How NOT to Think about Your Investments

Many stocks, perhaps most stocks, are trading at prices that do not reflect fundamental value, as determined by traditional methods.  The excellent team at Bespoke Investment Group, one of our featured sites, provides a great list of stocks trading at "crazy" P/E ratios.  (Since P/E is only part of the story, perhaps you should subscribe to their premium service.)  Unfortunately, we own a few stocks on that list.  Our cheap plays got even cheaper.

Bob Pisani's CNBC reports -- a good reflection of floor trader opinion -- pointed out the disjunction between the fundamentals and the price in stocks like IBM.  Great earnings, good prospects, no proximate link to subprime, but the stock is down 25% from the highs.

Briefly put, current prices are not a matter of analysis, but one of psychology.

It is time to check out our "go to guy" on such questions, Dr. Brett Steenbarger.

Great Advice from Dr. Brett

In any big event, whether it is a football game, the election, or the stock market, there is a nearly inevitable feeling that you "should have known."  He writes as follows:

When markets become unusually volatile, they make unusually large moves. To the short-term trader or the active portfolio manager, such moves look like phenomenal opportunity. This creates a kind of dissonance when their results do not reflect such opportunity. This dissonance is often expressed as regret: the word "should" becomes a prominent part of traders' thinking.

Underneath this regret is what behavioral finance researchers call "hindsight bias": the exaggerated sense of predictability in retrospect.

After some typical wisdom, which deserves to be read completely, he concludes as follows:

Given the limits of what we know and what is ultimately unknowable, not all movement is opportunity. The key to trading success is finding the patience to capitalize on those things you do know and the wisdom to accept what is uncertain.

Applying Brett's Advice

The most important step an investor can take is to understand what is happening.  Here is our analysis.

• Our system has created a climate where banks will not lend with each other.  Why not?  After Lehman was allowed to fail, no one knows which financial institutions will get government support.  Why lend to an institution that might not deliver?
• We are de-leveraging at Warp speed, since any write down at one institution ripples through the entire system as required by FAS 157 mark-to-market rules.
• The lenders to hedge funds, all becoming regular banks, now have more conservative business models.  Leading fund manager Ken Heebner  made this point tonight on Kudlow.  See the video here and here.  The hedge funds can no longer take a strategy that makes 5 or 6 percent a year and leverage it five times.  This means that hedge funds are selling -- forced selling -- the good with the bad.
• Individual investors are dumping their mutual funds, as they always do in times of stress.

What not to do

Do not just make a knee-jerk reaction.  Think clearly.  Think about what is happening and the causes.  That is the only way to spot opportunity.

Somewhere between Miss Moss's Latin class in high school and Neil Browne's excellent instruction in critical thinking, we learned about a prominent logical fallacy.  Once you know it you will see it every day.

Post hoc, ergo propter hoc.

You can look it up, but it means "after this, therefore because of this."  It is one of the most common errors in logic.

The most important application right now, also pointed out by Ken Heebner, is that the market keeps going down after each new government move.  The cause of this has nothing to do with government policy, except perhaps that it was too slow for rapidly changing conditions.  We should have started sooner, since government moves slowly.  It is the de-leveraging, especially in hedge funds.  To those who do not understand, it seems to be an instant verdict that the government plan does not work.

And this verdict is being rendered before the $700 billion has even been deployed.....We suspect that legislators who voted for the Rescue Plan feel somehow betrayed by the market.  It will take some time before the impact of the plan is felt.

And finally, what you should do

Understanding the factors behind the decline is important in finding opportunity.  If one accepts Ken Heebner's observation of reality, there is one set of conclusions.  If one believes that the market is correctly signaling the next Great Depression, there is another.  We shall revisit that dichotomy.  It depends on solving the problem of counter party risk, which we described last month.

Meanwhile, let us consider more great advice from Brett Steenbarger:

The ability to adapt to changing conditions and maintain the search for opportunity amidst market panic is a great example of how times of crisis can also be times of opportunity.

We will follow up with more about how we are positioning our clients to take advantage of current conditions.