Ducking thunder

It’s hard not to feel a bit shell-shocked by current events. Each piece of bad news makes a person want to duck and cover until the storm passes. Although I understand this feeling and can sympathize with it, I don’t think it’s constructive.

When you hear a loud clap of thunder, it’s hard not to duck. The problem is that by the time you’ve heard the loud noise, it’s much too late to do anything about it (not that ducking would help anyway). The danger is long past and you’re just reacting instinctually and uselessly at that point.

The same is true in financial markets. Unless you’re a professional trader working at one of the world’s financial centers, by the time you hear the bad news it has long ago been reflected in security prices. Whether it was Baron von Rothschild 200 years ago or instantaneous computer trading today, you and I are not going to benefit from trading on the news.

That doesn’t mean we can’t interpret the news more intelligently and act on it in the fullness of time, but thinking that we can duck and cover at the sound of thunder is total folly.

This reminds me of my experience in pilot training. Not surprisingly, you don’t want pilots to panic or freak out when an emergency occurs. Our human instincts don’t serve us well in the cockpit, so they train pilots through repetition–in a full-motion simulator–to keep their cool in emergencies and successfully deal with problems.  

We called it “dial-a-death” because the instructor pilot literally had a dial where he chose the emergency you were to handle. The first several times you were given a tough emergency, it was hard not to freak out, but over time you could learn to keep your cool even under the toughest of circumstances. For me, the key was to breath deeply and get very focused on properly diagnosing the problem and then meticulously taking corrective action. If you sat there thinking about the consequences and how worried you were, you were doomed.

I think this analogy is perfect for financial markets, too. We need to be ready for emergencies by preparing ourselves mentally. We need to expect things to go wrong instead of hoping, uselessly, that they won’t. We need to know how to act when things go wrong so our instinctual desire to duck is suppressed and we do what we know we need to do. We need to focus on controlling the things we can control instead of wishing we could control the things we can’t.

How do we prepare for financial emergencies? Go into the situation with your financial house in order: 
  • spend less than you make
  • save the difference (pay your future self, first)
  • invest your savings wisely (by being prepared for both good and bad market conditions that you know will happen, but not when)
  • have enough cash at your disposal to handle life’s inconveniences
  • get enough insurance
  • set up an estate plan  
Also, know what not to do: 
  • panicking won’t help
  • don’t assume see can see bad financial conditions coming (don’t worry, no one can consistently)
  • don’t assume that bad times won’t come
  • don’t believe you can “go to the sidelines” until the storm is over
  • don’t try to time when to get out and get back in (you will almost always do both way too late)
  • don’t inundate yourself with bad news that makes you want jump out a window (good pilots don’t stare at burning engines, they focus instead on putting the fire out)

If you’re more opportunistic (and this is clearly not for everyone, just like flying airplanes), be ready to benefit from others’ panic. Be ready to sell your safest holdings and buy what the panicky sellers are abandoning recklessly. Financial panics are always the best time to invest, and precisely when your instincts most desire to seek cover.  

Just like pilots can learn to handle terrifying emergencies, you can learn to handle and profit from financial panics. Be prepared, have a plan, take deep breaths, and don’t try to duck–it’s already too late.  

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Ducking thunder

Creating instability

I don’t envy the Federal Reserve.  They have an impossible job.  Can you imagine trying to set the price of t-shirts for the whole economy, much less the clearing price between suppliers and demanders of funds in capital markets? 

No matter how hard you try, you’d always set interest rates too high or too low, or supply too much or too little money.  This would lead to the inevitable shortages or surpluses that any Economics 101 course teaches to new students.  If you don’t believe me, please see the terrible record of any centrally planned economy.

And yet, the Federal Reserve still tries to make the economic system more stable through its control of the money supply and interest rates.  You’d think they’d learn.

Their failure can be seen, most recently, in the swing of commodity prices and interest rates.  Increasing the money supply to bring down interest rates has led to un-intended, but inevitable, consequences, like surging commodity prices and civil disorder in the third world. 

The Fed keeps insisting that inflation is low by reference to a) the corrupt Consumer Price Index (CPI) and b) the spread between bonds with and without inflation protection. 

The circular reasoning required for b) above just boggles the mind: 1) The economy is inherently unstable, so we need a Federal Reserve to prevent that instability from hurting people (they claim), 2) The Federal Reserve refers to free market interest rates (on the premise that market players aren’t just reacting to Federal Reserve talk and action) to decide whether they need to intervene, 3) So, if the Federal Reserve is supposed to prevent an inherently unstable system from becoming unstable, why is it using supposedly unstable misinformation from that unstable system to validate its need to act or not?

It sounds like a recipe for creating an even more unstable system.  And, so it has.

Below are three graphs.  A) shows a stable system where equilibrium is restored with damped oscillations over time.  B) shows a stable system where oscillations aren’t damped, but the system returns to equilibrium periodically and doesn’t fall apart.  C) shows an unstable system where the oscillations become greater and greater until things blow up or whatever is causing the divergent oscillations is removed. 

The claim is made that we need a Federal Reserve because the systems is inherently like B) or C) and the Fed will make things look like A).  But, look at the graph below of S&P 500 profit margins.  Does it look like the Federal Reserve is making A) happen, or C)?  Looks a lot like C) to me!

It is my contention that the economic system is inherently like A) above, not B) or C), and that Fed intervention is turning the economy into first B) and then C) above. 

This is by no means a proof or validation, but it should raise a question in your mind that perhaps markets should be setting interest rates and money supply just like it sets the price of t-shirt, TVs, computers and millions of other products.  Every experience with price controls in history has led to surpluses and shortages, and yet we have a Federal Reserve trying to set the most important price in the economy–the price of money. 

Maybe it’s time to dampen our oscillations by removing the thing that’s making our system unstable: the Federal Reserve.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Creating instability