Behavior and Belief

There is a reciprocal relationship between how we behave and what we believe. Many of us have an inclination to move from euphoria to despondency , from faith to fear. Financial history has always been a roller coaster ride of up and downs and this time is no different. It is important that we see ourselves and our money as being in continuity with longer term economic history as opposed to being separate or apart.

The funding of our personal/family long term goals is why we are investing in the first instance. The range of possible outcomes depends on our actions- on our behavior- at times such as this. It is important that we not fixate on the short term political/economic turmoil and stay with our long term plan. That is the best path to recovery.

Economic Trade-offs

The concept of trade-offs, that is, receiving  more of one "thing" in return for less of another "thing" is a substantive part of economic reasoning. At least it used to be. We now have 24 hours of news- an almost endless array of "information" but in exchange for this "more", we have a trade-off with the quality of the information which is decidedly "less". 

Many of the actions of the government over the past few weeks, while perhaps well intentioned , seem designed to obscure the trade-offs built into each economic decision. The housing rescue plan is one instant example. Those of us with mortgages are exchanging the payment in return for the occupancy. As one real estate lawyer likes to say "you have to pay to stay". This is what is sometimes called a "Hobson's choice" , basically a take it or leave it proposition where you have only one choice- to pay or not.  As I wrote in an earlier post, the real issue in housing may not be those already in foreclosure but those who are underwater but not (yet) behind. Certain provisions in the plan allow for the possibility of mortgage principal to be changed in a bankruptcy . This could prove as a perverse incentive to some of those underwater as a way to stay and not pay. 

Tinkering with economic trade-offs appears innocent but often has unintended negative consequences. We often see clients who struggle with trade-offs. If you retire early you have more time but in return you have less accumulated savings. If you seek a high degree of safety , you forgo much of the future growth potential . If you spend/withdraw more now, you have less for later. And on and on. 

Bad history= Bad economics

Much of the rhetoric and many of the analogies currently  being employed by journalists and those in government are historically inaccurate. While each economic period has unique characteristics, the most apt comparison we have is the 1981-82 timeframe not the 1929-1932 period. It is simply untrue to state that the current economic environment is "the worst since the Great Depression."

In 2008 , despite a sharp pull back in the 4th quarter, real (adjusted for inflation) GDP (Gross Domestic Product- the sum of all goods and services produced) was modestly positive for 2008. Compare that to GDP contractions of 1.9% in 1982 and 8-13% per year during the 1930-32 period. Job losses as a percentage of the workforce were identical in 1981 and 2008.  The current unemployment rate of 7.6% is still well under the 1982 peak of 10.8% and but a fraction of the 24% jobless rate reached in 1932.

Economic policies should be grounded in a realistic and genuine understanding of economic history. In the main, this is not what we see at present. 

Lessons from the Past

"Absent the ability to forecast changes in economic activity & policy more accurately than the forecasts that are already built into asset prices,investors should maintain an allocation to risky assets that is consistent with their risk preferences & long term goals." What we can learn from Past Financial Turmoil-Dimensional Fund Advisors- Dr. Inmoo Lee and Garrett Quigley

I had a chance to hear Dr. Lee present findings from his research paper recently and think they are on point. The only clarification or quibble I would have with the quote above is the word "preferences". Many investors might "prefer" little or no risk but they "need" higher risk levels to fund long term financial goals.

The paper explains how attempts to time allocation decisions among differing stages of the business cycle often prove futile. Markets are forward looking -anticipating changes before they actually occur. Prices have tended to recover quickly in previous bear markets and investors who maintained risky asset allocations (stocks) were generally rewarded for the risk.

Creative Destruction

Early 20th century Austrian (now Czech Republic) economist Joseph Schumpeter coined the phrase "creative destruction" in his 1942 book Capitalism,Socialism,and Democracy. Sounds like an apt title for today don't you think? Schumpeter was not attempting to engage in political debate but rather highlight the business cycle and natural evolutionary dynamic of capitalism.

A couple interesting points from his writings. First, he was highly critical of economist John Maynard Keynes, whose theories of fiscal stimulus we are now practicing. He believed that the innovative qualities of capitalism and particularly entrepreneurship were key . He describes a possible method of how the intellectual class might destroy capitalism from within via creation of a welfare state and restrictions placed on innovation/entrepreneurship. Interesting in light of the current environment.

What We Hear

I heard a long interview a few days ago with Professor Niall Ferguson-author or The Ascent of Money . He had an interesting observation about economic literacy and our overall poor understanding of economic history. He said "we don't teach financial history- we only talk about the generals and not the bankers". Well put- this poor (or factually flawed) view of history is at the root of our current problems.

On the same day I heard an interview with Dr. Nassim Taleb- author of 2 books on our list. Taleb is a difficult interview as he is highly charged and acerbic. He made a couple major points. First, he proffers that all asset bubbles are driven either by inflation (tech stocks in the 90's) or debt (housing in this decade). He also thinks banks are operating as "utilities " (like the electric company or cable company) and should be regulated as such. Finally, lending to the themes in his books, he thinks institutions should have "robustness to rare events" or they should be allowed to break (fail).

Housing-the good and the bad

The current economic tailspin started largely with housing (or more specifically with housing finance) and housing will likely be the path back to prosperity. Stabilization of housing is a noble ideal but it will prove difficult because of the fractured relationships involved in most mortgages. For the most part, homeowners have little or no relationship with the lender after the loan is closed and usually even less with the servicer. Perhaps it's time to shift mortgage lending back to the local community lenders away from the behemoth banks.

Apparently the days ahead will bring details of the government plan for housing. In reality, only a small percentage of the homeowners currently "underwater" (their mortgage debt exceeds the house value) can be salvaged. For the main, consumers over-bought and over-borrowed . Even with very low mortgage rates they still have too much debt. 

On the good news side- market bottoms are being formed in many of the hardest hit areas and market activity is increasing . Stay tuned. 

$9.7 Trillion

Bloomberg.com has a piece today by Mark Pittman & Bob Ivry on the lending programs and guarantees made by the federal government over the past couple years. Primarily from the Fed, FDIC and Treasury , about $3 Trillion has been lent to yet unnamed firms/banks with another $5.7 Trillion in guarantees. Just for perspective, the entire U.S. economy is about $14.3 Trillion . Bloomberg has filed a lawsuit in federal court demanding the disclosure of to whom; how much and when. Can't make this stuff up...

Buffett and Stocks

Famed investor Warren Buffett is the subject of a piece in the February 4 Fortune article titled Buffett's metric says it's time to Buy." The article details the relationship between stock prices and GDP (Gross Domestic Product= the sum of all goods and services produces in our domestic economy). The valuation reached a peak in March 2000 of 190% (the value of U.S. stocks was 190% of GDP).  During WWII this range was as low as 40-45% and tested those same levels in the early 1980's. Buffett says " If the percentage relationship falls to the 70-80% area ,buying stocks is likely to work very well for you." At present the estimate is about 75%. 

Welcome !

Well, we thought that clients and others might enjoy seeing some of what goes into our thought process . It is my hope that this will serve to re-inforce the long standing philosophy that we practice. I will try to link charts and articles that are appropriate and discuss items of interest. The frequency of items will vary but I intend to add commentary regularly . So check back often and let us know what you think.