September 2007

September 21, 2007 1:45 p.m. Today’s Confusing Markets Already Explained

Investors and analysts have been confused by many of the market developments of the last couple of years. They are easily explained, and the explanations are in my recent book, Invest Like a Fox…Not Like a Hedgehog.

Conventional economic theory misses a few critical elements of the way markets really work. I explore these in the book and use them to explain how these “strange” market activities occur. Here are some key points from the book:

While investors try to be rational, they are not always right. They make mistakes, and those mistakes result in misevaluations in the markets.

Investors are wrong because they cannot know the true meaning of economic events and data. Instead, they interpret the news and try to determine the value of assets based on the interpretations.

Investors can collectively be wrong as many of them adopt the same view.

Because beliefs tend to persist once they are widespread, it can take a while for markets to react to new information. There are lags in behavior changes, and it is hard to know how long those lags are. The lags also explain why consumers keep spending, though their home equity is stagnant or shrinking.

Investments that seem to be uncorrelated can become correlated just when an investor needs the diversification in the portfolio to be effective.

Most importantly, factors outside a market or even the economy can affect prices in that market. That is because investors use multiple sources of information and can make mistakes in interpreting that information. They are not the perfectly rational, all-knowing beings imagined in modern investment theory.

These and other points explain how bond yield spreads could shrink to such low levels for an extended period, how problems in the mortgage market can affect credit for other borrowers, and how those events can affect prices of seemingly unrelated investments.

Many followers of traditional economic theory were hurt badly by recent economic events, especially those using quantitative investment models that assume stable relationships in the markets. Those who follow our valuation cycle and invest with a margin of safety are set for steady, solid long-term returns and avoid the wildest swings of the markets. We set our Managed Portfolios in Retirement Watch to invest according to this approach. In the October issue, posted on the web site for members only, we make some portfolio adjustments to adapt to the latest changes in the markets.

September 21, 2007 1:35 p.m. Will the Fed Regret the Rate Cut?

Stock investors enthusiastically greeted the half-point cut in the Federal Funds rate on Tuesday. There even was a strong follow-through on Wednesday, which has not often happened the day after strong rallies this year. The belief seemed to be that the rate cut would loosen the credit markets, avert a recession, and put the economy back on the growth track.

I suspect, however, that the Fed and stock investors will come to regret the rate cut as a short-term palliative with negative long-term consequences.

The recent problems have not been high interest rates or lack of cash. Borrowers have been willing to borrow, but lenders have not been willing to lend. The hesitancy was caused by uncertainty over prices, values, marketability, and the long-term consequences of the housing downturn and other events. I think the wiser course would have been to continue to use other tools (as the Fed has) and let the markets continue their correction and adjustment process. Investors clearly were under-pricing risk the last couple of years and needed to begin re-introducing risk into their models.

Higher inflation could be triggered by the Fed’s latest move, and that could cause larger longer-term problems than the recent credit market crisis. I have not been worried about inflation the last few years. I believed the Fed was working to contain that risk and that most of the price increases in gold and other commodities were due to economic growth and greater wealth, rather than excess money. But the dollar has been falling this year. Productivity also has been improving at a slower rate and perhaps has seen its best days, making it hard for businesses to absorb cost increases by increasing productivity.

The reaction to the rate cut indicates that higher inflation is a real possibility. Gold, oil, and other commodities surged following the rate cut. Long-term interest rates also rose, a clear market forecast of higher economic growth and inflation. The dollar also fell, another sign investors expect higher inflation.

There also is a risk that the rate cut reinvigorates the aggressive risk-taking and use of leverage that began after 2003. We maintained that many of the valuations of the last few years were unsustainable, caused by excess liquidity and coverage. The rate cut raises the possibility that people will resume paying high prices for assets because low interest rates make it possible and because they believe the Fed has taken the risk of a recession out of the equation.

We cannot forecast how long stock investors will react positively to the rate cut and wait to learn whether inflation will become a problem. We will continue to invest with a margin of safety. New investment recommendations are in the October issue, which is posted on the web site. These should profit from a continuing rally and offer protection in a downturn.