Disclaimer: I am not an investment adviser and I don’t give investment advice. My expertise is in decision making and I am using the information quoted here to make a point about decision making, not about investment strategy.
One of the things we talk about when teaching decision making is that decision making is a distinctly human activity. That is to say that it is more than responding to stimulus . . . it is an cognitive act.
Because it’s a human activity, it’s subject to all the wonders and foibles that make us human. To the extent that it is a conscious act, the part of the brain most involved is the prefrontal cortex. It’s a very cool piece of wetwear that is also not capable of keeping track of infinite amounts of data. As a result, we construct mental short cuts (called heuristics by people who like big words) to get us through life. So, for example, when we see scissors and we think about crossing the room with them, there’s a mental shortcut that pops up for most of us that says, “don’t run.”
Mostly these mental short cuts work well for us, but only mostly. It turns out that there are lots of times they don’t. We call those a lot of things, but in this context, a useful term is a “decision trap.” It means what you think it does: a mental process that traps us, vs. helps us, make a high quality decision.
There are lots of decision traps which I’ll discuss at another time. The class I’m interested in right here and now relate to how we evaluate information. Again, there are fancy terms we could use but the general ideas are these . . .
- We tend to over emphasize the most recent news.
- We tend to give more wait to whatever was most vivid.
- We tend to over estimate our role in the good things that happen and understate our role when things go poorly.
- We generally do a terrible job of estimating nearly anything.
The list goes on.
What brings all this to mind is a piece I just read by a very smart man named John Hussman. He runs big pools of money and is one of what I think is a too small group of voices warning us to not be dazzled (assuming you are) by the run the stock market has experienced since March. This is a good example of a very healthy and positive decision quality activity: seeking out “disconfirming points of view.” Which means? When trying to decide what to do, actively seek points of view that are counter to it. Another way of thinking about this is to actively think through what could go wrong. In the case of “the markets,” it’s a lot. Here’s what Hussman has to say . . .
I should have assumed that Wall Street’s tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again.
We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let’s face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we’ve already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.
Taking the weighted average outcome for the two states of the world still produces a poor average return/risk tradeoff.
So basically he’s arguing that even given the best economic interpretation he can see, the intermediate outlook for investment performance sucks. And that’s if things are interpreted in their best light.
When people think about “markets,” they tend to think in terms of a perfect representation of all that is known about a class of things discounted for net present value. So all the optimists and pessimists are factored in. All the information and speculation is factored in as well. But it’s largely a useless thought if you don’t assume that all participants are rational actors and that all the information is in fact available and being used. So as long as real human beings aren’t involved, we’re good to go.
The problem here in this version of reality is that the snapshot provided by “the market” is not nearly as reliable as we wish it to be. Hussman says . . .
Frankly, I’ve come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them.
And . . .
In part, the market’s increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation.
Our current Fed Chairman’s voice literally quivers in response to the phrase “bank failure,” even though in the present context, a bank failure implies none of the disorganized outcomes that characterized the Great Depression. It simply means that the bondholders take a loss and the remaining part of the institution survives intact as a “whole bank” entity (and can be sold or re-issued back to public ownership, less the debt to bondholders, as such). The same outcome would have been possible with Lehman had the FDIC been granted authority from Congress to take conservatorship of a non-bank financial entity.
So what does that all mean? At this point, I’ve made my point. If you have a rosy outlook for 2010, at least consider an alternative set of scenarios. But not to leave you hanging, here is Hussman’s point of view . . .
In my estimation, there is still close to an 80% probability (Bayes’ Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we’ve observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.
As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.
“This is why people didn’t figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.
“Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully.”
Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons’ editor now at Weeden & Company): “The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years – and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing – and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued.”
I’ll leave you to make your own list of large-scale secular forces that could upset the apple cart. It’s worth the time doing that. Then ask yourself or your investment adviser, what impact these forces would have if you were right on the down side or wrong on the upside.
