way out (whilst avoiding a depression caused by deflation & debt-induced personal bankruptcies) involves making existing loans servicable whilst at the same time not allowing people to add to their current debt burdens.  Hence there is a delicate tightrope to be walked along by lowering interest rates for existing borrowers but simultaneously rationing the availability of credit at the same time so that we do not dig ourselves a deeper debt hole than the one we are already in.

Credit can be rationed in two ways, either by restricting the availability of credit (via very strict lending criteria) or by raising the cost of credit (only extending new loans at high spreads over Libor or Base Rates).  Banks are currently not lending freely for many reasons which include households & corporates being unwilling to borrow, the banks wanting to make profits to rebuild their balance sheets and the knowledge that UK banks are going to have to refinance most of the maturing sterling loans which were previously extended by foreign banks (who have now all but ceased lending in the UK), amounting to roughly £80 bln annually over the next few years.

If we are ever to escape consumers having too much debt then the cost of credit needs to be kept high otherwise very low borrowing rates will simply encourage more borrowing which will prove too expensive to service when base rates eventually normalise towards the 5% level (this prospect is at least two years away).

Consumers paying down debt, however slowly, will keep the Austrian School happy as they believe the economy will never recover properly until the high debt burden is worked off.  The Bank of England may well be trying to encourage the banks to move the money they have on deposit at the BoE and lend it into the real economy but it is in no-one’s interest for this to be achieved by the banks lending at very low margins to borrowers of poor credit quality.

The upshot is that any recovery is going to be slow and protracted and banks are going to be making a lot of money during the long, slow recovery as defaults and loan loss provisions will eventually subside but banking margins will remain high as consumers will continue to be charged high rates for borrowing (personal loans, credit cards & mortgages).

The good news for the Government is that UK banks making big profits imply lots of future corporation tax revenues from the banking sector.  However, if banks make hay for long enough then eventually there will be calls for a windfall tax to be imposed on the banks “excessive profits” but that prospect is many years away (although it is hard to envisage a cash-strapped Government resisting the temptation to levy a windfall profits tax - but surely only after they have sold the UK banking shares they currently hold (LLOY, Northern Rock & RBS) at a good profit for the taxpayer).

One year on from the bankruptcy of Lehman Brothers and we have seen global stockmarkets spend six months plummeting to a low in March 2009 and then another six months rallying back again.  The Dow and S&P are now 15% below the levels at which they stood on the Friday before Lehman went bankrupt on the weekend of September 15th 2008.  The FTSE is just 5% below its close on the eve of Lehman’s bankruptcy.  We are still amidst the fog of war and nobody can quite work out whether stockmarkets are now too high following the impressive 50% rally since March or whether stockmarkets still have room to rally because an economic recovery may be starting (which then leads to an argument about whether the stockmarkets will fall again next year should there be a double-dip recession).

If we track back to the week before Lehman went bankrupt then stockmarkets had already fallen 20% from their highs in October 2007 and they were discounting some type of a recession and had not yet begun to rally in anticipation of an economic recovery.  The bankruptcy of Lehman changed the outlook so severely that markets sold off savagely to discount some type of 1930’s-style depression (with leveraged players being forced to liquidate which pushed share prices down even further).  The governments and central banks stepped in with some determined spending of taxpayers’ money and as the spectre of a depression has receded, stockmarkets have rallied back to their current levels (which are still below where they were on the eve of Lehman’s bankruptcy).

So have stockmarkets rallied too far or do they still have room to rally some more?

Although markets never move anywhere in a straight line, it feels as if they still have room to rally further as the tentative economic recovery which has begun goes on to establish itself more firmly.  Given that on the eve of Lehman’s bankruptcy markets had not yet even begun to discount an economic recovery then in order to discount whatever shape of economic recovery we are about to experience, stockmarkets should logically be higher than where they were in early September 2008.  The US and UK are likely to report positive economic growth for the quarter just ended when GDP data is reported for Q3 2009 and only time will tell whether they go on to report another quarter of growth in the final quarter of 2009 (see One Quarter at a Time).

So stockmarkets may well continue to climb the current Wall of Worry for the next couple of quarters and we can then start to consider the possibility of whether there will be a double-dip recession in 2010.  Although central banks continue to print money and interest rates will stay rooted near zero for a long while yet, a sense of normality is starting to return to corporate life with takeover activity returning to stockmarkets (Kraft/Cadbury and Balfour Beatty/Parsons Brinckerhoff being just two recent examples) and companies are finding it possible to raise equity capital (even though they are most unwilling to get deeper into debt).

Tentative it may be, but the recovery (which may well be long, slow & grinding) is only just beginning.   The fog will clear from the battlefield over the next few quarters and investors will be able to assess things more clearly.  The bad memories of the last year are still fresh in investor’s minds but stockmarkets look forwards, not backwards.

Stockmarket rallies are said to climb a “Wall of Worry” as the stockmarket climbs higher in spite of the various problems that already exist or may be about to happen.  There will always be many Cassandras and Perma-Bears out there highlighting the many reasons why the stockmarket is too high and is riding for a fall.  The vast majority of the time they are wrong but they have their day in the sun when the market does indeed fall (often after having risen substantially since the bears originally started shouting about their worries).

The reality is that stockmarkets broadly follow the economic cycle as GDP expands during times of economic growth (which happens most of the time) and as GDP contracts during recessions (which rarely last long but do cause sharp and painful falls in stockmarkets in the order of 30% to 50%).  When a recession ends the problems of the downturn are still fresh in people’s minds and it is these worries that the stockmarket’s rally overcomes.

The Bank of England continues to do its best to debase Sterling by printing as much money as possible without scaring the gilts market.  The only reason Sterling hasn’t collapsed against other currencies is that the other major central banks are all involved in various forms of printing money (quantitative easing) themselves.  Sterling is however steadily weakening against the Euro as the ECB is the only major central bank not currently printing money freely (see Vee are Not Embarking on QE).

But the BoE has shown it means business by recently increasing the amount of money it is planning to print from £125 bln to £175 bln and the Governor letting it be known that there is more money where this came from as he would rather print £200 bln.  The Governor is doing his best to stay ahead of the likely £175bln-plus of gilts to be issued this year.  However so far the QE money spent by the BoE has ended up mostly in commercial bank reserve deposits back at the Bank of England (a telling indication of just how much cash the banks now have is that 3-month Sterling Libor at 47bps is now below the Bank Rate for the first time since the credit crisis broke in the summer of 2007).  The challenge is how to get this money injected into the real economy given that households and corporates don’t want to borrow and companies are preferring to launch rights issues to fund their acquisitions with equity rather than debt (and the REITs are busy selling new shares to pay down their debts too). 

The BoE have hinted that the next trick they will try in their attempt to move the money currently held by the banks at the BoE is to stop paying interest on this money.  Given that the Bank Rate is only 50bps then reducing it to zero may not be a big enough incentive and the banks may well just shift the money into the very short end of the gilt market.  However not paying interest on commercial bank reserves will come in very handy when the time eventually comes for the BoE to start raising interest rates again, so we can expect this policy move to happen at some stage.  The more drastic step of paying a negative interest rate on commercial bank reserves (by charging the banks interest to deposit money at the BoE) will achieve nothing as the logical response from the banks would be the same – shift the money into short-term gilts.

With everyone looking to raise equity and retire debt, getting the QE money into the real economy may take a quite a while longer to work (there is no history to refer back to here as the Japanese were too timid when they tried QE).  In the meantime the BoE has little option other than to carry on printing money until a sustainable economic recovery takes hold.  Expect Sterling to continue to depreciate against real assets and harder currencies such as the Euro.