Back in January, we described ways in which the world has changed since the last secular bull market. Among the wonderful features of that Goldilocks era were the consistency of high equity returns and the calmness of markets. Well, as Hugh Grant said in his memorable British-Brooklyn accent in Mickey Blue Eyes, "Fuggedabout it!" Volatility is back, it's brash and it's here for the duration. If we understand what's causing this volatility, we can learn to work with it.

It starts with a jockeying for capital. Around the globe, securities markets are struggling with an increasingly boisterous clash over it between governments and the private sector. This public-private competition for scarce capital is a headline-grabbing, market-moving reality in socialist Europe, in the largely free-market America, in Islamist theocracies, in communist China and even in those Latin American economies fumbling for a place in the eco-political spectrum. The world over, this contest influences everything, and investors lose sight of it at their peril.

Here in the U.S., in just three years total government spending as a percentage of gross domestic product has been catapulted from 35% to a stunning 45%! It doesn't look temporary, either (www.usgovernmentspending.com), and that's upsetting the markets. This is the new nail-biting reality to which economists, business people, voters and investors are struggling to adapt.

Why is this government/private ratio so important? Three years ago, the cash-generating, job-creating, productivity-enhancing private sector accounted for 65% of GDP, and government for the remaining 35%. The private two-thirds of the economy threw off almost enough cash to support both itself and the government part.

I say almost enough, but not really enough because the private sector was spending every after-tax dollar it earned (i.e., saving almost nothing) and meanwhile the government sector was spending more than it took in from the private sector. And now the part of the economy that has to support the whole system has shrunk to just 55% of the pie. Is it any wonder that the securities markets are stressed about how all the bills are going to get paid?

Neither in Europe nor here in the U.S. has the government spending surge been funded by an increase in tax revenue. Rather, the government's employees, vendors and dependents have been paid from the proceeds of massive sovereign debt issuance. For this reason, the government-private sector struggle for capital has so far played out in the credit markets of the world and inevitably shaken currencies and the price of gold. The uneasiness of lenders is beginning to migrate to our stock markets, and for good reason.

Until there's broader confidence that we're in a self-sustaining, job-creating recovery, we'd be naive to think politicians will risk their re-election on spending cuts; after all, that might tip the economy back into recession. So if the spending cuts are unlikely, the only way to reduce the government deficit would be to increase tax revenue. Yet higher tax rates would merely shift the government's funding pressures, since higher personal taxes would crimp consumer spending, and higher corporate levies would reduce net profit margins.

Investors are keenly aware that capital is a finite resource; it's especially in short supply where populations are aging and savings are slim. Whatever capital governments need must be commandeered from the private sector. And if the government deficit is not going to shrink, we should expect the cost of capital to rise. We would see the higher cost of capital in higher interest rates and more discounting for sovereign default risk and inflation risk. We would also see it in lower P/E ratios, either because of competition equities face from bonds with higher yields and/or because rising tax rates imply slower growth and smaller corporate profits.

Mutual fund flows out of equities suggest that the public, disillusioned by two market crashes in one decade, never bought into the 80% U.S. rally of 2009-2010. Perhaps individual investors (a.k.a. owners of capital) are beginning to suspect that our best economic growth years are already in the record books now that government spending is approaching one-half of GDP.
The recent huge uptick in market volatility is our clue that a serious adjustment in valuation is in the offing.

Learning To Cope
By definition, a market is a mechanism for figuring out prices, especially in the classic examples of stock and bond markets, where buyers and sellers of securities process information about traditional economic variables affecting interest rates, credit risk and all the ordinary inputs that influence companies' prospective cash flows. Of course, it's hard to tell how things such as raw material costs and new products will affect any market. But investors can rationalize away these uncertainties, make estimates off them, set prices and diversify the risks.

It's a different stew of uncertainties on the front burner today. Stirred in with these usual earnings forecasts are things we don't know how to model: cross-border bailouts, protectionism, bold interventions by regulators and legislatures, and out-of-left-field mandates by dictators. These sorts of policy surprises tend to rattle investors' confidence and cause them nightmares.

Policy decisions that would have been Page 10 news when the private sector dominated the economy have a front-page impact when the ratio is inching toward 50/50. As a result, a lot of investors refuse to play at all. Those still in the fray are easily spooked, and deep-pocketed, mainframe-wielding, volatility-loving professional traders take over the game.

Since government's share of the economy is unlikely to suddenly contract anytime soon, we'll need to get better at political calculus and learn to cope with the volatility. I offer these few reflections to broaden our thinking on this important subject.
Debt management versus economic recovery. Across the developed world, we are seeing market pressure to manage down the public debt. At the same time, the recovery from a serious recession still seems to depend on government support.
Economic recovery and government debt management are conflicting goals, and the recent micro-volatility in the stock market reflects this stress. In hindsight, perhaps the macro-volatility of the past decade is related to the same issue.

When appraising the strength of the recovery and mulling your stock-bond allocations, be sure to give serious weight to the long-term political calculus related to debt management, both public and private. If you think businesses are going to grow and government spending will retreat, at least assign targets to some of your favorite mile markers (jobs, consumer spending, productivity) that you can monitor. If they're not unfolding as expected, you may want to make portfolio adjustments sooner rather than later.

It's political now. The struggle is about access to a limited global pool of capital. Government's desire for capital to fund its various initiatives is every bit as strong as businesses' motivation to fund their growth. Both teams in this competition have legions of supporters rooting for their side. Often as not, the government's cheerleaders are its employees, suppliers, pensioners and other beneficiaries of its outlays. Private sector growth tends to be championed by owners and employees of businesses, by their citizen customers and by investors in mutual funds and 401(k)s.

In countries with representative governments, all these participants vote, so elections are a key indicator of how the contest is going. Pay attention to elections and to interest rates-that's how we'll see which way the energy is flowing.

What's the ideal balance? We're someplace near the middle of the game, and the government seems to have the momentum in the U.S. In Europe, where government has been ahead, we see signs that capital is pushing back (spreads have widened in the credit markets and austerity budgets have been approved).

Most investors believe the private sector is the engine of growth and prosperity and that we'll all be better off with government in its traditional role as protector of the commonwealth and enforcer of reasonable game rules. And (here follows a personal opinion) that role is more affordable when it's closer to a quarter of the GDP than a half.

A dominant role for private activity seems appropriate because government needs the private sector's risk-taking, drive and innovation to fund its activities, not the other way 'round. Business needs strong government to ensure the safety of its citizens and enforce just laws designed to protect their right to life, liberty and the pursuit of happiness (which has traditionally included the notion of profits). And because investors are also citizens, the private sector should gladly fund a vigorous government. The question of the moment is, "What's the appropriate balance?" This is game day; the players are on the field. And the outcome matters, especially if you're a retiree depending on the productivity of your life savings.

Trading is for traders. While we're awaiting the outcome, it's pretty dangerous to trade the short-term swings. Board volume is apparently dominated by high-velocity trading models, momentum traders and hedge funds with monster turnover. Those of us who operate outside those information flows are well advised to get comfortable sitting on the sidelines. From time to time, though, the fast traders and momentum players unwittingly create pricing extremes which the rest of us can take advantage of. Keep your buy list fresh so you are ready to pounce when volatility creates extraordinary fundamental values in securities that you understand.

Most of the daily price moves are irrational. Just notice how often prices swing 1% or more in the last trading hour without any news to provoke it. Our clients spent a lifetime building their nest eggs and they ought not be subjected to unnecessary speculation. It is natural for clients to be concerned when their portfolios are "lagging the market," but let's work hard to remind them about the seriousness of risk, about how they felt at the end of 2008. And try to manage according to their lifestyle goals instead of an arbitrary benchmark.

A huge range of possible outcomes. It is important for those of us charged with preserving clients' savings to be aware that in this government-private sector competition for capital, the range of possible outcomes is much wider than anything we imagined during the great period of economic stability in the 20th century known as the Great Moderation.

For example, what if unbridled quantitative easing to increase the money supply (what Federal Reserve Chairman Bernanke likens to a helicopter drop of money) begat runaway inflation as one potentially extreme policy outcome. That's ugly enough, yet we could probably figure out how to invest for it if we saw it coming. But how about a double-dip recession accompanied by widening spreads, a renewed credit crisis that starves small business, an investor flight to the "safety" of government bonds, a debt-deflation spiral and protectionism that takes the depression global? It sounds like a perfect time for Keynes' deficit spending idea. Oh, yeah, we already did that.

Isn't there a middle ground where we gradually pay for our years of overspending and get back on the growth track? We all hope so. If there is, it's probably some combination of letting markets set the price of bonds and mortgages, and limiting government's annual deficit to something less than the economy's growth rate so we can "grow into our debt burden." Maybe we could eliminate institutions "too big to fail" and socialize risk. That would be nice.

I also believe personal money managers need access to and familiarity with tools that can help protect their clients' capital against things that go bump in the night. Among these are an enormous variety of inverse funds, bear funds, paired trades, long-short or market-neutral positions, precious metals and commodity strategies. The list of noncorrelated and negatively correlated options grows daily.

Let's all study hard, delegate carefully, practice patience, insist on transparency, set realistic expectations and diversify like our lives depend on it. Our clients deserve no less.