Comment of Behavioral Finance

Financial markets depend on people’s decisions and are therefore irrational. This is not an indictment of investors’ cognitive abilities but a simple understanding that people are not machines and do not make decisions like them. The inconvenient consequence of this fact is that no set of mechanical rules can ever either predict the future with precision or fully explain the past and present. Fortunately, we can still provide value to our clients without needing to work in absolutes. Not only can we live in a world of constant imperfect knowledge, but we can be successful without being 100% correct. I do not mean to imply that we should discard all quantitative approaches to finance, rather we need to understand all the possible risks associated with a model and be conservative in how we value the information it produces.

Real or Not?

One note from today’s data on deflation. The headline in the Wall Street Journal says China grew at 6.1% last quarter. That doesn’t sound bad. But what was not in the story is that nominal growth was just 3.7%. The other 2.4% was because of deflation. To get real (after-inflation) growth you subtract inflation and/or add deflation. Growth in China is slowing down more than the headlines suggest.

Since when does real GDP growth count only in an inflationary environment? If economic activity remains constant in a deflationary environment, real GDP should be flat not negative.

Will IDC Determine taxpayer losses under the TARP?

According to a Bloomberg article regarding the Fed’s use of TARP funds, the Fed is using IDC pricing to determine the value of assets it will accept as collateral in exchange for U.S. treasury bonds. Bloomberg is suing the Fed under the Freedom of Information Act however; the Fed is refusing to comply under the theory that diclosing details of the TARP would violate trade secrets with respect the involved banks. The fact that a single firm is determining prices that do not need to be disclosed to the public should set off massive alarm bells throughout the country but fear has so permeated the country that we seem willing to borrow any amount of money from future generations in order to protect our own retirement savings. After all, no one should have to sacrifice the co-pay on their Viagra prescription for their children’s future. If people really believe that government is capable of policing itself, we should shut down all the regulatory agencies and cut the taxes that support their budgets. If not, why don’t they get off their asses and show us a transparent government that uses our taxes to add value to the country rather than destroying it.

Bagehot is (still) dead

Fed Head Ben Bernanke has stated that he agrees with Bagehot in principle but that the high interest rate was only to discourage unnecessary lending that would strain England’s limited resources. Under Bernanke’s theory, the U.S. now has nearly unlimited resources therefore the interest rate should be more reasonable. This argument has several assumptions. First, inflation is not a concern. In dealing with a financial crisis, short term goals are driven by irrational fear leading to poor decisions such as those made by the patron saint of unintended consequences, Alan Greenspan. Inflation should not be the priority but it should be a factor. Second, increasing the national debt is not a concern. We cannot continue to believe that the U.S. will be capable of growing its way out of debt since we are unlikely to be the economic beneficiaries of another few world wars. As a taxpayer watching the baby boomers spending my future social security benefits, no one seems interested in a plan that would not be either the mother of all tax increases or the elimination of social benefits before I reach retirement. Third, if GE and Goldman are willing to pay a 10% dividend on preferred stock with warrants to boot in order to access capital from Berkshire, why should we accept losing money on ANY deal. Even assuming government workers are incapable of securing comparable agreements due to incompetence or the mistaken assumption that businesses need to be incentivized to save their sorry asses, we should at the very least demand that if the government is going to nationalize the financial system, it needs to be more profitable than the system it replaced. Otherwise, what the hell is the point.

A “Loss of Value”

The media keeps harping on how more than $1 trillion in value has been wiped out by the market over the past week. While prices are cheaper, the market neither creates nor detroys value. For those skeptics out there, consider the marginal analysis. As numberous academics and practicioners have written, stocks follow what is descibed as Brownian motion in the near term. This means that each tick up, down, or constant can best be described as random and only in the longer term does the general direction of price movements become apparent. Should the marginal tick which is best described as random be credited with creating or destroying value? No. Companies create value through good management of resources. The stock market has nothing to do with value creation. The market is a mechanism for price discovery.