The weekly economic newsletter, "Comments on Credit," became famous in the late 1970’s when Salomon Brother’s Managing Director, Henry Kaufman, used it to spread the bearish analysis that earned him the nickname, "Dr Doom." Salomon was long ago acquired by CitiGroup, which continues to publish "Comments on Credit" as its flagship opinion-shaper, now under the authorship of Chief US Economist, Robert V. DiClemente. On Friday he wrote, "Given the systemic stresses, recession scenarios do not capture the potential for a more serious breach that could entail lasting changes in financial intermediation which flows through to reduced productivity and a slower rate of economic growth beyond the cyclical horizon."
English translation: "Oh shit!"
Yes, the economy is in bad shape and likely to get worse before it gets better. At this moment of confusion and apprehension, the most valuable contribution I can make is to distil what I have learned in almost thirty years of professional investing into three inter-related principles, my life’s lessons.
1. Nobody can ever consistently and accurately predict the financial markets. Those who know me will know how I persistently avoid making interest rate predictions or giving financial advice. I am profoundly uncomfortable even providing the annual rate forecast without which the Bank’s budget cannot be written. My reluctance is not based on a selfish desire to keep some deep knowledge secret or from an equally selfish fear of being proven wrong by events. The simple truth is that I don’t know what’s going to happen in the future.
And neither does anyone else. Our society has placed economists in the false position of having to predict the future in order to make large salaries and garner lucrative lecture fees. Economics is not prophecy; it is science in the same sense that History and Anthropology are sciences. It can illumine the past and help us understand the present. That’s a lot, but that’s all. It’s part of human nature to look to some expert for "The Answer." When we were children, Mom and Dad always had the answers, and somehow, we just can’t shake the belief that somebody, somewhere, KNOWS, but just isn’t telling. There may be universal truths in the hard sciences of physics and chemistry, but not in economics.
2. The financial markets are enormously more powerful than any human attempts to control them. I grew up in San Francisco, within sight of the Pacific Ocean, so maritime imagery is natural to me. I think of the markets like an ocean and market participants like sailors. We make our ships as seaworthy as possible. We study the ways of the sea and its lore. But we know that we do not control the ocean. We know it can rise up and overwhelm us anytime, with no warning and no regret. In recent years Federal Reserve chairmen and governors have taken to boasting that their wise policies were responsible for the low inflation and financial stability the country enjoyed for so long. This was pure hubris. The monetary policy of the Federal Reserve worked for precisely the same two reasons that the unique public/private amalgams that were Fannie Mae and Freddie Mac worked: It was in enough people’s interest and the fundamentals of the economy were sound.
Don’t believe me? Then ask yourself this: How else could a change of one quarter of one percent in the rate of interest banks charge each other for overnight loans maintain price stability and contain unemployment, the Fed’s statutory mandates? The Federal Reserve possesses a popgun that investors have, for many years, tacitly agreed to treat like a howitzer. To again quote Robert DiClemente: "It is especially frustrating that the most immediate avenues to improvement in the money market have defied policy action. If the Fed were raising the funds rate in this environment, officials could not have expected a more significant response across interest rate markets." In other words, when times are rough, fiddling with the fed funds rate is ineffectual. Indeed, one of the casualties of the present crisis could be the Fed’s ability to use the fed funds target rate as an effective tool of monetary policy.
This is not to say the Federal Reserve is not essential. The prudent use of the Fed’s reserves to increase or decrease the money supply is a vital function in maintaining our financial system’s integrity. But the Fed doesn’t control the system. In fact the Fed’s greatest triumph—breaking the back of the Great Inflation of the 1970s—was achieved not by manipulating the fed funds rate, but by explicitly setting the rate free to be determined by the not-very-tender mercies of the markets. In October 1979, Paul Volker announced that the Fed would target the money supply instead of the fed funds rate. The markets raged like a typhoon and the economy eventually fell into its worst post-World War II recession, but inflation was crushed. This is not a prescription for future action; it’s just some historic clarity on what a nation’s central bank can and cannot do.
3. Investing is a function of personality. The financial markets are startlingly democratic. They don’t care where, how, or even if, you were educated. They don’t care about race, gender, religion, sexual preference, or anything else. They only care about success, and there are many ways to achieve success. We see this most clearly in the stock market where technical analysis thrives on its arcane charts with bear flags and head shoulders formations despite the majority opinion that it’s all mumbo-jumbo. But in all markets, there are successful bulls and successful bears. There are investors who are successful because they are analytical, and investors who are successful because they are intuitive. Most people, of course, are a mixture, but while there is no surefire guarantee of success, there is a surefire guarantee of failure. An investor who is fundamentally analytical will fail if she tries to invest intuitively. An investor who is fundamentally intuitive will fail if he tries to invest analytically.
The notion, that the key to successful investing is embedded within the essential nature of the investor may sound simplistic or perhaps bizarre. In fact, it is nothing more than the application of the ancient Greek dictum, γνῶθι σεαυτόν, know thyself. The practical result should be a discipline that can be followed in good markets or bad. My discipline has been built up over many years. It ensures that when I buy a bond, I must have a good reason for it. The next day, I must have a good reason for holding the bond, and so on for each subsequent day. If not, I should try to sell it. Every trade must benefit the Bank, both on its own merits and in its contribution to the Bank’s entire balance sheet. I am honest in my dealings with brokers. If a trade is their idea, I may or may not do it, but if I do it, I’ll do it with them. I do the best I can every day and come back tomorrow and do it again. Tactics and even strategies change, but not my discipline. Discipline in investing is the antidote to fear. And fear, as FDR so astutely remarked, is exactly what we have to fear in difficult times like these.
What all three principles have in common is humility and modesty in the face of a force far greater than any possessed by an individual or group. That force is the collective weight of all the opinions of all the investors around the world translated into actions in (relatively) free financial markets. This is not fatalism or a Zen-like acceptance of what is simply because it is. Rather, it is the acceptance, indeed the celebration, of the enormous collective power of human intelligence, emotion, and choice. Investing is a profoundly human activity; there is nothing "natural" or "organic" about it. It’s something human beings have chosen to do, and something we will keep on doing no matter what. And like every human activity, the more light and truth we bring to it, the better it will promote the ultimate goal of human happiness.