Seeking Alpha

Nathaniel Crawford's  Instablog

Nathaniel Crawford
Send Message
View Nathaniel Crawford's Instablogs on:
  • Voltaire, The Market and the Danger of Optimism

     

    In Voltaire’s Candide, Dr. Pangloss is a tutor to an aristocratic family where he teaches his pupil Candide “all is for the best in the best of all possible worlds.” Pangloss is the perennial optimist, who always has a positive outlook on life, no matter what tragedy may befall him or society. He can even see the benefit of New World syphilis (which he contracts), saying that it was really a good thing since had Columbus not discovered America, we would never have had the pleasure of chocolate! Throughout the novel, Dr. Pangloss suffers many hardships, which includes nearly being hanged by the Inquisition after the Lisbon earthquake. However, this never deters him from boundless optimism. 
     
    Voltaire’s work prompts me to ponder about the unswerving optimism these days, which is expressed by assorted pundits and gurus of the stock market about the dangers of this false optimism on society. It seems that in America we suffer from a panglossian attitude toward life, the economy, and especially the stock market. We naively believe that the all is well and that the future will be better than the past. We elect politicians who craft simplistic slogans like “change” and “hope.” No doubt optimism can be a positive emotion, but for investors it can be a dangerous proposition.    
     
               Let’s go back to the summer of 2007 when the sub-prime crisis began and the securitization market shut down. At this time, everyone knew that the housing market was in decline and that it would have a ripple effect on the US economy and the stock market. You would think that the market would have started to decline as investors worried about the future. Your logic would be correct, but you would have lost money as the stock market went on to hit new highs by October with the Dow surpassing 14,000 for the first time. Why were investors optimistic? At the time, the argument was circulating that subprime was “contained” and would not impact the larger economy. It was not just investors who believed this; Fed Chairman Ben Bernanke and Tresury Secretary Hank Paulson both subscribed to this theory and went around giving speeches propagating this myth. The only skeptics of the “goldilocks theory” were a few hedge fund managers like Hugh Hendry of Eclectica. who predicted that the economy was in real peril. However, they were easily dismissed as “doomsayers” and “perma-bears,” who were irresponsible and wrong.
               
               As we transitioned into 2008, market conditions continued to deteriorate as the housing correction affected other industries such as financial institutions and consumer companies. In March, Bear Stearns collapsed but was rescued by the Federal Reserve, which organized a shotgun marriage between JP Morgan and Bear Stearns. For a while, investors were unnerved, but they were quickly brought back into the optimist club by pundits (Jim Cramer) and politicians (Paulson) who boldly proclaimed that this was the bottom; the economy would swiftly rebound in the second half of 2008, even though facts like job losses, falling home prices, troubled banks indicated the opposite. This false optimism fueled investor appetite for cyclical and commodity related stocks. The euphoria grew as oil topped $140 on the belief that global demand was strong and that the US economy would have strong growth in late 2008. Even the nationalization of Fannie Mae and Freddie Mac could not dampen investor enthusiasm. Every time the government intervened, markets soared as investors brushed aside warning clouds and instead looked to the future for optimism and hope. Not until the collapse of Lehman Brothers and AIG did the market finally come to the realization that all was not well with the economy. In early October, the market began to crash as investors woke up to the fact that the economy was suffering a serious crisis.
     
             The events of 2007 and 2008 have proven that investors need to remain skeptical of this false optimism, which dominates our society. To be a successful investor you need to imagine what could go wrong, as opposed to what could go right. Listening to politicians, economists, and pundits will not benefit your portfolio. They will always tell you things are fine and that it is a good time to be investing your money. These people preach the same gospel of Dr. Pangloss in Candide. They lure you into a false sense of security and leave you vulnerable. We see this pattern emerging once again in 2009 with the concept of “green shoots,” a slogan which is repeated endlessly by the media and politicians. President Obama and Treasury secretary Geithner are predicting that the economy will recover by early 2010. Professional money managers appear on TV to tell people that this is the time to buy stocks because the market always reacts before the economy improves. They postulate that if you don’t get in now, you are going to regret it. Does anyone see similar parallels to 2007 and 2008?
     
             If you buy into the “green shoots” thesis and think it is a good time to buy stocks, I would advise you to keep an eye out for possible events that could derail your hopes. Eastern Europe countries like Latvia are on the verge of economic collapse, thanks to years of irresponsible borrowing (mainly in foreign currencies like the Euro and Swiss Franc). They are faced with mounting liabilities, contracting economies, and a world recession. So far, the problems have been subdued by loans and aid from the IMF, but this could change at any time. If one of the Eastern European countries were to collapse or suffer a currency devaluation, it could have ripple effects similar to the debacle of the Asian financial crisis in 1997-1998. Many western European banks, especially in Austria and Sweden, have large exposure to these markets, which could lead to another leg down in the world economy. 
     
            Another situation that begs investor attention is the fiscal problem plaguing California and other states and municipalities. All it takes is a default from California to trigger investor uncertainty and panic in the municipal bond market, which could lead to another credit crunch as investors refuse to purchase state issued bonds. This would make it very hard for states to fund their activities and could well lead to a federal government bailout for the states.
     
            I don’t write any of this to alarm anyone but to inform people of the possible risks facing the stock market and the world economy. It is a good time to “stress test” your own portfolios for these possibilities and any others you can think of. I am tired of the never-ending optimism that has ruined so many 401Ks over the last two years. This panglossian attitude is also detrimental to our economy as politicians and economic planners (Federal Reserve) ignore potential problems by issuing useless platitudes such as the “economy is fundamentally strong.” Looking ahead for possible dangers is not being a doomsayer; it is a realistic way of protecting your portfolio. Be wary of the green shoots if there is no basis for them. I remember the end of Voltaire’s Candide, which was neither panglossian nor pessimistic. After a life full of hardships and catastrophes, Candide and his friends retire to a country farm to take responsibility for their own affairs. They “cultivated their own garden” and let the rest of the world go by. For investors, I would recommend a healthy skepticism about the green shoot theory and a pragmatic attitude about potential challenges ahead. Cultivate your own viewpoint based upon facts, and don’t rely on the experts and their propaganda.
     
     
     
     
     
     
     
     
     
     
    Jul 03 8:52 PM | Link | 1 Comment
Full index of posts »
Latest Followers

StockTalks

  • buying kewl as an cheap play on the housing market. it is a undervalued timber company
    Feb 1, 2013
  • buying more KEwl as a bet on rising timber prices
    Nov 30, 2012
  • finally KEWL is starting to move up
    Nov 8, 2012
More »

Latest Comments


Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.