The Monster in the Closet

It is again rumored that there IS a monster in the closet, and this one is bigger and badder than any previously imagined. The monster is in the form of bad debts on bank balance sheets -- creating an insolvent US banking system with "$2.5 trillion" worth of bad debt. I'd say that's a scary situation to be in.

There are a number of potential remedies to dealing with the monster -- the UK may choose to go the route of nationalization, which is apparently favored by Shelia Bair (currently head of the FDIC). The danger of nationalization is the destruction of shareholder value that would ensue and the further loss of investor confidence.

In anticipation of this worst-case scenario, today we saw the stock market acting as if nationalization were likely to occur - creating a self-fulfilling prophecy of plunging share and asset prices, which itself increases the risk of banking collapse. Such psychological positive feedback loops don't stop unless some signal is given by the government (or a credibly strong authority) that nationalization is not likely to occur. Because we're in the midst of a momentous political transition, such information probably won't come this week. Which sets us up for a very volatile week.

Psychologically speaking, there are a few things we can do when we think there's a $2.5 trillion monster in the closet, which roughly parallel the "freeze, fight, or flight" response:

1. FREEZE: We can hide under the covers and hope it goes away (hasn't worked so far).
2. FIGHT: We can grab a baseball bat and run into the closet swinging. (This seems to be the TARP method, but too many blows have missed the monster and hit us on the other arm -- ouch - which makes parents (i.e. taxpayers) angry and reduces our monster-fighting motivation).
3. FLIGHT: We can jump out of the bed, sprint to the light switch with a pounding heart, fumble to find the switch in a panic, turn on the light, and slowly turn to face the monster. (Just shedding light on the monster reduces the uncertainty and fear we feel.) If instead of turning on the light we fled from the house, then we'd be homeless and the monster would get our Serta, which isn't tolerable for most of us.

Right now we're hiding under the covers, and the monster has been growing bigger and more bold.

I'm concerned that in the next rescue - Part 4 - the government may destroy shareholder value via nationalization. To do so would further undermine confidence in the stock market, at a delicate time, and in my opinion it could delay the economic recovery. The lower asset prices go due to nationalization, the more forced liquidations and underfunded pensions we'll see. That may be inevitable in the course of this unwinding, but it's not economically desirable.

If we turned the light on the monster, had a long honest talk with it, gave it it's own bedroom (the "good bank, bad bank" method), and let it find a job on its own time, then we might make it through without being eaten. Seems like the best option so far.

We may have to live with a stinky expensive monster for a while, but that's better than ignoring it and having crippling anxiety attacks and insomnia which ultimately undermine our ability to get on with life.

And don't forget that the banking system was insolvent in the early 1980s as well, and it made it through that storm intact.

Richard

Yeah, But Are You "Sure-Sure"?

Ivory soap is famously 99.44% pure. I like that extra 44/100s. It gives me peace of mind.

If only financial forecasters would follow the Ivory model in their predictions. I've been hearing/reading/seeing a lot of expert predictions these days. New calendar years and volatile markets seem to attract them.

Now, let's be clear, I don't have a crystal ball. (I do have a Magic 8-Ball. But when I asked it if the Jets would make the playoffs it told me "Signs Point to Yes." So I'm thinking it's busted.)

The only predictions I will make with any confidence are these:

1) All consensus predictions will be too narrow in scope.

2) People will overuse artificial parameters in the form of round numbers and calendar years when formulating those overly narrow predictions.

Okay, I cheated.

Those aren't predictions. They're observations of human behavior that are among the most reliable you will ever find.

How reliable? Research into the area that behavioral finance folks call "overconfidence" indicate that when people are asked to predict a range in which they are 99% confident results will fall (i.e., a 99% confidence interval) they are correct 80% of the time.

Now at first blush, that may not seem so awful. 80% vs 90-something%...what's the big deal?

But it is awful.

Truly, horribly, make-you-want-to-toss-your-cookies awful.

Why?

Think of the corresponding behavior in light of such predictions. When we're 99% of something, it's basically as close to saying we're absolutely certain as we're going to get.

You could go Ivory Soap and say 99.44% certain but when we blurt out, "I'm 99% sure that won't happen", we're essentially saying, "No shot in hell."

That's dangerous even when it's TRUE.

Once in a hundred years was the standards to which they built the New Orleans levees. That works fine... right up until your neighborhood has to be airlifted off the rooftops.

But with market predictions, it's 20x worse. Events that people - and this includes experts, mind you -- say would happen every 100 years (1%) - happen EVERY FIVE YEARS (20%).

Let's say you listen to a more conservative expert predictor. He/she is twice as good and are accurate 90% of the time.

That STILL means every 10 years we're going to experience something that "nobody" saw coming.

Nassim Nicholas Taleb wrote a book called The Black Swan. (It's not as good a book as Richard Peterson's Inside the Investor's Brain, but it's certainly worth reading).

Where are we seeing such predictions these days?

Oh... everywhere.

"Where do you believe the S & P will be a year from now?"

"How high do you think unemployment can go?"

"What are the chances you will have to cut your dividend, Mr. CEO?"

Remember, fellow investors, fight the danger of narrow framing and don't be drawn into sharing the outlook of those who look at the horizon through a key hole and tell you wide it is.

We have no reliable way of knowing how bad (or how good) it's going to get.

The key is to expand the scope of expectations and to have plans in place for even the most unlikely-seeming scenarios.

Think "Ivory Soap".

And good luck.

-Frank

(If you are interested in a MarketPsych seminar, please feel free to contact us at [email protected]. I'm 99.44% sure you will find our seminars valuable.)

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