Fearing Fear Itself

A Market Correction is upon us. As even a cursory look at a longer term chart will indicate, indices do not go for very long in a straight line. So here we are, carving out yet another “tooth” in the saw-like track that would be the Market over the past year-plus. As of a month ago, stocks had in about a year delivered what would be a decent return for five years. The path of least resistance no longer pointed upward, and so an interlude of back and fill has commenced.

Share prices are exemplifying what I take to be a larger drama: an ongoing divergence between the objective consideration of peril, and its subjective manifestation we understand in terms like “scary”. It seems that even though the world in many respects has become a less dangerous place (in terms of objective likelihood of being done in by disease, famine, war, crime or poverty as it was understood before it became a political construct) it has at the same time become a scarier place. We see it in the prescription counts for psychotropic drugs, one indicator among many of a raging epidemic of unhappiness despite what by the reckoning of our predecessors has been an unimaginable rise in standards of living. The world is in many respects safer than it has ever been, and yet we are more aware than ever of what remains of its not inconsiderable dangers. Even a couple of decades ago, we rarely if ever heard about mass murderers, floods or tornados more than a few miles from wherever we lived. Now all manner of tragedy, strife and absurdity comes at us like the electronic equivalent of a fire hose. It is as if such media has become a vast system for scouring out the fetid crevices of a fallen world and then pumping the most titillating of it into our living rooms and offices. Considering all that 6.7B humans and a what seems at times like an angry planet are capable of, how surprised should we be that our newfound awareness has made the world seem a lot scarier?

Naturally, this disconnect between objectively understood risks and subjective reactions that work themselves out in fear and greed plays out in financial markets. We needed a correction and so we are getting a correction. It is being helped along by fears centered on the goings-on in Europe (It sure isn’t the recovery of Corporate America that is freaking people out!). I have tended to diminish the import of the purported crises at the root of these fears, which after all involve a handful of tiny states that have been dysfunctional for longer than anyone can remember. It did not fail to occur to me, though, that the Crisis du Jour might be about something even larger than a non-issue like “Omigosh, Greece is even more dysfunctional than Italy! Who knew? (It least Italy, for all its flaws, has some centers of innovative excellence. Greece has nothing.)" It seems that maybe all those misgivings of a decade or so ago about launching a unified currency and then implementing the unified political structure (wherein such a currency might actually be sustainable) just might be coming home to roost. The uncertainty that seems to have triggered so much selling just might have a basis in the crack-up of yet another utopian scheme hitting the skids.

So, how awful would that be, really? If the more grown-up nations went there own way and left the perpetual adolescents to that form of tough love that is being left to their own devices, how would that hurt the global economy, once the dust has settled? Tourists would get nicked by the forex sharpies a little more often, a lot of signage would have to be changed, and the vending machine industry might get a wave of retrofit work (though card based currency has certainly taken the edge off that), but otherwise, what’s the problem? The Euro was a presumed triumph of the will to subsume a plethora of viscerally held identities into a utopian scheme of command and control. Calling to mind that which is said to pave the road to Hell, its impetus was no doubt rooted in ideals. But however much the initial impulse might have been the desire bring an end to the lethal xenophobias whose out-workings have defined the history of Europe, that is getting to be a long time ago. With the passage of the generation that can actually remember the wars, and the establishment of comfortable sinecures within the fortress that is Brussels, the impetus has most certainly evolved. In the 21st Century, we are supposed to believe that the ministrations of an elite nomenklatura can somehow render Europe into something more than a geographic designation. As Mr. George Will recently put it, “ The European Union has a flag no one salutes, an anthem no one sings, a president no one can name, a parliament (in Strasbourg) no one other than its members wants to have power (which must subtract from the powers of national legislatures), a capital (Brussels) of coagulated bureaucracy no one admires or controls, a currency that presupposes what neither does nor should nor soon will exist (a European central government), and rules of fiscal behavior that no member has been penalized for ignoring.”

It would seem that the Euro, indeed the whole European Union, is shaping up to be not much more than a conceit of continent’s political class. As I compare & contrast that sprawling and diverse patch of ground with the United States of America, it seems ludicrous that such a project should succeed. We are also vast and diverse, with differences that play out regionally (e.g., what barbeque is best?). We have our wounds from past struggles. However, these differences pale in comparison to what in many cases is a tribal rootedness going back a dozen centuries or more. We have a common language (is there anything that that makes neighbors into “others” more so than that they carry on using a language we do not understand?). We also have a Constitution which has proven to be exactly that, something durable enough to define us through some mighty tough tests. Europe is more like what twenty years ago we call Yugoslavia than anyone wants to admit (To the extent religion defined the quickly forgotten genocide that denoted that redrawing of borders, it was scarcely about doctrines or dogmas, but rather an element of cultural affect denoting “us” versus “them”.) I don’t see Europeans going at each others throats anytime soon, but I don’t see Greeks and Germans living in the same house, so to speak, either.

So perhaps there is substance behind the fear that has triggered so much selling, the beginning of a reordering of a decrepit yet significant economic bloc. Still, its seems quite farfetched to arrive at a genuinely dire outcome, except from the perspective of the more profligate states (Based on economic vitality, why should the standard of living in a place like Portugal or Greece be more in line with Germany or France than with Botswana or Bhutan?) Those places could be in for some rough sledding, and with that we should expect that cousin of unintended consequences that is unforeseen developments. The flight to safety ensues, but don’t be surprised if its duration is determined less by facts on the ground than by prices doing all they are going to do in that direction, and the “keepers of the cue cards” recognizing that the path of least resistance is ready to go the other way.

When President Roosevelt tried to encourage our ancestors by claiming that they had nothing to fear but fear itself, he wasn’t exactly telling the truth. There is objective danger in the world that warrants fear. He was cautioning against letting a natural emotion feed on itself until it rendered us incapable of responding to and overcoming the dangers at hand. In our hyperaware, hyper-connected world, and especially where those putative signals we call prices can be moved with a mouse click, we do well to remember that the crowd is full of players who are fearful that others might become even more fearful. At times like this moment, the most fearful are the ones who are at the margin setting prices. But we also have taken stock of a certain orderliness to the universe, and can rest assured that the extreme conditions thus rendered will in fairly short order be finding their way toward some opposite extremity.

ShakeNBreak

What passes for a Market correction these days seems to be upon us. Whether it breaches the traditionally understood threshold of -10% remains to be seen, but at the very least the Bull spirits are taking a breather in the same way we saw this past June and January. The breakneck rise of recent weeks was unsettling (as in, that nagging voice we might call the unreality fairy, urging us to trim some while the giddiness lasts). More recently, volatility is cutting the other way. As usual, the world of commerce really hasn’t changed that much, but the seeming keepers of the cue cards have shifted our focus. Is Spain really any more of a train wreck this week than it was last week, or even a decade ago (or even a century ago, for crying out loud?) If we woke up tomorrow and the variously arrayed rock piles and sheep pens that is Greece had disappeared into the Aegean Sea, would there be a noticeable impact on the world economy, other than an end to that flow of remittances from east coast of the US? (One suspects that all the Greek owned restaurants in the US going out of business on the same Friday night would have a bigger impact on our economy.) “Contagion” seems to be paralyzing would-be investors at the margin, not that we should be surprised. After all, it was not much more than a year ago that we got a scarifying dose of contagion, a day after day kick-in-the-nuts leaving psychic bruises that will be tender for some time to come.

The outsized volatility of recent weeks has gotten me thinking about why it seems to be getting more so as time goes by. (By volatility, I mean the tendency of share prices to vary days at a time more than the intrinsic value of the underlying enterprises change years at a time.) Years ago, as the “Information Age” was dawning and academicians were framing out various notions of market efficiency, it seemed plausible that that as information flow became cheaper and “fundamental” data more accessible, “soft” market efficiency would serve to dampen volatility. Despite the cost reductions and ubiquity of such information far exceeding our decades ago expectations, the opposite seems to have occurred. A feel for, if not understanding of, Price Reality (fear & greed, money flows, sponsorship) seem to count for more and more. An approach based on Commercial reality (being able to assess the intrinsic value of an enterprise and purchasing shares at a discount adequate to compensate one for the attendant risks) seems more than ever to require an ability to avert one’s gaze. This phenomenon is akin to idea that ubiquitous information has made the world much scarier irrespective of whether it is any more dangerous than it was six, sixty or six hundred years ago. We are freaking ourselves out, and not surprisingly, there are those who are well positioned to take advantage of it.

For much of April, share price volatility tended to make me feel full of myself, as many of my holdings were delivering in a couple of weeks what I had hoped for over the next few years. More recently, that same volatility has driven me distraction, as in seeking out things to do so I won’t have to think about how much net worth evaporated that day. It’s tempting to lament how this symptom of societal credulity gets under one’s skin, but such would not be the healthiest of responses. A better response would be to recognize that as long as technology keeps making it easier for clever factions to manipulate various others, volatility is going to tend higher and not lower. As investors, this means going either grizzly bear or hedge-hog. The grizzly, or alpha predator if you will, has been endowed with the best equipment to do what he does, and goes about it with remorseless focus. It has been a great time to be a grizzly, but those of us who are not equipped to be grizzlies (by virtue of knack, experience and affiliation with resources) will get our asses handed to us if we go out and pretend to be one. Better to be a hedge-hog, to recognize one’s limitations but attune oneself to one’s surroundings and be opportunistic. Volatility can also be the friend of the scavenger.

Just as political factions can be expected to use the Infotainment deluge to stir up the rabble in unrelenting clamor to “Do Something!” about hob goblins du jour, we should understand that the volatility rendered by nearly instant dissemination of dubious information serves the purposes of various factions within the financial world.

The most obvious, from where I sit, is the patient, flexible (lifestyle is not riding on near term results) value investor. As much as it pains us if we let it, volatility is our friend. What we lived in the months leading up to March 2009 (or many of the past few days) would make us think otherwise, but whatever stocks we bought in the months approximating that dark hour should prompt us to embrace it. Here, the truly part time investor, the one who can stay on top of it with a few hours of work each week and then not even think about daily fluctuations, would seem to be at an advantage. The way volatility has evolved in recent years has strengthened my confidence that even though “low single digit” might be the best assumption for the long term rate of return for the indices going forward, an astute and patient value investor can probably generate a “high single, low double” rate of return. Emphasis on a portion of that return coming from growable dividend income, the discipline to wait for the Market to be in puke mode before buying, and to make sure one has buying power and stomach when such inevitable interludes arise are the keys.

Not surprisingly, volatility is also the friend of anyone who occupies an advantageous position in what we call “trading”. This has come to include not only hedge funds (who might not hedge much of anything, ever) but mammoth pools of capital we for some reason call “banks”. Trading would be a pretty lame business, like operating a tofu stand on the shoulder of the Interstate, if prices rarely if ever bopped around way out of step with intrinsic value. The casinos we call banks might blame volatility for their recent near death experiences, but that was just volatility that got a little out of hand for a few weeks. That “banks” have recovered so dramatically has less than nothing to do with their traditional role in that arcane activity that was lending, and everything to do with betting cost-next-to-nothing funds on the most volatile wagers they could find. The posturing, the well timed indictments, the slap on the wrist fines for abetting naked short selling will go on, but be assured that any regulation that might tamp down the volatility that the smart guys running the casinos have been feasting on will be smothered in its cradle by this faction.

It has also occurred to me that many if not most of the companies whose share prices get whacked out from time to time are also well served by exorbitant volatility. This is an outgrowth of what stock options have evolved into over the past twenty years: a non-cash form or compensation that in many cases “wags the dog”. Consider how important stock options have become. It’s not just important the buccaneers who have finagled themselves into where they get their names in the proxy statements. Its all those engineers and middle managers for whom a stock option grant or two is an important part of smoothing the bumps on the ride that is a working life. The ubiquity of this form of compensation got me thinking about what it means for share prices relative to intrinsic value. Its not a calculation lifted from the footnotes. There is an ideal pattern of share price over time, and it is not in synch with intrinsic value. Ideally, for the point of view of a company that compensates its important employees with option grants, the share price will be undervalued most of the time. It will become especially so every once in a while, at which time more grants than usual are made. It really only trade up to intrinsic value and then some for a couple of quarters, once or twice in a decade, at which time options are exercised, stock sold and the cycle repeats. Options for a stock that hardly fluctuates over time are less valuable to managers and employees than options tied to shares that get stupid from time to time, especially if the principal owners of those options can have a hand in affecting the perceptions that drive volatility. So as long as volatility is the friend of option based compensation, we should not expect those corporations whose share prices are occasionally “victimized” by volatility to lobby for policies that might tone things down.

Selling in May and Going Away is starting to seem like a good idea, but only in the marginal sense of raising buying power for the future by trimming marginal holdings. As much as the past week plus has made us want to reach for the barf bag, it is still very early in a longer term Bull Market.