“What the —- do I do now?” This was the actual subject line of an e-mail I received that really summed up most of the correspondence I got in response to an article I published last summer.

To be fair, I painted a fairly negative macro picture of the world, throwing around a lot of fancy words, like “fragile” and “constrained system.” I guess I finally figured out the three keys to successful storytelling: One, never say more than is necessary; two, leave the audience wanting more; and three …

How Investors Should Deal With The Overwhelming Problem Of Understanding The World Economy
Source: Pixabay

Well, never mind No. 3, but here is more. Before I go further, if you believe the global economy is doing great and stocks are cheap, stop reading now; this column is not for you. I promise to write one for you at some point when stocks are cheap and the global economy is breathing well on its own — I just don’t know when that will be. But if you believe that stocks are expensive — even after the recent sell-off — and that a global economic time bomb is ticking because of unprecedented intervention by governments and central banks, then keep reading.

Today, after the stock market has gone straight up for five years, investors are faced with two extremes: Go into cash and wait for the market crash or a correction and then go all in at the bottom, or else ride this bull with both feet in the stirrups, but try to jump off before it rolls over on you, no matter how quickly that happens.

Of course, both options are really nonoptions. Tops and bottoms are only obvious in the rearview mirror. You may feel you can time the market, but I honestly don’t know anyone who has done it more than once and turned it into a process. Psychology — those little gears spinning but not quite meshing in your so-called mind — will drive you insane.

It is incredibly difficult to sit on cash while everyone around you is making money. After all, no one knows how much energy this steroid-maddened bull has left in him. This is not a naturally raised farm animal but a by-product of a Frankenstein-like experiment by the Fed. This cyclical market (note: not secular; short-term, not long-term) may end tomorrow or in five years.

Riding this bull is difficult because if you believe the market is overvalued and if you own a lot of overpriced stocks, then you are just hoping that greater fools will keep hopping on the bull, driving stock prices higher. More important, you have to believe that you are smarter than the other fools and will be able to hop off before them (very few manage this). Good luck with that — after all, the one looking for a greater fool will eventually find that fool by looking in the mirror.

As I wrote in an article last spring, “As an investor you want to pay serious attention to ‘climate change’ — significant shifts in the global economy that can impact your portfolio.”

There are plenty of climate-changing risks around us — starting with the prospect of higher, maybe even much higher, interest rates — which might be triggered in any number of ways: the Fed withdrawing quantitative easing, the Fed losing control of interest rates and seeing them rise without its permission, Japanese debt blowing up.

Then we have the mother of all bubbles: the Chinese overconsumption of natural and financial resources bubble. Of course, Europe is relatively calm right now, but its structural problems are far from fixed. One way or another, the confluence of these factors will likely lead to slower economic growth and lower stock prices.

So “what the —-” is our strategy? Read on to find out.

I’ll explain what we’re doing with our portfolio, but first let me tell you a story. When I was a sophomore in college, I was taking five or six classes and had a full-time job and a full-time (more like overtime) girlfriend. I was approaching finals, I had to study for lots of tests and turn in assignments, and to make matters worse, I had procrastinated until the last minute.

I felt overwhelmed and paralyzed. I whined to my father about my predicament. His answer was simple: Break up my big problems into smaller ones and then figure out how to tackle each of those separately. It worked. I listed every assignment and exam, prioritizing them by due date and importance. Suddenly, my problems, which together looked insurmountable, one by one started to look conquerable. I endured a few sleepless nights, but I turned in every assignment, studied for every test and got decent grades.

Investors need to break up the seemingly overwhelming problem of understanding the global economy and markets into a series of small ones, and that is exactly what we do with our research. The appreciation or depreciation of any stock (or stock market) can be explained mathematically by two variables: earnings and price-earnings ratio.

We take all the financial-climate-changing risks — rising interest rates, Japanese debt, the Chinese bubble, European structural problems — and analyze the impact they have on the Es and P/Es of every stock in our portfolio and any candidate we are considering.

Let me walk you through some practical applications of how we tackle climate-changing risks at my firm.

When China eventually blows up, companies that have exposure to hard commodities, directly or indirectly (think Caterpillar), will see their sales, margins and earnings severely impaired. Their P/Es will deflate aswell, as the commodity supercycle that started in the early 2000s comes to an end.

Countries that export a lot of hard commodities to China will feel the aftershock of the Chinese bubble bursting. The obvious ones are the ABCs: Australia, Brazil and Canada. However, if China takes oil prices down with it, then Russia and the Middle East petroleum-exporting mono-economies that have little to offer but oil will suffer. Local and foreign banks that have exposure to those countries and companies that derive significant profits from those markets will likely see their earnings pressured. (German automakers that sell lots of cars to China are a good example.)

Japan is the most indebted first-world nation, but it borrows at rates that would make you think it was the least indebted country. As this party ends, we’ll probably see skyrocketing interest rates in Japan, a depreciating yen, significant Japanese inflation and, most likely, higher interest rates globally. Japan may end up being a wake-up call for debt investors.

The depreciating yen will further stress the Japan-China relationship as it undermines the Chinese low-cost advantage. So paradoxically, on top of inflation, Japan brings a risk of deflation as well. If you own companies that make trinkets, their earnings will be under assault.

Fixed-income investors running from Japanese bonds may find a temporary refuge in U.S. paper (driving our yields lower, at least at first) and in U.S. stocks. But it is hard to look at the future and not bet on significantly higher inflation and rising interest rates down

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