Weird way to start the week, but work with me here.
You’ll learn a big lesson, I promise.
In fact, you may even end up smarter and impress you friends with this one.
Ready? Let’s go…
Investing Rule #32: Don’t confuse correlation with causation.
One of these days, I’m going to take some time off from my crazy life, set myself up at the beach somewhere, and write a book:
From Rules to Riches: 101 Rules for Investment Success
Do you like the title? Maybe it needs work.
But the basic idea is that the fundamental rules for being a successful investor are mostly, pretty simple.
It’s having the discipline and self-awareness to follow them that’s hard!
Take Rule #32 – don’t confuse correlation with causation.
This comes straight from Statistics 101. It’s not a difficult idea. Just because two things happen at the same time, doesn’t necessarily mean that one causes the other.
For example, studies show that people who floss tend to be thinner than those that don’t. So does flossing make you thin? Of course not. It’s just that more health conscious people tend to watch what they eat, as well as look after their teeth.
I remember once on Sesame Street, back when I was a kid. Bert comes up to Ernie and says, “Why are you holding a banana to your ear?”
“It keeps away the alligators,” he says.
“But Ernie, there are no alligators on sesame street.”
“See, it’s working!”
But these are easy to spot. What about this one?
“Gold and shares tumbled on the back of softer than expected Chinese growth numbers.”
Now, I’ve seen this one more than once this week – in financial journals that should know better.
Not that I really blame the journalists. They’re under pressure. They’ve got deadlines to meet. If two things happen together, why not just say that one caused the other?
Trouble is, it gives us, as investors, a false picture of what’s driving trends in the market. And remember that backing longer-run trends is what separates you from the jump-at-anything herd.
So let’s pick this one apart.
The first thing I’m surprised hasn’t rated a mention is how unusual it is for shares and gold to take a battering together.
Remember, the primary driver of gold prices over the past decade or so has been gold’s value as a hedge against inflation and economic disaster.
And what, on the face of it, does softer Chinese GDP and falling share prices increase the likelihood of? Economic disaster.
And so really, if Chinese GDP was the cause, we should have seen the price of Gold go up, not down.
No, gold is marching to the beat of its own drum. As I’ve written already, the hedgers and speculators in gold are rushing for the exits. The stampede just happened to peak in the week that China released their growth numbers.
And so what about the connection between Chinese GDP and the sell off in shares we saw at the beginning of the weak?
This at least has some logic behind it. The argument goes that China is one of the few engines of global growth right now. If GDP in China stalls, it will take a large chunk out of global commodity and consumer good demand, and the nascent global recovery will be nipped in the bud.
The trouble is that I don’t think you can draw much connection between the GDP numbers, and actual demand out of China.
Most experts I know reckon the Chinese GDP data are mostly fiction. Can you imagine collecting that kind of data across a country of that size, with that many people?
And if you’re going to ban Google and YouTube, how open are you going to be to publishing the economic truth anyway?
That’s why a lot of attention is giving to the other indicators of activity in China – things like electricity demand for example.
The question then is, why would China publish a downside surprise?
The thing to remember is that China is attempting a massive rebalancing. It’s trying to massage down a credit bubble, without hitting the skids on real growth.
Credit growth, especially in the less-tightly regulated shadow finance sector, is going gang-busters – again.
Chinese credit issuance surged to a record high in January, reaching Rmb2.5 trillion ($400 billion) – up more than 50 per cent from December and more than double the figure a year ago. Check out the chart:
But when credit is expanding this quickly, investment protocols go out the window, and you end up with a whole bunch of white elephants in your back yard.
And China has been saying for a while that it needs to change up the game. It needs to rebalance away from investment and public spending and towards domestic consumption.
It’s a massive task. Newly-appointed President Xi is calling for the “courage” to deepen reforms. “We must have the courage, like gnawing at a hard bone while wading through dangerous water,” said Xi.
(I’m sure it was more inspiring in the original Mandarin.)
If you ask me, the downside surprise on the growth numbers is just part of this agenda. Beijing lowered the growth target for 2013 to 7.5 percent a few weeks ago, but at the same time has been a pains to point out that the target will be increasingly difficult to achieve this year.
And why are they jaw-boning GDP? Well investment decisions are based on expected returns, which in large part are determined by growth going forward. So if the growth outlook falls, marginal projects will become unprofitable, and it might put a pause in the run-away expansion of lending.
The print numbers have changed, but the economic reality remains the same. And in my view, that reality still looks pretty robust to me.
And so gold will keep heading south, but the stock market will bounce back pretty quickly, and stay on the up and up.
I’ve been saying so for a while. But remember, that doesn’t mean I caused it.