How to Look at the Market

I notice this post by Bruce Bartlett on Andrew Sullivan’s site. I apologize for the length, but I feel I need to post the whole to make my point. Take it away Bruce.

Two years ago, I first saw problems arising in financial markets. The problem was that the Federal Reserve had been easy for a long time in order help get the economy moving after the recession of 2001. This led to overexpansion of certain sectors of the economy that could not be sustained without a continuation of the easy money policy. In 2005, the Fed began reversing its easy money policy. This inevitably meant that those sectors–in this case, housing–that were dependent on easy money would likely crash. As I wrote in an August 2005 column:
“The problem here is that just because the Fed is raising rates gradually, the impact will not necessarily be gradual. It could come quite abruptly. Think of a balloon. Whether you blow it up slowly or fast, at some point it is still going to burst. The same thing oftentimes occurs with monetary policy. It may appear that nothing is going on for a long time and then, suddenly, something dramatic happens to show that monetary policy is working as expected.”
I became very concerned by my analysis, even to the point of shorting the market in anticipation that my view would soon become widespread and lead to a market correction. And then nothing happened. The market sloughed off problems in the housing market and among subprime lenders. When I would talk to Wall Street-types, I was assured that things were under control. Everything was carefully hedged. The balloon wasn’t going to explode, I was told. It would hiss a little air and everything would be fine.
Contrary to my expectations, the market went up. I closed my short positions, swallowed my losses, and concluded that my analysis was incorrect. Well, I should have had more confidence in myself, because the chickens have been coming home to roost this week exactly as I predicted two years ago.
One point I am trying to make is that to be successful in the stock market, it is not enough to understand fundamental trends and be correct in your forecast. There’s also the critical problem of timing. If you are too far ahead of the pack, as I was in 2005, the information is essentially valueless. In fact, it can be counterproductive, as it was in my case. Even if I had held my short position all this time, I still would have lost money because even after the steep decline this week, the S&P 500 index is still more than 1,500 points above where it was two years ago. I still would have lost money.
Over the years, I have observed lots of investors and forecasters making similar mistakes, so I know I am in good company. The trick, as best I can tell, is not to be too much smarter than the market, but just a little smarter. If you are too smart, you move too soon and you end up losing money even though you were basically correct in your analysis. If you are only a little bit smarter, you figure out what’s going on just before everyone else does. There’s a great deal of money to be made with that kind of knowledge.

As I read this, Bartlett is saying that his mistake was that he was too intelligent. I’m not trying to make fun of Bartlett, indeed, he’s a very sharp guy. But the bottom line is that he lost money on a trade that wasn’t very intelligent. Sometimes smart people do things that aren’t so smart.
The key is to evaluate information correctly and within its proper context. Sure, there were lots of problems in the mortgage markets, but that doesn’t mean it will wreck the whole system. Even when disaster comes, it’s usually not disaster. He writes that “chickens are coming home to roost.” Not exactly. As I write this, the Dow is down about 900 points from its high, or about 6.4%.
The trick isn’t to be just a little bit smarter, but it’s what kind of intelligence. It’s not just the facts you know, it’s being able to think critically about those facts. Bartlett’s comments remind of Gilbert & Sullivan’s Modern Major General who knows “many cheerful facts about the square of the hypotenuse.”
When people analyze the market, they tend to have a bias towards drama, which usually flatters the analyst.

Posted by on August 14th, 2007 at 11:26 am


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