Friday, August 1, 2014

Bear Baiting

Yesterday the drop in the Dow wiped out the entire prior stock market gain in 2014. As of this moment it is down another 36 today. There is nothing unusual in this. Nor does it indicate anything about where the number will be at year’s end, though the very fact that the market is near an all time high can’t help but be a cause for worry. The worry itself makes a bigger correction more likely, humans being what they are. In the case of coin flips, after 10 consecutive “heads” it is the rare gambler who will bet on “heads” again even though the odds for the next toss remain 50/50. After a string of stock market advances wary investors start eyeing the exits, and one bad news day that once would have been ignored can cause a stampede.

Stock market corrections don’t necessarily entail downturns in the general economy, especially if they don’t reflect real underlying imbalances. The truly big ones usually do both, but the size of the market drop doesn’t tell you much about the size of the general downturn. The October Crash of 1987 was proportionally bigger than the one of 1929, but, instead of preluding another Great Depression, the recession was delayed and modest. The recession following the comparable 2001 crash precipitated by the dot-com boom/bust was the mildest since WW2 despite the other events of 2001. The one thing we can be sure about is that crashes and recessions will happen again. (See my 2011 review of This Time is Different by Princeton economists Carmen Reinhart and Kenneth Rogoff in which they tell us that this time is never different and that every type of financial system is at risk “no matter how well regulated it seems to be.”)

During the 1987 and 2001 crashes, Alan Greenspan was at the head of the Federal Reserve. Largely because the US economy rebounded in both cases without lasting damage, Greenspan was the most respected central banker in the world right up to his retirement in 2006. Nowadays he catches heavy fire from both Right and Left, with both inclined to misrepresent his views and to quote him out of context when he acknowledges his mistakes. Yet, those two market collapses troubled him at the time, not only for their real world effects, but because they were hard to explain by prevailing economic theory: crashes of that scale were happening too frequently. It long has been known that what John Maynard Keynes called “animal spirits” amplify the number and size of what would be low-probability economic events if producers, savers, and consumers – otherwise known as people – behaved rationally; these give the bell curve “fat tails” as people follow the herd instead of assessing the economic fundamentals. After 2008, Greenspan became convinced of what he suspected earlier: the tails were not just fat but “positively obese” beyond anything that had been recognized, especially on the downside. Fear evokes a stronger herd response than greed.

In his book The Map and the Territory (2013) which I have in hardcover but which will be in paperback next month, Greenspan says the good news is that these factors can be incorporated into economic models. “I have recently come to appreciate that ‘spirits’ do in fact display ‘consistencies’ that can importantly enhance our ability to identify emerging asset price bubbles in equities, commodities and exchange rates -- and even to anticipate the economic consequences of their ultimate collapse and recovery." The bad news is that bubbles and collapses will happen anyway. However, there are ways to limit the damage.

Why was 2008 so much more devastating than 1987 and 2001? Unlike those previous years, banks and shadow banks were heavily leveraged, so that, when the runs started, short term credit utterly dried up in a way unseen since 1907. There was too much debt, he says, and what banks counted as assets (e.g. mortgage backed securities) were often highly vulnerable securitized debts. Greenspan exhibits no confidence in lengthier laws (beyond those against actual fraud) and more numerous overseers to do anything useful to prevent a repeat of events. He notes that regulators failed to foresee any of those crashes, and in the run-up to 2008 actively promoted the housing bubble that burst so destructively. His prescription is simpler: capital requirements need to be larger so that banks and other financial institutions can survive the inevitable bursts of asset bubbles. He thinks reserves are still far too low, and says he had been seriously wrong while Fed Chair about the risks and reserve requirements.

Even if he is right, his prescription makes it easier to pick up the pieces; it doesn’t prevent the smashes. I certainly have no clue when the next one will be. No one else does either (unless the Illuminati really do run things, in which case send me an invitation). As for my personal approach to choosing individual stocks, I’ve never found any advice to be better than what I got years ago in a college business class: throw darts at the stock listing pages of The Wall Street Journal. On average it works as well as any other strategy.

Animal Spirits – from Trading Places (1983)


  1. Good article Richard. I've found my best advice comes from Peter Lynch's book, One Up On Wall Street, which is: Buy companies that you buy products from, ie. if you drink Coke or Pepsi, buy that stock, if you have a Netflix subscription, buy stock from that company, if you have an iPhone, you might buy Apple stock. It's not foolproof, but then what is when talking about the market, but at least is a good indicator of trends, and if you can forecast a few of those trends you can ride that wave.

    For another example, I missed the wave on cell phones. It was not a product that I ever thought I would use. I still do not use one a lot, only on road trips, however, due to my bias, if I had seen that trend, and not been so close minded, I could have made some money. Oh well,coulda, woulda, shoulda. Personal computers was another wave, cloud computing currently is a wave (though I don't own any shares in that), and there have been many waves historically.

    But you are right that the market has rises and falls. I experienced the bubble along with many investors. I had too many eggs in one basket: Microsoft, Oracle, Intel, etc. Needless to say, when the bubble burst, I felt it burst in my portfolio as well. So another rule of thumb: Diversify. Jim Cramer is right about that one. Have a varied portfolio. Win some, lose some, hopefully though, learn from your mistakes.

    Another rule of thumb that I've practiced is just to ride the market out (buy and hold). A lot of people do get nervous during a downturn--who can blame them? It's scary. But I've found if I have stocks that I consider bellwether stocks, it has been best for me just to hold onto them, in fact, that's a good time to buy more--income average the stock price down and you can lower the buy price of them. If you sell them, when do you get back into the market? Probably once you've noticed that stocks are back up again and doing well, you've missed the rise curve back up and missed out on a lot of gains.

    1. We all try to beat the market. Entrepreneurs (including classic corporate raiders) create their own value. Among pure traders, however, who take no part in the structure or operation of firms in which they invest, few succeed at beating the market, and luck is typically a better explanation than foresight for those few.

      The phone companies themselves missed their own waves and troughs. For years they concentrated on video phones which few people bother about except (in a niche way) on skype which strictly speaking isn't a phone. Texting, on the other hand, was thought to be a minor feature to be used for business memos. The flood of teen texts took them completely by surprise. As you say, just diversify and hope for the best.