The Dangers of Trading Headlines

In 2007, author Nassim Taleb wrote his very interesting book, "The Black Swan," the theme of which is that the impact of rare events is huge and highly underrated. The idea behind the entire premise of the book is that these events are rare, In previous entries I have opined about the dangers of 24 hours on investment markets. The media have a profound affect on behavioral finance, and it is our individual ability to filter the media which potentially makes us successful investors.
With the recent events in the Middle East, and the earthquake & tsunami in Japan, combined with the financial events/turmoil of the past few years, the term “black swan” is being kicked around more and more, and the label is being placed on many things. I even read an article noting that “black swans were becoming a more common occurance.” This is just irresponsible journalism.

There are geopolitical, natural, social, & financial “events” that happen every year, and it is in the ability to manage those risks that we see financial successes or failures. To name a few of these events over the past several decades:


2000s

• Oil Shocks (2005)
• Corporate Accounting Scandals (2002)
• 9/11 (2001)

1990s

• Tech Bubble Bursts (1999)
• Bosnia-Balkan Crisis (1995)
• War in the Persian Gulf (1990)

1980s

• Savings & Loan Crisis (1989)
• Chernobyl (1986)

1970s

• 3 Mile Island (1979)
• Watergate (1974)
• Vietnam War spreads to Cambodia (1970)

If pressed to, I bet that I could use this loose description of a black swan to name an event every year going all the way back to the 1920s. The point of Mr. Taleb’s book (and it is a great read), is that we cannot mentally grasp or predict the type of event that a black swan is; and therefore cannot plan for it.

As individual investors, it is sometimes difficult to divorce or emotions from our investment decisions. “Media Events” can contribute to these poor decisions. Consequently, we often give in to the emotion of selling low and buying high.

Bull still feels like a Bear—2 years on from the bottom…

On the 2-year anniversary of the current bull market, it may not be a bad time to take a step back and look at where we were not too long ago. What may have felt like financial Armageddon, turned to a sustained market rally, and financial markets are back above the mark they were prior to the crisis.
In probably the most tumultuous time in the market since the start of the Great Depression, it was very difficult to tame emotions for some as a number of investors dumped equities at or near the bottom and shifted to fixed-oriented securities. The reality is that many probably should have never had that much risk exposure anyway.

Over the last 2 years, pundits & money managers have tried to define the “new normal.” Others have declared death to the “buy and hold” investment strategy. The truth is that those who did not panic have recovered much of what they lost—and done so with less volatility. While “buy and hold” may be an okay investment strategy during the accumulation phase of your life, a unique set of risks has always existed during pre-retirement and early post-retirement. This is what necessitates a different investment strategy—not the undefined “new normal.”

Perhaps the reason why this bull market still feels like a bear to many of us is the fact that the 2008 financial crisis was such a trauma, and that some are waiting for another Lehman Brothers to rear its head. Volatility still feels high, though the VIX (the index which measures volatility) has been much lower. The market saw many swings in 2010, which were influenced by headline trading (Euro issues, Gulf oil spill), but they were mildly one way, and then mildly the other…miss one of the mild swings upward and you may have significantly affected your overall success for returns for the year.

While the world gets more complex and economies grow more inter-dependent, the difficulty in staying committed to an investment strategy through emotional ups and downs becomes the biggest challenge to those that need investments growth, but cannot stomach swings.

2011 Oil Shocks on the Way?

The price of oil is up 25% in two weeks, while production is down only 1% due to the Libyan instability issue. So far it seems to be an issue of “the price of oil mirroring headline.” But what will higher oil prices mean for the global economy?

The simplest notion is that higher oil=higher petroleum at the pump= less money for the consumer. Right now, consumer spending is an important part of the domestic economy.

A big questions is what the reaction from government bankers will be. Those at the European Central Bank have hinted that they will raise interest rates in the short term. Bernanke and the Fed have indicated they will keep the status quo for now. This is a real balancing act as inflation worries hang in the balance.

If production does decline due to a protracted unrest in Libya or “contagion” across the Middle East, some have suggested dipping into the country’s oil reserves to ease prices at the tank. It is unclear what real affect this would have on price, because of the emotional affect of using up reserves. If price is already up on a 1% drop in production, what would lowering reserves do to the attitudes toward oil?

Reforming Property Ownership

With 25% of all mortgage holders in the US owing more on their notes than their homes are worth, and distressed transactions account for 66% of sales in CA, it is important to step back and ponder the significant role that emotion plays in the largest segment of most people’s net worth. Do we have a healthy relationship with property ownership in this country?

If you look at the property boom that spawned from the “dotcom bust,” we see the collective heard shunning fantasy business plans and instead opting for “hard assets.” But there are a few inherent issues with investment in real estate that make it a potentially dangerous asset class:

• As mentioned before, Americans have more of their wealth in Real Estate than any other asset 
• Property and debt go hand in hand—and the banks that secure that debt set aside less money for those loans because of the property as a hard asset as collateral for the loans. 
• As property values increase, homeowners have the opportunity to re-leverage debt by accessing equity (There was a doubling of mortgage debt in the US from 2001 to 2007). 
• Property is not only an inefficient market, but also an inefficient asset class—meaning that you cannot offload pieces of it like you could with an equity portfolio (e.g., you cannot sell off your kitchen, but you could dump an underperforming large cap stock); illiquidity can strand owners in their properties even when it is not a negative equity situation; and the market for the same four walls will be different in different locations (arbitrage?)

Given all of the danger, let’s not get the idea that owning a home is a bad idea, however creating government subsidies and programs to promote “irresponsible” home ownership may not be a good one. The systemic issue seems to be the amount of debt that home buyers are allowed to take on. The Swedish government set a maximum loan to value of 85% last year for mortgage ratio; and that is a step in the right direction.

Whether ending the 30-year mortgage device, or phasing out income tax deductions for mortgage interest, or setting more stringent standards for first-time buyers & family businesses (where all household income is reliant on one business) makes the most sense is hard to say.