The Rules of the Game Have Changed

01/27/2009 12:00 pm EST


John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger, editor of Capital Growth Letter, says big structural changes in the markets have altered fundamentally the way he looks at investing.

In reviewing the events of the past year, one conclusion seems inescapable: We have seen a structural change in the financial markets. [I always believed that] monetary policy and price action were the two most important determinants of the future direction of the markets. It seemed clear that monetary policy was the more important of the two as it led price action, which was more of a confirming indicator than a leading indicator.

Beginning perhaps in 2007, things began to change. Whenever we worried about price action, we would check the growth of money supply, the levels of interest rates, and related factors which remained bullish and suggested that stocks could be bought into weakness.

The problem is that during the past couple of years, the forecasting power of the growth rate of money and interest rates vanished. So, as the stock market started to get into trouble, we kept finding monetary conditions bullish, [so we] remained bullish in our outlook, recommending the purchase of stocks throughout 2007 and 2008.

What happened? My best guess is that increasingly the financial system became independent of monetary policy. Hedge funds were most likely a large factor as they represented a new dominant class of investors outside of the needs and constraints of the prior investor class. Beating the stock market was no longer a motivation; rather, absolute returns—often squeezed out with the help of massive leverage—were the new Holy Grail.

As 2007 matured, many hedge funds began to come under pressure as return streams dried up and performance went negative. At the same time, a real estate bubble was starting to burst. The second half of 2007 was marked by a delevering on the part of hedge funds lenders came under pressure and as hedgies were no longer able to grind out their desired returns.

The sum total of all of this was a regime change in the markets. Relationships that had been viable as forecasters of future market activity lost all relevance as the financial markets decoupled from the underlying forces that had governed them for so long. For the first time in modern times, Congress, the Fed, and the Treasury find themselves pushing on the proverbial string.

So, what to do? First, our monetary work will be demoted to a supporting role, with the emphasis on problems created by the monetary environment. Second, the primary guide of our strategy and tactics will be market action plain and simple.

Investing psychology swings in long cycles. Fear is now the topmost emotion and each down tick inspires visions of looming disasters. Greed is no longer a factor, and the refusal is now to see any way out of the perceived morass. In a mere 14 months, we've come full cycle, from unbounded optimism to unfettered pessimism.

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