I just returned from back-to-back conferences featuring some of the brightest minds in the investment industry. The Strategic Investment Conference, May 2-5, was followed by the 65th annual Conference of the CFA Institute May 6-9.
At the CFA Conference, Daniel Kahneman delivered a talk he called “Psychology for Behavioral Finance” in which he attempted to explain how the human brain operates and why it can lead us into making bad investment decisions. He said the functions of our brains are divided into two systems: “System 1” is intuitive and automatic… it’s always “on” but not necessarily accurate. “System 2” kicks in when the need to be more accurate demands effort. System 1 can handle a simple arithmetic problem like adding 2+2. Multiplying 24 X 17 requires System 2. The problem is that humans can be a little lazy. We tend to let System 1 handle as much as possible and we’re not always aware when a situation requires more effort. Stopping your car when you see a red light is pretty much a System 1 task… but texting and driving… now THAT’S definitely a System 2 function! (I don’t condone texting and driving but you get the point).
The System 1 part of our brain can hear one word and automatically prepare itself to hear other words associated with that word. He called this the “priming” effect. If you hear the word “black,” your brain may automatically be primed to hear the word “white.” When you see the yellow traffic light, you automatically know a red light is soon to follow.
But System 1 can mislead you. When your brain is on auto-pilot (which it tends to be when you are watching CNBC), you can hear words that you “associate” with other words. You might associate the word “Booyah” with a good investment opportunity. This can lead to misunderstandings.
To illustrate, Mr. Kahneman told the story of being at a party with his wife. At the party, his wife pointed across the room to another man and referred to him as being “sexy.” She followed that with the phrase “He undressed the maid himself,” which wasn’t any kind of statement Mr. Kahneman would have expected to hear from his wife. Not only was it an odd piece of information but, more importantly, he wondered how his wife came to possess such information?
What she actually said was, “He underestimates himself” but, because her phrase was preceded with the word “sexy,” Mr. Kahneman’s brain associated her statement with the word “sexy.” The word “sexy” primed his brain to hear any subsequent phrase differently than he would have otherwise.
Another behavior that Mr. Kahneman described is called “anchoring.” Anchoring causes us to rely too heavily on one piece of information when making a decision… sometimes a piece of information that should not even be a part of the decision making process. Investors are frequently guilty of this, and anchoring can lead to bad investment decisions. The decision to sell a stock should be based ONLY upon your expectations of the future performance of that stock. Many investors, however, take into account the price they paid for the stock. Tax considerations aside, what you paid for a stock should have nothing to do with the decision to sell. Even though you might think a stock trading for $50 is going to decline, the fact that you paid $70 for the stock may prevent you from selling. You are “anchored” to that $70 price and feel you deserve more than $50 when you sell.
I’ve heard this frequently for the past four years when people contemplate selling their house. I’m sure you have heard at least one person say, “I can’t sell it because I will take a loss on it.” And a year later the loss has increased. The price you paid for the house should not influence your decision to sell your house.
____________________
As I think about some of the conclusions I made from attending both conferences, I am reminded of an old joke… Why did God invent economists? Answer: To make meteorologists feel better about themselves.
Having said that, here are my key takeaways from both conferences:
In the United States we will not see higher interest rates or significant inflation any time soon… probably not for a couple of years. I know, I know… not a day goes by that I don’t get email from clients and/or colleagues warning me that the actions of Ben Bernanke and the Fed have destroyed our monetary system. I’m constantly reminded that we are on the path to Financial Armageddon. If that is true, then I must confess that the path to Financial Armageddon is a rather vague and long and winding path. I’ve been hearing this for years and… so far… there’s not even a glimpse of it.
On the contrary, most of the minds at both conferences think we are more likely to see DEFLATION and lower interest rates in the near term. One economist, who has been correctly predicting lower interest rates for the past several years, thinks we will see the 30-year Treasury bond trade at 2%. As I am writing this, the 30-year Treasury bond just dipped below 3%. And he added that, if he ever saw the 30-year Treasury at 2%, he would start buying equities.
How can printing billions of dollars not lead to inflation and higher interest rates? Maybe eventually it will… but in a global deleveraging cycle, there isn’t the level of consumer spending we normally get in an economic recovery. We are in the third year of this “recovery,” and spending growth is not even close to what it has been in previous recoveries. In addition, the Federal Reserve is paying interest on reserve funds sitting in the banks. Therefore the banks have less incentive to make loans. They are getting paid interest from the Fed without making loans! So, if the banks don’t have incentive to lend and consumers are paying down debt instead of spending, we don’t get the level of inflation we would normally expect.
I’m not saying we aren’t going to see inflation (and maybe even hyper-inflation). I’m explaining why we don’t have it now, and why a few intelligent people think we aren’t going to see it any time soon.
There still remains a glut of homes in foreclosure and homes yet to be foreclosed upon. The supply of homes will continue to exceed the demand for homes until a robust home rental market develops. As more homes in the “for sale” pipeline are converted to rentals, the demand/supply ratio will improve.
What about the dollar? Why hasn’t it lost value? If we print hundreds of billions of dollars, doesn’t that make the dollar worth less… and less… and less? Remember, the value of the dollar is a “relative” issue. The dollar’s value is “relative” to other currencies. And the United States is not the only monetary union printing a lot of paper. More than once at both conferences, I heard the dollar being referred to as the nicest house in an ugly neighborhood. One speaker said, “In the land of the blind, the one-eyed man is king.” I don’t know that I want to be a one-eyed man, but being king doesn’t sound so bad.
No matter how much paper the Fed seems to print, the appetite for the dollar doesn’t seem to wane. Not only does it not seem to suffer, but every time there is a shocking geopolitical event, the dollar rallies as investors all over the world rush into it… the dollar is still the safe haven for investors. Once they own the dollar, then the obvious place for them to invest is U.S. Treasury bonds.
There has been so much investing in Treasury Bonds that the 10-year Treasury bond is trading with an interest rate BELOW 1.8%! With a current inflation rate north of 2%, that means investing in a 10-year T-note results in a negative real rate of return. What does that tell you? Why would investors invest in something that guarantees a negative rate of return for 10 years? It tells you that investors view the investing environment as being dangerous. When investors settle for a slightly negative but guaranteed rate of return, it means they are scared to invest anywhere else.
The Fed is betting that it will be able to implement a successful exit strategy… that, when the economic recovery truly begins to exhibit robust growth, the Fed will be nimble enough to reduce the money supply and avoid runaway inflation. Most of the speakers expressed skepticism of the Fed’s ability to be that nimble.
____________________
Europe is a disaster and is almost certain to end badly. As I write this, Greek 10-year bonds are trading with an interest rate in excess of 28% and depositors are beginning to take their money out of the Greek banks. The consensus was that Greece will leave the Euro and return to its previous currency, the drachma. Spain is not out of the woods, and Spanish 10-year bonds are now back above 6%, an indication which means investors aren’t sure if Spain will default. Portugal bonds are above 11% but the size of Portugal doesn’t concern economists as much. They are more concerned about Spain.
One of the expectations of adopting a common currency in the European Union was that all countries would consistently be able to borrow at a common interest rate. I guess we can say that plan is moot. German bonds are at 1.5%, Greece 28%. Next idea?
And the European Central Bank has a balance sheet bigger than any other bank in the world, including the Federal Reserve Bank of the United States. So if you think we have problems…
____________________
China is going to slow down… possibly a lot. China has allegedly been growing at 10%+ each year for the past decade. But too much of China’s GDP for the past decade has come from investment… buildings, bridges, roads, etc. Not enough of it has come from consumption. At some point, there are enough roads, bridges, houses and office buildings. Unless consumption becomes a more significant piece of China’s GDP, the growth rate could slow to less than 5%….which, by the way, would be a very nice rate of growth for the U.S. right now. However, a sub-5% growth rate for China will come as a big disappointment to global investors and would not be a positive for equity markets.
One of the speakers sees opportunities in the Emerging Market nations outside of the BRICs (Brazil, Russia, India and China). A country he specifically mentioned was Indonesia.
____________________
Several speakers feel that gold remains in a long-term secular bull market, although it has backed up considerably since almost hitting $1,900/oz. They don’t view it as an inflation hedge but as more of a currency hedge (sometimes that’s the same thing). With central banks all over the world printing paper currency, gold remains the one common currency between nations… the currency that is not subject to the printing presses.
____________________
The municipal bond market has been strong for the past 18 months and our allocation has been larger than normal. We feel there remains good value in municipal bonds. Supply has dwindled as there have been very few new offerings of new bonds in this economy. Municipalities have tightened the budget and postponed projects. In addition, many bonds are being “called” or retired, further reducing the supply which makes the remaining bonds more attractive.
____________________
The month of April saw the U.S. stock market take a breather. The S&P 500 declined a fraction of 1% although it is still up almost 12% for 2012. Even Apple declined over 2% so you know investors must have found something fun to do outside in the good weather. The decline has continued this month. At Boyer & Corporon Wealth Management, we look for opportunities in a declining stock market. However, we don’t think we have to hurry.
____________________
Final words of wisdom from Mr. Kahneman, which I found worthy:
We anticipate gossip when we make decisions. We make better decisions when we anticipate intelligent gossip.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.