Jul

5

The basic theme of Victor Canto's Cocktail Economics, a book well worth reading, is that economic principles can be applied to pick the ideal times to shift your allocation between bonds and stocks. The main economic principles utilized are the elasticity of demand, the shifts of supply and demand curves, and the incentives and competition that lead to pricing power for individual companies.

Canto is an expert on the energy industry and has many analogies between the flexibilities of the oil, natural gas , and coal users and purveyors, and the proper variations that an investor should make in maneuvering a portfolio.

He pays much attention to lower tax rates and multiple locations as a prerequisite to flexibility, supply-side economics concepts popularized by Art Laffer and John Rutledge as a foundation for superior returns in stocks. The beginning chapter in the book on the economics of real estate sets the base for the book. It shows that transactions costs of say five percent round trip are an essential feature of the returns from real estate, and that holding period returns don’t vary much within a location. Thus, the returns from real estate are very much superior if a holding period of at least seven years is used.

It then compares transaction costs on stocks which are much lower, and variability among industries and investment styles which are much wider in stocks, and posits that there is a much better opportunity to garner returns from active management of stocks than real estate. Along the way to showing you how to garner these returns the author has many big ideas about how to accomplish it. He believe the Big Mac index is a key to superior stock returns and recommends that you buy companies where the Big Mac index is going to change in the right direction. He also believes that by looking at past movements during economic shocks that you can find groups of stocks that will do well the next time such shocks, like reductions in tax rates, disruptions in supply, or tightening Fed policy, are going to change the landscape.

When I was in elementary and secondary school, the principals often called me into the office and admonished me, "You should know better, you're father's a policeman. We expected more of you." I had a similar reaction to Canto's book. He's a Ph D from the University of Chicago Economics Dept. He runs a successful economics and investment consulting firm. He's a friend of John Rutledge, vetted as one of the smartest and most successful men he knows, and he's an expert on energy economics. I expected more of him. The book, however, is seriously deficient in that it assumes perfect knowledge of forthcoming events as a prerequisite to returns.

Regrettably, if you knew the exact real returns from treasury bills a few years in advance, or what the pricing of individual companies was going to be after a economic disruption was going to occur, or you knew which way the exchange rate was going to move, then it would indeed be possible to make superior profits. But we live in a world of uncertainty. And despite Canto's self-reported great predictions where he was able to see what the impacts of various economic events were going to be, it is virtually impossible for the economic everyman at whom the book is aimed to assume that he can beat the market with superior insights into future events that might give him an edge.

In addition to the defect of assuming perfect knowledge for most of his recommendations, the book suffers from many untested assertions. He presents no evidence whatsoever that the Big Mac index works with perfect or imperfect info for stocks, and he has many untested assertions that are a foundation for his recommendations, for example that when total profits for the economy are up, this will be bullish for stocks.

He also pays no attention to the law of ever-changing cycles, which belies the basic premise of many parts of the book, that looking at past moves when such things as energy prices go up, or the economy slows, is a guide to proper allocation between bonds and stocks, large and small caps, et al, in the future.

He states that if you know whether an increase in prices comes from a movement in the demand or supply curve, it is possible to predict whether it's bullish or bearish for stocks. But one doesn’t know whether there has been a move in either curve, or much more important, whether it was anticipated in previous price moves of the individual stocks.

As an example of one of many deficiencies in the author's arsenal of recommendations, I would point to his idea that there are cycles in the moves in large and small cap stocks, with persistence in superior performance, of one group versus the other. No estimates of variability, predictability, relation to predictable economic variables, or accord with randomness, or retrospection are given. The observations that throw the three or four large runs of superior performance out of kilter are put aside as ephemeral phenomena that should be dismissed.

With all it's defects, and its many self-serving assertions about the greatness of his past results, and its grab bag of very special chapters on such things as the similarities between returns and energy flexibilities, and I have just highlighted a small number of them, one must know this is a big book with big ideas. It is well worth reading for the discerning reader.


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