Short equities. Why? Logically, it is clear that no one can spend more money than he has forever. It is also clear that there is too little political will to raise that critical fact as a reason for forcing the unpleasant changes in Europe (or America, for that matter) required to return to economic health. It seems the preference is to continue in our profligate ways until there are absolutely no alternatives.

In the meantime, the hole we dig for our financial future only gets deeper as we continue to mis-allocate capital. The decline in economic health accelerates quickly if it is not stopped early, a fact that the markets and others seem to be missing. This acceleration is like a reverse trickle-down effect. As entities become less profitable, they pay less and employ less, which means people are paid and eventually consume less. And the cycle repeats faster and faster. Eventually, Europe will have to face this fact as will the U.S.

To illustrate this natural phenomenon, I use a small farm as a metaphor.

  • Assumptions

    • Purchase price of farmland per acre: $10,000

    • Annual cost of seeds, labor and debt per acre: $750

    • Selling price of fruit produced by farm: $2 per pound

  • Scenario 1

    • Mr. Farmer plants seeds that yield 600 pounds of fruit per acre.

    • He makes $150 per year.

  • Scenario 2

    • Mr. Farmer plants seeds that yield 400 pounds of fruit per acre.

    • He loses $150 per year.

Scenario 1 is the only scenario that makes sense to a rational person.

Scenario 2 reflects the general financial condition of countries operating with deficits.

In Scenario 2: To avoid the bank foreclosing on his land, the farmer must cut costs (fire employees since his only variable cost is labor) or increase his revenues by increasing the yield on his land. In other words, choosing to cultivate the lower-yielding crop wastes resources that could otherwise sustain more jobs and produce more disposable income.

Extrapolating this analogy to a sovereign economy, it is clear how economic health begins to decline when members of the economy allocate capital to lower yielding investments. As this trend proliferates, capital regenerates at a slower and slower pace. This cycle results in less capital available for reinvestment and growth as well as lower income for the economy. Those are two very powerful drags on future growth rates.

Governments can temporarily mask deterioration in economic health and capital regeneration by increasing money supply. (See related story on page 46.) The increase in money supply can absolve the farmer from his capital allocation crime in the form of (1) a government subsidy that allows him to break-even or make a little profit or (2) inflation in the price of the farmer's land, which “creates” equity that lowers his cost of borrowing or that he can cash out to cover costs.

In neither case is the underlying financial deficit addressed in a sustainable way unless we assume infinite subsidies or infinite acceleration in inflation (even then the farmer relies on his land value inflating faster than the wages he pays).

Increasing money supply only eases the symptoms of the decline in economic health and does nothing to address the underlying cause. I would argue that easing the symptoms instead of addressing the cause makes matters worse. If investors do not suffer the consequences of their poor capital allocation decisions, what will stop them from continuing them and worsening the problem? Look to Wall Street for the answer to that question.

Keeping interest rates artificially low for long periods of time has a similar effect. As detailed in an article I wrote last year, investment opportunities are more plentiful near the cost of capital. When the cost of capital is lowered, more capital flows to lower-return activities (why work harder to make a profit than you have to?). Thus, low interest rates can undermine the medium- and long-term structural growth rates of economies by diverting capital from higher-return activities to lower-return activities.

To illustrate, here is Scenario 3:

  • Mr. Farmer's annual cost of borrowing declines by $151.

  • He makes $1 per year with the lower-yielding seeds.

Even though the farmer may be perfectly content to make a little money under Scenario 3, his choice to allocate his capital (i.e. land) to a lower yielding investment means that the growth of his disposable income and the amount of people he employs will be lower versus Scenario 1. Therefore, easy monetary policy, in this case, encourages investments in lower-return investments, which produce fewer jobs and regenerate capital at a slower pace. Not a good effect for anything but the very short term. Government subsidies and protectionism have the same effect.

Preventing capital from flowing to its highest and best uses carries a heavy opportunity cost that is paid in the form of lower future prosperity.

All the noise about whether or not Europe can bail out this or that country is a sideshow to the real issue, which is that too large a portion of the European economy is simply not competitive in the global society. As a result, they have spent more than they make and are now facing bankruptcy unless someone gives them more money to bridge the deficit between their income and spending.

Recognizing that allowing a country to go bankrupt could have Lehman-like affects, I do not advocate letting every insolvent country implode. But letting Greece and Italy simply devalue their currency every decade or so as they did in the past would be just fine. Throwing more good money after bad is not a solution.

My overriding message is that the only path to fiscal health is intelligent capital allocation. As long as capital is allowed to flow to its higher and better uses, financial problems will resolve.

The potentially unfortunate flip side to intelligent capital allocation is taking capital away from those who mis-allocate. That process can be difficult and painful, in the short term but the alternative is worse. If we do not take capital away from those who mis-allocate now, they will eventually take it from society at large later.

Europe, especially Germany, is learning this lesson the hard way. European leaders are running out of ways to disguise the ugly truth that the best-case scenario for the Euro zone over the next few years is recession forced either by:

  1. Profligate countries cutting back spending;

  2. Solvent countries diverting large amounts of money to keep the profligate countries from imploding;

  3. Some combination of the prior two scenarios.

No matter what, it is clear that a large portion of European resources will be diverted to internal repair for some time. The math is simple: Consumption will have to fall from “earned and borrowed” levels to “earned repayment of past debt” levels.

In turn, the rest of the world will experience a significant decline in the purchasing power of a large customer of its goods and services. Global growth will decline as a result of so much European capital being diverted to covering the debts of its over-spending past. This slowdown will push the United States GDP growth back toward recessionary levels, which will only exacerbate our existing problems with unemployment and lack of personal income growth.

In time, the rest of the world will experience a decline in the purchasing power of another large customer (the U.S. consumer). At this point, no government can do anything (Keynesian) to bail us out. The ole “spend our way out of trouble” strategy has exhausted all its influence. It is not only impractical but, now, also unfeasible. The investment and portfolio management implications of this predicament are that asset prices, including stocks, will fall and do so rather dramatically.

While painful to some in the near term, this fall would be a healthy cleansing. Allowing markets to provide natural price discovery for assets will signal that a real bottom has been found. At which point, sophisticated investors (i.e. not speculators) have the confidence to begin redeploying capital.

The sooner sophisticated investors are able to begin allocating capital to higher-returning investments, the sooner the health of our global economy and its structural growth rate can begin to improve.

In the meantime, the best way to make money is to be short.