We are all familiar with one application of thermodynamics—forecasting the weather. We know that meteorology is very successful at telling us whether it will rain tomorrow but can tell us almost nothing about the weather 30 days from now. We also know that all storms are transitory. Today’s thunderstorm will surely end when it has spent its energy.
To us, a weather system is the best and simplest metaphor for economic change. We all know what happens when high and low pressure systems come into contact—thunder, lightning, tornadoes and hurricanes. In economics, when investors are confronted with return differentials, the result is asset price changes.
We think of global investing as an exercise in meteorology. Our job is to identify the thermodynamic shifts caused by changes in tax rates, government spending, regulatory policies, or monetary policy that lead to localized return on capital differentials between two groups of otherwise similar assets. These return gaps are the thermodynamic engine that drives capital gains and losses.
The way to make money investing is to identify a storm system that is powerful enough, and will last long enough, to serve as an energy engine for revaluing a portfolio. Then you move capital into position to take advantage of the impending price changes driven by the arbitrage activities of other investors.
Dr. John Rutledge
Chief Investment Strategist