THE FINANCIAL PHILOSOPHER

Rationality & Prediction: One Year Later

"Those who have knowledge don't predict.  Those who predict don't have knowledge." ~ Lau Tzu

Extending upon the recent discussion here on rationality, let's revisit one year ago today, October 6, 2008.  The stock market was in free fall, declining nearly 10 percent in just five days, and the herd reaction was panic.  As I think back to my own emotional state, I believe mine was also panic... but not for the same reason as the herd!

My panic was that others were panicking!  My attempt to remain rational and orderly amidst irrationality and chaos may just have been, well, irrational!  This hindsight observation begs the question, "When is it best to follow the herd and when is it not?"  This may be the most common question on the minds of almost every investor, trader or asset manager when making investment decisions or giving recommendations, especially during extreme volatility.

If you are interested, feel free to read my blog post from exactly one year ago, Reasons Not to Sell Stocks Now.  If you don't care to read it, here's the synopsis:  As the herd was running for the exits, I was hyper-intentionally resolved to maintain my cool-headed contrarian stance.  I can now admit that, in frustration, disgust and a bit of haste, I made the one and only "prediction" on this blog, which was that stock prices, as measured by the S&P 500 would close higher one year later and would even outpace the average money market fund! 

What are the results of this prognostication?  The S&P 500 closed one year ago, October 6, 2008, at 1056; yesterday (technically one-year later) it closed at 1040; and today, October 6, 2009, the S&P peaked intra-day at 1061 and finally settled at 1055, just a one point below its year-ago mark!

Of course, at the time, I didn't imagine how bold this prediction would appear, especially as the S&P 500 fell another 40 percent lower by March 9, 2009!

"There are no facts, only interpretations." ~ Friedrich Nietzsche

Those of you who have read this blog for long, know that I do not believe in making (or acting upon) predictions. 

Without getting deep into a semantic analysis, one may argue that any action taken based upon an expected future result is a form of prediction.  While this may be true, I should qualify my previous statement against prediction by saying that, in general, I believe it to be foolish to forecast an outcome that may be significantly influenced by the whims of human emotion.

On a lighter note, I can't help but think of some advice someone gave me with regard to emotions and personal relationships:  "Would you rather be right or happy?"

This advice seems to work well with investing and financial markets, wouldn't you agree?

Recession is 'Official:' Is It Time To Look Forward?

"It' easy to see -- hard to foresee." ~ Benjamin Franklin

Now that we are "officially" in a Recession, what does that mean for stocks going forward? 

Of course, no one really knows the answer to that question, and I certainly will not attempt to do so here.  What some of you may not know, however, is that, once the "recession call" is made, stocks have historically been quite close to a significant march upward.

The reason for this is that economists look backward and investors look forward.

The stock market is often referred to as a "discount mechanism." Discounting, in reference to stocks, is essentially a means of pricing the value of stocks today based upon their expected value in the future, typically six to nine months in time -- a "crystal ball," if you will, reflecting forward expectations of economic health.

In other words, much like a barometer that measures the general business and consumer confidence of our economy, stock prices today reflect our nation's general economic health six months from now. For this reason, the stock market, as measured by the S&P 500, is a component of the economic Index of Leading Indicators.

"You cannot see the mountain near." ~ Ralph Waldo Emerson

Now for some perspective:  From the high mark on October 9, 2007, to the recent low mark put in on November 20, 2008, the price movement of the S&P 500 is a 51.93% decline. Of course, we will not attempt to "call a bottom" or make any predictions here, but let's make a few observations with specific reference to data (and following table) taken from Fidelity's Market Analysis, Research & Education (MARE):

Here are the prime points, in reference to the table above, from the November 26, 2008, MARE article, "US Stocks Often Rebound During Recessions:"

The average U.S. economic recession -- defined as a period of significant decline in economic activity -- has lasted about 11 months.

Investors historically have begun anticipating a recovery in the economy and in corporate earnings prior to the end of a recession.

On average, the stock market has begun to recover about halfway through a recession, with the typical rebound being about 25% in magnitude (from market low point to end of recession).

Bear markets that have occurred during past recessions also have tended to end during those recessions (73% of the time, 8 out of 11 instances).

"Faced with the choice between changing one's mind and proving there is no need to do so, almost everyone gets busy on the proof." ~ John Kenneth Galbraithe

While it is true, as Keynes said, that "the market can remain irrational longer than you can remain solvent," it is also true that irrational investors eventually grow tired from their exhaustive behavior; the excesses of the market are diminished or removed; and the pendulum finally begins to swing in the opposite direction -- the direction of the rational investor...

Depression or Not?

"Bad reasoning as well as good reasoning is possible; and this fact is the foundation of the practical side of logic." ~ Charles Sanders Peirce

Are we headed for a Depression?  The media has certainly tossed around comparisons of the current financial crisis to the Great Depression but this type of sensationalism, which is used to steal our attention, is expected from a source of information whose primary objective is to sell advertising.

I would not give this subject any attention if I had not observed several traders and bloggers who are experienced and knowledgeable of market and economic history are also joining the media noise to draw serious parallels from this financial crisis to "the D-word."

Are we headed for a Depression or are we not headed for Depression?  Should a rational person be asking this question now?

Let's take a look at some opposing views from notable sources and draw our own conclusions... 

An economist and notable blogger, David Merkel, recently posted an article titled, "It's Called a Depression," where he draws several parallels from this current financial crisis to a depressionary environment, which is generally defined as a 10% decline in economic growth or Gross Domestic Product (GDP):

• Many go hat in hand to the government
• The spreads of the bond market are at record levels since the last depression, and maybe comparable.
• There is policy paralysis and confusion.  No one knows what to do (or leave alone), they act blindly or cower in fear.
• Ultra-safe investments have record low yields.
• Banks don't trust each other.
• GDP is shrinking, and unemployment is increasing at a rapid rate.
• Financial businesses are failing and shrinking at high rates.
• The government comes in to "help" the markets, and ends up replacing the markets.
• The security of banks and other financial entities is open to question.

Mr. Merkel's grim observations are based upon his view that the "gears of finance are jammed," which results from "financial systems that are in danger."

"To every action there is an equal and opposite reaction." ~ Newton's third law of motion

The counter-argument we will look at comes from fund manager, John P. Hussman, and his recent article titled, "The Stock Market is Not in Uncharted Territory:"

Meanwhile, it is notable that data that measure investor panic, such as risk-premiums and intra-day market volatility, already match historical extremes (1932, 1974, 1982, and 2002) – points where stock prices were not far from their lows even though negative economic news persisted for a longer period.

If we seriously need to talk about the Great Depression (I personally believe that it is an outrageously dire comparison), we should recognize that even during that prolonged decline, it rarely made sense to sell into a major break of a previous low, because investors invariably had a chance to sell on a later recovery to the prior level of support.

If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives.

Veterans like Warren Buffett and Jeremy Grantham... know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

Mr. Hussman is essentially saying that today's stock prices have already (or nearly) factored in a worst case scenario, which is quite severe but significantly less severe than the Great Depression.  Furthermore, he implies that a prudent investor will not pay much attention to labels put forth by the news media but look for value opportunities that such an extreme environment has historically created.  

"All human situations have their inconveniences. We feel those of the present but neither see nor feel those of the future; and hence we make troublesome changes without amendment, and frequently for the worse." ~ Benjamin Franklin (1706-1790)

While Mr. Hussman's points come from a stock price and valuation perspective and Mr. Merkel's come from an economic and bond market perspective, both contrasting views show respect for history and illustrate the broad spectrum of opposing views prevalent today.

In my personal view, I believe conditions are certainly bad but likely not as bad as most people perceive them to be, especially the sectors outside of housing and financials.

Market cycle extremes, both on the upside and the downside, are accompanied by extreme emotions where our brain's limbic system will naturally seek patterns that make us believe that the current momentum will continue in the same direction... but the pendulum swings both ways...

Are fears of Depression justified or is it just more noise?  Or is there a human tendency to find the worst outcome that will make our current environment seem more tolerable?

What do you think?

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Related Post: "Know Thy Risk"