The Evident Folly Of The Pseudo-Rational Marketplace

Includes: EU, SPY, TLT
by: Katy Delay

The recent Cyprus debacle was fascinating to watch as it unfolded. Today, a "solution" seems to have been found by the players, who are the European Union, the European Central Bank, the International Monetary Fund, and Cyprus's political and banking representatives. This "solution" entails the wiping out of bondholders at the island's biggest bank and a minimum 30% haircut for the largest depositors (the figure is probably low), while forcing the closure of bank number two.

Rather than comment about the remarkable gymnastics performed by the politicians and technocrats who negotiated the outcome (for an excellent article touching on this, read Holman W. Jenkins, Jr.'s piece in Saturday's Wall Street Journal), and without mentioning the horrifically unfair effect upon those poor Cypriots who did nothing to deserve this pain, let me turn my focus onto a third factor of this saga: the apparent passivity of the people who invested large sums of money in Cypriot banks.

The press had been pointing to Cyprus's problems for several months now (Examples: "Could Cyprus Bring Down the Euro Zone?" from January 11, 2013, and "Rifts Over Cyprus Bailout Feed Broader Fears" from January 24, 2013). How do we explain that people who were smart enough to amass disposable incomes over 100,000 euros were stupid enough to ignore the warnings and keep such large accounts on this precarious island?

After mulling over this question, I have come up with only a few tentative hypotheses:

1. Cyprus's largest investors were too busy enjoying life to notice, because most of them are Russian oligarchs who spend lots of their time dallying between luxury resorts on the French Riviera, and too little reading the newspapers.

2. The deposits are too small to worry about, representing only an insignificant proportion of their owners' diversified wealth.

3. No safer investment alternatives exist.

4. The investors made the assumption that the IMB, EU, and ECB would bail out the banks without conditions, due to Cyprus's relatively small size yet its symbolic significance for the maintenance of the Union.

5. Investors tried to move their funds, but the Cypriot bankers and/or politicians wouldn't let them.

I can think of no more possibilities, and none of the above explanations really satisfies me. After all, even gangsters read the papers, hate to lose even small quantities of money, find good places to stash it, and have the sense not to trust politicians and bureaucrats.

So must we therefore assume that the market is not as rational as we assume it to be?

I fear the answer is yes. From my observations, the market is made up of one part relatively rational retail investors such as you and I, and one part wild-eyed crazy gamblers who think they can profit more than others over the long run by taking big short-term risks and timing economic and financial events.

Therefore, my advice to you:

- Do not believe that markets are always rational and that they will always show warning signs of impending events; they may be efficient (i.e. they will eat up all your wealth very efficiently), but they are definitely going to act very irrationally during times like these.

- Do not assume that your money and investments are safe because someone in a position of authority says so, or because your favorite index is at a record high.

- Keep your eyes open to see what's going on around you.

- Read the papers.

- Don't believe those who say, "It can't happen here."

- Don't blindly trust your bank, your politicians, your bureaucrats, or anyone else trying to give you investment advice.

- Keep some cash - or even better, something of widely accepted, intrinsic value like small gold coins - in a very safe and handy place.

- Think "preservation of capital" rather than profit during these unstable times, and don't try to make a quick extra buck by timing the markets.

- Invest disposable wealth with caution, reason, and--above all--basic common sense.

What does this mean specifically? I am not an investment advisor, so I will limit my thoughts to the following:

First, whether you are invested in the U.S. stock market, inflation-indexed U.S. treasury bonds, the more reliable foreign stocks and bonds, commodities, or real estate investments, be sure that you're at least solidly hedged with gold in one way or another. The degree to which you hedge with gold is a personal decision, but a vital one.

Secondly, some clear thinkers believe we are headed for a U.S. bond/dollar crisis if and when inflation starts up, at which point the Fed will emit signals of distress, given that unemployment most likely will not have attained the benchmark of 6.5%. (Read Seth Lipsky's piece about the Fed's mandate and Congressional efforts to address this institutional weakness.) The stock and bond markets will react accordingly. (Regarding inflation, I have had to pay a 30% mark-up on my travel this year as compared to last. Is this an omen of things to come?)

Third, surely Treasuries cannot get any higher in price, or lower in interest, and are not attractive at this point. They're in a bubble of sorts. At worst, they will pop; or at best they will straggle along for years.

As for the rest, stay nimble and alert.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long gold stocks.

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