When Uncertainty Is King of the Market, How Should Its Subjects Cope?

This is a time that is particularly conducive to impulsive or instinctive behavior. It is a time that behavioral economists love because it proves their case about irrational human behavior. People react and they react on the basis of a gut feeling or a snap judgment.

These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book Snap Judgment - see my post that reviews this book.) Yet we humans, individually and collectively, continue to perform in this way.

Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” WSJ ) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?

Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.

So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.

When the economic indicators seem strong, the price of oil goes up, as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.

This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.

This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.

The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.

But this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.

The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.

Furthermore, remember that, on average, the expected returns on trading are zero, and there are still fees that need to be paid. But using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.

As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.

It is also important that an investor should stay in the areas of the market that he or she knows best. If your skills lend themselves to the technology sector of the stock market, then stay there. If your skills are in the government bond market, then stay there. If your skills are in the foreign exchange market, then stay there. Again, discipline and focus are all important.

Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea,” then beware, for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve, but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.

Comments

[Larry House:]

Good adivce, John. Thanks.

Jul 09 02:23 PM

[Ricard:]

Very nice article.

"Furthermore, remember that, on average, the expected returns on trading are zero, and there are still fees that need to be paid. But using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities."

I interpret this as 'maintain discipline by controlling your vices.' Good advice.


"Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. "

I'd argue that uncertainty never came or left, but has always been with us. To those who think uncertainty has paid a house call Sep 09, it was probably a very rude call indeed. On the flip side, if stocks do climb significantly in the next 10 years, uncertainty would still be with us - it would just be a matter of whether or not you choose to ignore the elephant in every investor's living room. Always keeping an eye on the certainty of uncertainty would make it easier to sell at peaks and buy at dips, IMHO.

Jul 09 02:32 PM

[Mad Hedge F...:]

Who's uncertain? ) CNBC held a dynamite interview with David Rosenberg, former Merrill Lynch chief economist and current strategist at Gluskin Sheff, who offered the kind of big picture, 30,000 foot view that I love. We are well into an epic post bubble credit collapse. Deleveraging in the private sector is dramatically overwhelming any fiscal stimulus Obama can throw at it. The $50 trillion US household balance sheet is shrinking at an unprecedented rate. The unemployment rate will easily sail through 10.8% to a new high and spill over to a higher foreclosure rate. We’ve had two decades of baby boomers living beyond their means, and it is now time to revert to the mean. The stock market has already priced in an earnings recovery which we won’t see until 2012 at the earliest. Bull markets move in perfect 18 year cycles, and we are only half way through a generational washout in equity ownership that started in 2000. “Buy and Hold” is dead. An S&P 500 trading around a 13 multiple means will be stuck in a 650-950 range for years, and that’s being generous. Rent, don’t own stocks. The one place to be is commodities, because they will be underpinned by the undeniable demand coming from Asia, and have benefited greatly from consolidation. The big “Tell” here is that in last year’s huge sell off , they all bottomed at the previous cycle’s peak prices. It’s nice to hear someone reading from the same sheet of music as I. Too bad Merrill Lynch didn’t listen to David. Wow, do you think I should be selling rallies here at 886?

Jul 09 03:43 PM

[Jason Rines...:]

Hmmm. The article did not contain any particular advise so I will give you some. First, I am out of the market totally and made this decision in March. I like or should I say liked bonds. I advise to wait until this fall which will be a continued bloodbath in equities and consider 5 year buy and hold. Defensive positions such as Healthcare, specifically pharmaceuticals. Growth in IT, specifically companies that can create efficiencies and/or automations to cut labor costs. I would go company specific diligence rather then index investing. Cash is always king but especially so in a depression. Management of each company your looking at is also key. I don't like the government trade in banking but do like government trade in Higher Ed, Health and Energy. For that, you must also learn to conduct lots of diligence into legislation. I bet 1% of the entire population will read the 1,000+ page behemoths coming out that tell an investor exactly where government will trade and whom will benefit. That gives you 1% a massive advantage.

For disclose, my decision to exit the market was because I choose to spend my time on my early stage businesses in IT and Consumer Healthcare marketing (and reentering Higher Ed later this year) which were established some years ago. More opportunity to grit teeth to grow revenue for 5 years and liquidations events then what my return could be in bonds or stocks. If I had all day I would learn to become a day trader.

Jul 09 03:53 PM