How to Predict Policy Decisions -- Focusing on Europe

One way for investors to gain an edge is through accurate forecasting of policy decisions. The edge is great because the investing community -- traders, bloggers, pundits and TV talking heads -- emphasize problems and ignore solutions.

There are many reasons for this, including the following:

1. Problems are more obvious
2. Problems make a better story - -more page views, more comments
3. Repeating information about problems caters to reader preconceptions. Reinforcing this makes the writer seem smart. Both writer and reader are happy.
4. There is an active market for bad news and criticism. If you are tempted to disagree, watch some ads on financial TV--the single best measure of what is working. Or try this thought experiment about two headlines:

Bernanke's Crisis Leadership

Bernanke's Failed Legacy

Putting aside the merits, which do you think would get more attention?

Applying this to Europe

For investors to get an edge, you need to have information or analysis that is not widely known. The European problems and attendant stories occupy hundreds of columns each week in the financial press and even more blog posts. There is a general consensus about what will happen if there are no policy changes.

The media highlights pundits who predicted something or other in the multiple years before 2008, implying that there is some special skill in the hunting of black swans.

One of the many differences between now and 2008 is that this problem is vastly more analyzed and understood. There is not an unknown market in synthetic securities, rated AAA, that dwarfed the underlying market.

To get an edge this time requires a different skill. You need to think not about the problem, but about the solution. To do this, let us look for the best source on solutions in 2008. Who accurately predicted the alphabet collection of programs? The determination to avoid disaster? The willingness of doctrinaire Republicans to intervene? The willingness of the Fed and the Bush Administration to stretch the law to aid financial institutions? The extension of this by the Obama Administration to non-banks?

Was there such a source? If so, let me know.

The Winning Perspective

In this series about Europe I do not expect to provide a complete answer in any single article. I do hope to nudge thinking in the right direction.

I suggest that we view the various political leaders as intelligent, informed, and acting in the interest of their constituents. I'll go into this in more detail in the next installment, but here are some examples.

Merkel -- understanding the value of the eurozone to Germany and eventually supportive. Meanwhile extracting every concession possible.

Draghi -- cognizant of the problems. Under no pressure from the single mandate of price stability. Unwilling to be pressured into abandoning long-term principles. Stumbling a little in conflicting statements. Requiring institutional change before any commitments.

Lagarde -- posturing for an international constituency. Highlighting the risks. Willing to be part of the solution, but pressing for cooperation.

Geithner/Bernanke -- emphasizing the risks, but limited in policy alternatives. Operating from a perceived "glass house."

Chinese leaders -- enjoying the bully pulpit and the ability to lecture the West. Unwilling to take the lead role in a bailout. Understanding that Europe is their biggest export market. Knowing that a European recession is against the Chinese self-interest. Willing to join in a solid investment program that is not a pure bailout.

And many other participants, creating ideas that have not even been discussed.

Here is another question. The latest European Summit suggested avoiding the problems of a full treaty via various bi-lateral agreements. Which of the political science or legal amateurs -- hedge fund managers who are reading treaties and deciding what can be done -- even considered this possibility? That would be no one. Just as they did not consider TARP, TALF or any other such program in 2008.

Investment Conclusion

My working hypothesis is that there will be a messy negotiated compromise to the European problem. It will include many participants and some leverage. Austerity. Sale of public assets. Haircuts on debt. Eurobonds. ECB bond buying. It will include everything that has already been mentioned and some things we have not yet heard about.

European bank capital will increase. Confidence will gradually be improved and interest rates on sovereign debt will fall. It may take years to accomplish in full.

There will be no single meeting with a final plan announcement. Each incremental step will be met with skepticism from the usual suspects, beginning with the fact that it is not comprehensive.

If you wait to invest until this is all solved, you will be buying Dow 20K.

Investors need to learn how to measure progress and risk. It must be a measure, not a binary choice influenced by headlines.

 

Next installment: Why leaders seem dumb -- start by calling them politicians.

 

 

Comments

[TK]

You laid it out perfectly in WTWA. I'm looking forward to your further analysis. Thanks for helping me understand a little bit more about an area that has become a bit of a hobby for me.

[oldprof]

Angel -- The book sounds quite interesting -- at least for people like us!

It seems to be available from various sources, so I'll try to take a look.

I have a continuing interest in the factors involved, and I am unsatisfied with the popular conclusions. It is almost enough to make me wish that I was back at the U.

Jeff

[oldprof]

TK -- I tried to lay this out a bit more in my WTWA article. For the moment, lets watch Italian bond yields. These are bad, but not the disaster level predicted a couple of weeks ago.

I'll have more in my Europe series, but that is the best I can do right now.

It is the right question -- how to monitor progress when there will not be a single magic plan.

Jeff

[Angel Martin]

Jeff, in terms of forecasting policy initiatives in 2008, this book is worth a look. It is long out of print, and would be easy to dismiss as just another failed doomer forecast.
http://www.amazon.ca/Great-Reckoning-William-Rees-Mogg/dp/0330327925

The book was written in the early 1990's with the S&L crisis as a backdrop. There is a long discussion showing that real estate prices could fall, and historically had fallen a lot in some periods. They analysed the financial and economic impact of a 50% fall in real estate prices in the US. Their analysis was that a financial shock of that magnitude would precipitate a downward spiral towards a depression. They forecast that the authorities would go to great lengths to prop things up including: bailing out Fannie and Freddie, quadrupling the deficit, expanding the fed balance sheet hugely with questionable real estate loans, zero interest rates, bank bailouts, reconstituting depression era institutions like the Resolution Finance Corporation...etc.

There is also a revisionist discussion of Hoover's conduct following the 1929 crash, showing how, unconstrained by ideology, he took very aggressive and unexpected actions in the weeks following the crash.

In 2008, as events unfolded, I couldn't help but think how prescient this book was - at least on real estate prices, the gse's, the fed's actions and the actions by the bush administration.

Also, for reasons too lengthy to go into here, other parts of this book convinced me that 2008 and the aftermath were not a rerun of 1929, but more like the mini-depression of 1920-21.

[TK]

Investors need to learn how to measure progress and risk. It must be a measure, not a binary choice influenced by headlines.

What would be a good measure of progress? What steps, beyond what has already been done, would give you confidence they were making progress?

Thanks

[oldprof]

Angel -- The market usually focuses on what worked the last time. Most of the big betters on the collapse were completely wrong for years, as documented in The Big Short. They were losing investors along with respect. It was only afterward that they were celebrated.

Similarly, no one expected much from the various government actions in 2008-09, but we have learned from the experience. Programs like TARP, TALF, recapitalization, and QE's get attention.

I am trying to say that unlike 2008, this problem is well understood, but the solutions are not. Someone who had a good record on the 2008 solutions would be a good source now, even if the market gave him/her no respect at that time.

Maybe I'm still not explaining it very well, but it is the best I can do at the moment.

Thanks for the question.

Jeff

[Angel Martin]

quoting from the article:

"You need to think not about the problem, but about the solution. To do this, let us look for the best source on solutions in 2008. Who accurately predicted the alphabet collection of programs? The determination to avoid disaster? The willingness of doctrinaire Republicans to intervene? The willingness of the Fed and the Bush Administration to stretch the law to aid financial institutions? The extension of this by the Obama Administration to non-banks?

Was there such a source? If so, let me know."

Jeff, i don't really understand this point. If an investor would have known that list in 2008, how would that have helped?

I'd say the opposite, knowing that list might have convinced an investor to hold onto financial stocks, when BKX fell by more than 75% post Lehman.