I’m watching weak economic numbers roll out, and listening to the pundits about how deep this recession could be, and whether this has been priced into global equity markets. I’m wondering where things are headed, and it makes me recall some words I have read both recently and not so recently.

I recall the term “epistemic arrogance” when reading Nicolas Taleb’s book “The Black Swan”: if the difference between what someone actually knows and how much he thinks he knows is in surplus, then arrogance is implied. A deficit of the same shows humility. This significance was highlighted in an article I read recently (James Montier, 27 October 2008, An Admission of Ignorance: a humble approach to investing). The author points out that investment managers are loath to admit ignorance. A number of insights to investment management flow if one can admit that they don’t, and can’t know everything. The biggest take away, of course, is that one can’t build an investment process on hope.

So, back to our forecasters who are looking for a market bottom on the premise that equity markets are a leading indicator of the economy, while others among them wonder how much worse things can get. In the end, some will be right in their calls: but we will only know in hindsight. As for myself, I’ll plead ignorance: I don’t know where the economy is going in the near or medium term (it’s probably not good, though). But maybe, as far as drivers of equity markets go, we’re looking in the wrong place.

Here is a disquieting thought for some in the forecasting business. What if over the longer term, stock market returns are not correlated to economic growth? Below is just one data point, but it’s interesting to note the results: according to data compiled by Crestmont Research, there isn’t a large correlation between GDP growth and stock returns over bull and bear market cycles, or ten year periods. For investors, rather than guessing at the direction of the economy or hoping that this is the bottom for equity indices, opportunities can be found in the here and now based on common sense and some work. One random thought: corporate bond yields are at their highest in years, and one doesn’t have to buy the debt of nearly-defunct companies to make long-run equity-like (i.e., 8-12 percent) returns.

Copyright 2003-2008, Crestmont Research (www.CrestmontResearch.com)

What drives returns, then? That’s for another time …

Eric Dzuba
Associate Portfolio Manager