An Obvious Metaphor

By: Michael Ashton | Sat, Aug 27, 2011
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When an obvious metaphor presents itself, I'm just not big enough to turn it down. As I write this, a hurricane is bearing down on Wall Street.[1]

This is one we have seen coming for a while. Prudent people know what to do - clear the beaches, prepare the emergency kit, and get ready to ride out the storm. Some less-prudent people make dinner plans and will scurry home just before the scheduled arrival of Irene. And some crazy ones are always shown on the Weather Channel: usually, surfing.

Investors are the same way. We have seen the storm coming for a while. Prudent people have canceled aggressive investment plans, hunkered down; some people figure they can get out just before the worst of it hits, and a few people are running towards the disaster with surfboards.

I marvel at the modern miracle of satellite imagery and weather forecasting. We've literally seen Irene coming for a week. It's hard to think back to when it wasn't that way. But it wasn't so long ago when the early warning system was a few hours at best, and you couldn't tell the difference between a bad storm and a Category 3 hurricane until it arrived. People lived differently then, more conservatively. Boats headed to shore when bad weather was coming, rather than try to guess whether it was something they could ride out. Storm shutters were closed before it was absolutely necessary to do so. Your safety relied on your conservatism. Nowadays, we know exactly when to batten down the hatches, to within a couple of hours. I think that means that today, we get more done, thanks to modern meteorology.

It is important to remember that meteorology is still an inexact science although it is vastly advanced from the 'old days' when your best defense was having an experienced weatherman like Harold Taft at your disposal. At times, like right now, it looks like the worst of Hurricane Irene might miss us, and the storm's violence is lessening faster than forecasters expected. This is ironically when the storm is the riskiest, because there is a tendency to relax. "Maybe I won't put tape on the windows after all." "Maybe it would be okay to drive to Grandma's for dinner." But storms also re-strengthen, and they change headings. They don't always hit where they are supposed to. This happens far less often than it used to, but it still happens sometimes.

Financial forecasting has progressed far less than has meteorology, and yet investors - encouraged by the Federal Reserve's cult of economists - seem to regard forecasts of warm and sunny weather as a sufficient reason to cast caution to the wind. Investors today protect themselves much less than our forebears did. Dividend yields until the middle of the last century were always above bond yields, because stocks were perceived as riskier. Now, investors believe they are more-sophisticated, and can operate with narrower margins of safety. Although they still occasionally get blown away by a sudden Hurricane Enron or Flash Crash, they view these as isolated events and not part of the unavoidable fabric of riskiness of financial markets.

We are in the midst of a financial crisis that started in 2008-09 and had the "eye" of the hurricane in 2010. Many investors seem to think the worst is over. I had two separate friends on Friday night protest that "the market was up 4% this week!" while seemingly missing the fact that 3.6% of that happened in about one hour during Friday morning.

The cause of that rip higher is curious. Chairman Bernanke delivered his long-awaited Jackson Hole speech, at which many investors expected him to hint at QE3. He didn't so hint. Stocks began to fall, as you would expect. Then, abruptly, they turned and shot higher. Partly, this was because there seems to have been plenty of fast money that expected (like I did) that the Chairman would not make a habit of proposing major policy measures at Jackson Hole, and those traders needed to cover. But it was at least as much caused by a crazy speculation first propagated by CNBC: the Federal Reserve added a second day to its September meeting, and CNBC commentators suggest that that was the QE3 promise. Obviously Bernanke can't announce QE3 now; he's going to do it in September and this is his way of telling people so! To a person with a hammer, everything looks like a nail. If your only hope is QE3, then it is critical that you find a hint of it, somewhere.

Keeping in mind that the Federal Reserve is far from unified at the moment, and keeping in mind that QE2 was at best ineffectual, this is very unlikely to happen. It is actually more likely that a topic of conversation at the September FOMC will be the question of how to introduce an inflation-targeting policy. (That, too, can't really happen since the Fed tied its own hands for two years, but it is a pet project of Chairman Bernanke and continues to be an object of study and discussion). But "QE3 is coming" is the message the market received. You can see this from the fact that bonds rallied, stocks rallied, and commodities rallied, while the dollar declined. That's the QE playbook!

So the CNBC meteorologists have declared that it is safe to go back into the water; we got out of Bernanke what we needed to. Happy investors are pounding back into the surf, while sober ones who have seen this before are peering out and shaking their grizzled heads in disbelief. "These kids never learn," they grumble. "One of them's gonna get killed one of these days."

 


[1] There's always a degree of comedy involved in watching how elected officials scurry around trying to appear officious and yet calm, trying to do enough that they won't be blamed for insouciance but not doing so much that if nothing happens they won't be accused of overreacting and inconveniencing the populace. My favorite example in the extant case is New York City Mayor Bloomberg, who on Friday declared an evacuation of "low-lying areas" in the city. Um, isn't it all low-lying? Manhattan is built between two rivers. Its elevation is, basically, a few feet on the positive side of zero. The high point is Central Park Reservoir, at around 100 feet above sea-level; Columbus Circle is 60 feet. 8th Avenue and 20th Street, 12 feet. Avenue D, 3 feet. I am not saying that the city should be evacuated, but merely that evacuating "low-lying areas" of the city is splitting hairs.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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