November 29, 2007

Institutional Idiots

“Idiot wind; blowing like a circle around my skull----from the Grand Coulee Dam to the Capitol” ---Bob Dylan

There seems to be a powerful “idiot wind” blowing through the world’s Financial Markets these days. While this in itself doesn’t surprise me, I do find it disconcerting that the “idiots” involved with the latest crisis are our most respected institutions.

THE WRITING WAS ON THE WALL

Surely, these “idiots” knew that they were writing and buying-up bad loans (variable rate, interest only, escalating principal, etc.,) attractively but dangerously structured to lure too many individuals who could not possibly afford the rising payments. Yet, with each passing year, the “idiots” were writing and investing in more and more of these types of loans with no apparent concern for the consequences.

As far as private investors were concerned, we all knew that real estate prices couldn’t climb forever. Yet, by the end of 2005, it seemed that almost every person I met was engaged in one of the following: becoming a real estate or mortgage broker, buying land for development or speculating in condominiums. It was obvious to me that something had to give, and that the market had peaked. I began to write and urge caution regarding all of this about 2 years ago when the warning signs became crystal clear to me.

Didn’t the Institutional “Idiots” realize the bubble was about to burst and that when it did, home equity values would sink and there would be no way out? Seemingly oblivious, throwing caution to the wind, they continued to write, buy, slice, dice and repackage these mortgages with impunity. However, as much as I may congratulate myself on a timely call, I know these Institutional guys are smarter than I and that there were other forces at work.       

FEAR AND GREED

Fear and greed---- History has taught us that these two raw and powerful emotional forces are the arch-nemeses of rational thought. In the case at hand, I believe it was fear and greed that completely blinded our (formerly) highly respected Institutions;

Greed in thinking that the mega-profits that were being generated from the sub-prime mortgage market would continue forever; Greed in thinking that Institutions, being Institutions, were above the immutable laws of the markets; Greed in ignoring history ….in ignoring the powerful forces of capitalism that would eventually even out the pricing of a grossly over-valued asset (that had no place in the portfolios of our Institutions in the first place.)

Fear in thinking that each Institution had to essentially “keep up with the Joneses” and stay in the marketplace with an asset they knew was dangerous; Fear that shareholders would balk and put pressure on management if they opted out of the sub-prime marketplace and showed lagging returns.

For private investors, greed can manifest itself in the buying and chasing of fast rising stocks and/or commodities and in refusing to sell off shares to maintain the proper diversification of risk in their portfolios. Fear can manifest itself in the selling off of good, solid companies whose stock prices are down because of a rising tide of negativism and or the cyclical nature of the marketplace.

In other words Fear and Greed lead to irrational behavior.

So, at the end of the day, our Institutions were not truly “idiots,” they were just guilty of abandoning the institutional investment model and succumbing to the all too human model; getting swept up by emotions ….by the greed and fear that can lead to toxic consequences for any of us.
              

AM I TOO BLINDED BY SELF-INTEREST??

One of the hardest things to do, as you all know, is to look into the mirror and evaluate oneself. One of the reasons I was able to step back and opine objectively on the Real Estate debacle, was that I didn’t depend directly on that business for my income. So the natural question that follows is; am I able to provide the same level of objective advice to my clients regarding equity market crises…

The answer to that question is that in my heart of hearts I believe that I can for the following reason:

Similar to the leading investment advisors throughout the country, my practice is not about market timing. It is about assessing risk and finding the right asset allocation formula for each unique client. We all understand that stocks are cyclical in nature and that markets will have some rough periods along with smoother periods. But, ultimately, history has shown that ownership of a diversified blend of solid companies in the form of stocks is the absolute best choice an investor can make for wealth building. Of course, there are tactical short-term portfolio adjustments that will be made periodically, but in general, our strategy doesn’t change when we hit bumpy periods such as the current one.

The current volatility resulted from the sub-prime mortgage crisis and was exacerbated by the intense media pessimism and negativity that all too often accompany correction periods. This is not to ignore the crisis, or claim that it is media created; the current liquidity problem is “as real as rain,” as a teacher of mine used to say. However, my macro point of view is that the forces of Capitalism with the ‘invisible hand’ described by Adam Smith will, ultimately, prevail and markets will recover.

MY ECONOMIC/MARKET PREDICTIONS

After a 4½ year bull market we are due a market correction; healthy corrections occur even in optimistic times. The indications are that the slowdown will be short-lived and the real issue will be inflation.

In order to maintain orderly debt markets (given the still unfolding mortgage mess) and Global liquidity, analysts predict that both the European Central Bankers and the U.S Federal Reserve will lower interest rates and keep pumping money into the system. Cheaper money will ease liquidity problems and help stimulate the economy. However, as soon as the liquidity crisis subsides, the World’s bankers will then have to raise interest rates to prevent inflation…and I expect a cyclical rebound in the U.S. dollar and a drop in oil prices. This should benefit businesses and they will continue to profit from the rise of global capitalism (but may not be all that nice for U.S. consumers.)

At the end of the day----This will all pass and we will move into other phases of the economic cycle. As I previously stated, none of this really matters in the long-term. Owning shares of companies in a properly balanced portfolio is the best way to make money and keep pace with inflation.

LOOKING AHEAD

So, while we are, indeed, experiencing many economic challenges and uncertainties, it is all really 'business as usual' from my standpoint and I firmly believe that you should stick to the game plans that we formulated together.

A risk adjusted, effective asset allocation is the best strategy to reduce the impact of market volatility, insulate you against inflation and maximize potential growth.

Don’t believe in my philosophy? Don’t agree with my predictions or prognosis…Ask the Institutional “Idiots” who created the current crisis what they think…after all they are the big guns…. they are the smart guys…right???

Austin A. Frye, MBA, JD, CFP®

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