Thursday, March 26, 2009

Beware the Herd Behavior of Bulls

Bulls, and other cattle, run around in herds. Participating in herd behavior is risky, because herd animals don't think for themselves. They just follow everyone else. In the stock markets, that meant riding the Dow up to 14,000 and then down to 6,500. The conventional wisdom (read, herd mentality) is that you shouldn't try to time markets. Yet, every contrarian who sold while the Dow was high, or simply stayed out of the market since 1996, outsmarted the herd.

Of course, no one wants to miss out on the market's recovery. That's why the market had such a sharp snapback after the Dow dipped to 6500 a couple of weeks ago. But sharp snapbacks reflect herdlike investing--a lot of people jump in because other people are jumping in. The short sellers add to the buy pressure by covering their shorts whenever they smell a snapback. But if there's one thing that's repeatedly ambushed the herd during the current recession, it's that sharp snapbacks have proven illusory, serving as preludes to new market lows.

That hasn't been for technical reasons. It's that things are bad in the nation's and world's economies. The stock market ultimately reflects the underlying economy. Recently, the government has been putting out positive news about relieving banks of toxic assets, pumping cash into the consumer loan markets, and spending yet more, this time through the federal budget bill. And some recent statistics about durable goods orders and recent home sales haven't been quite as appallingly bad as expected. But you can't have a healthy stock market based on government spending and a couple of very bad, but not horrendous, statistics. If the stock market is to truly recover, the free enterprise part of the free enterprise system has to be doing well. There, however, the news is less glowing.

Commercial real estate is sliding fast, following in the footsteps of residential real estate. This complicates the federal banking regulators' tasks, because commercial real estate loans are a staple of hundreds of medium sized banks. The derivatives-based problems of the major banks could be dealt with through contacts with a handful of formerly very well-paid CEOs. It will take an army of regulatory staff and probably many billions more from taxpayers to cope if the commercial real estate downturn causes banks to collapse.

Trade protectionism is on the rise. Trade barriers of various subtle or not so subtle designs are springing up like dandelions on a well-watered lawn. Things are happening so fast that they may have already slipped out of control. It's unlikely the upcoming G-20 meeting will produce any breakthroughs. In anticipation of the meeting, fingerpointing and recriminations are already in the air. The G-20 meeting is more likely to illuminate differences among the 20 than any unity of policy.

International trade is wilting. Among other things, the Japanese economy's exports have fallen by almost half, compared to a year ago. The Chinese are struggling with millions of newly unemployed, without the unemployment compensation programs that, in the U.S., keep the jobless from becoming immediately desperate. If the major exporters make fewer sales in America and elsewhere, they'll have less money to buy U.S. Treasury debt. Unlike the Federal Reserve, they can't print dollars to fund the Treasury Department's borrowings. If international trade continues to stagnate, we could easily all become poorer.

U.K. Bond Auction Fails. A recent auction of 40-year U.K. government bonds received bids for 93% of the bonds being offered. By contrast, the U.S. Treasury's auctions are routinely oversubscribed. While, by itself, the failure of one U.K. bond auction of a really long term maturity doesn't signal the need to boost one's supplies of freeze-dried food, water and camping equipment, it's rather troubling at a time when government action is the only game in town for reviving the world's major economies. If the U.K. continues to have funding problems, guess who might have to bail it out? (Hint: look in a mirror if you're unsure.) This isn't a theoretical point. The U.S. "loaned" the U.K. an enormous sum of money via the Lend Lease Program during World War II and didn't get repaid. We've bailed out the U.K. in a previous crisis, and it's not inconceivable we might have to do it again.

Cognoscenti skeptical of Geithner's plan. Many, and perhaps most, of the more discerning commentators have expressed concerns about the effectiveness of Secretary Geithner's toxic asset purchase plan. While it's clear that he'll give the ranch away to hedge funds and other institutional investors for participating--which is why they're now signing up--the plan doesn't resolve the devil that's been hidden in the details all along: how do you set the purchase price of the toxic assets? The banks will want the highest price possible, while the private investors will want the lowest price. If the buyers offer too little, the banks may keep the dodgy stuff on their balance sheets, thereby undermining the plan. Banks may resist regulatory pressure to sell at significant losses, since that would require them to recapitalize with current shareholders being diluted. And if the recapitalization is funded by the taxpayers (which is likely to be the case), then executive compensation and a lot of other aspects of banking will be dictated by the government. That's fair from the standpoint of the electorate, but not much to the liking of bankers aspiring to a mansion in the Hamptons.

Put some cash in the market now, if you like. But remember that it could easily become a long term investment if the economic picture follows current trends. Herds can stampede over cliffs if they don't watch where they're going, and there's no certainty that the current rally isn't headed toward thin air. Corporate earnings reports for the first quarter will start coming out next week and the G-20 meeting begins the following weekend. We'll soon know more.

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