The midterm elections will set the the stage for a major power redistribution in Washington. Now that Democrats and Republicans are in the final stretch of the midterms, a much-anticipated Wall Street rally is in the air.
When it comes to investing there are two major schools of thought: the we-believe-in-the-intrinsic value theory and the no-such-thing-as-an-equilibrium theory.
Investors such as Warren Buffett try to uncover the true intrinsic value of a company and hunt for what they believe are undervalued equities, under-appreciated, obscure companies with great management and an excellent outlook.
Warren Buffett has recently decried stocks as overpriced. Wall Street likes to follow Buffet on the assumption that financial markets converge around an equilibrium close to what could be considered the intrinsic value of assets and who could know that value better than the Oracle of Omaha?
The other school of thought takes the opposite view. George Soros and his followers try to anticipate macroeconomic trends and act on them without giving much thought to the so-called fundamentals. Soros formulated his idea of how financial markets work in his General Theory of Reflexivity. In his view, the perception of economic reality is always biased and there is no such thing as an “intrinsic value”. He does not buy into the theory that financial markets return to an equilibrium. He believes that once false assumptions gain traction they tend to reinforce the prevailing bias, leading to the emergence of bubbles. The prevailing opinion has the power to change the underlaying fundamentals, so revered by value investors, for better of for worse. For this mutually reinforcing feedback loop between the perception of reality and the reality Soros coined the term “reflexivity”.
When the markets crashed back in October 2008 and in March 2009, George Soros was among the very first hedge fund investors who were getting in at the very bottom of the market at bargain-basement prices to cash out as soon as possible. Soros’ Quantum Fund/Soros Fund, has produced on average returns of around 30% year-on-year.
Whether these are “the best of times” or rather “the worst of times” highly depends on your standpoint. Main Street and Wall Street are disconnected.
One of the best ways to put in a nutshell how to invest was famously expressed by the investor legend Sir John Marks Templeton, best known and admired for running the Templeton Growth Fund from 1954 until 1992. Sir Templeton put it bluntly in what became his wildly publicized investor credo: “avoid the herd and buy when there is blood on the streets”. This is not the case right now by any stretch of the imagination.
However, if you subscribe to the theory that markets are all about perceptions, interesting times lay ahead.
Should the Republicans overwhelmingly take control of the House and the Senate, the rally could continue. If they take over the House and make big inroads in the Senate, we may see a power struggle over deficits and taxes which could unnerve Wall Street.
If history is any indication we could well see the rally extend after the elections. But there is also the possibility that the current rally is a one-time effect of Bernanke’s QEII and that Republican gains are already priced into the market. In this case, we may well see a dramatic trend reversal.
With a Republican House and a reinvigorated GOP in the Senate, any stimulus President Obama may dream up will have to include tax cuts and spending cuts on entitlement programs. In the unlikely case of a crushing Democratic defeat and a total Republican takeover of both chambers, the prospects of extending Bush’s tax cuts could fuel another end-year rally. If you opt to jump in on it, don’t forget to get out.