Buying is Believing The financial markets have shown a great tendency to surprise of late. A few weeks ago, several consecutive days of dramatic declines left the Dow Jones Index languishing at its lowest level in years and many analysts speculating that the bottom was nowhere in sight. More recently, the market is up markedly. On an almost daily basis, the major indices make huge moves in one direction or the other, but fortunately there have recently been more good sessions than bad. The Dow Jones is now well above its trough (at least at the time I am writing), and the same analysts who were predicting doom earlier in the month are now trumpeting a major rally.
Let me make a few quick points and then one major one. First of all, the market is following its usual pattern of overreacting to daily events and the ebb and flow of information. The cumulative prospects of all major US public corporations (which is what market performance is ultimately supposed to reflect), many of which have been around for decades and some for more than a century, do not swing back and forth by 3-4% on a regular basis in the span of 24 hours.
Second, stock analysts are notorious for making 180-degree turns in their opinions based on the slightest of whims, then abruptly going back the other way. Don’t lose too much sleep over that.
Third, volatility in and of itself is not a bad thing. Basic laws of the universe (the second law of thermodynamics, to be precise) and centuries of history tell us that as markets mature and have access to a greater base of information, they will tend to fluctuate more over time. This phenomenon is entirely expected and predictable. Don’t sweat it.
And now—the biggie! We are in the midst of the quarterly sideshow known as “earnings season.” Various companies report their results over a period of a few weeks, and the market responds accordingly. That is precisely what is happening at present. General Motors, Intel, Microsoft, IBM, Texas Instruments, Motorola, and 3M have all had their day and, depending on current performance and future prospects, the market has made its obligatory triple-digit move. Most of the numbers have been pretty decent relative to expectations, and thus a fairly healthy overall uptick has emerged from these seemingly chaotic gyrations.
Why is this process so important at present? There is one critical reason. In order for the market to react positively to strong earnings announcements, it has to believe them. That simple fact is monumental in the post-Enron, post-WorldCom world. Investors are doing what they always do—and that is the point. Quietly, and without fanfare, we have been given an unmistakable signal that much of the lost confidence has been restored. The signoffs on financial statements, audits, indictments, “perp” walks in handcuffs on the evening news, modest reforms, and correction mechanisms inherent in the market have had the desired effect.
When the information that forms the foundation of global equity markets is called into question, it has enormous adverse implications. The mechanism that ultimately drives much of capital availability in the world can neither function properly nor generate growth. If this condition persists for an extended period, it will inevitably have a pronounced negative effect on economic prosperity. The fact that the reaction to positive earnings has been exactly what you would expect is revolutionary in its implications. While we can debate the merits of triple-digit responses to deviation by a penny or two from anticipated earnings endlessly (and, I, for one, think they are far overblown), things are back to what passes for normal.
Whether the current rally is sustained remains to be seen (I feel pretty good about it, but that’s beside the point). What we do know, however, is that the remarkable system that permits both short-term rallies and long-term stock appreciation is alive and well and back in the groove. In the final analysis, that bit of news is much more noteworthy. As trivial as it may sound, buying is believing.
Irrationality Lives Two seemingly unrelated things caught my eye over the past week or so. First, a survey of investors found that two-thirds of them think putting $1,000 in the stock market (when the Dow was about 7,500) was a bad idea. Two years ago, when the market was soaring above 11,000, the same survey found the exact opposite conclusion—two-thirds thought it was a great time to invest.
If you stop and think about it, that really doesn’t make much sense. As a group, investors were more likely to buy at a time when the market was widely thought to be exhibiting “irrational existence” then at a time when it is performing well below the levels justified by economic conditions. You would think it would be just the opposite. Since when was “Buy high and sell low” a good idea?
The second event was the selection of David Kahneman, an Israeli-born psychologist now at Princeton, to share this year’s Nobel Prize in Economics. It was only the second time that someone outside the field of economics and finance has won this award (the other one, also from Princeton, was mathematician John Nash of A Beautiful Mind fame). How does a psychologist garner a Nobel in Economics, and what does that have to do with our backwards investors?
Going back to the origins of modern economics and the Western philosophical tradition on which it is based, most of our models were based on the notion that consumers and investors are rational. We certainly recognized that not everyone would be totally sensible all the time, but our friends in classical mathematics assured us that, across the whole population, these deviations would cancel one another.
Kahneman and Amos Tversky, a fellow psychologist he met as a young professional at Hebrew University in Jerusalem, began to experiment with human behavior to test our time-honored assumptions. (Tversky, who ended up at Stanford, would have no doubt shared the Nobel had he not died in 1996; you have to be alive to be eligible, which is a good reason giving many others, for economists to aspire to a long life.) They discovered that we were at times systematically irrational, that is, we consistently made the wrong decision. Armed with this knowledge, our models got better.
A few examples illustrate this point quite well. Consumers value a 2% cash discount, yet object to a 2% surcharge on the use of credit cards (even though the numbers come out exactly the same). When we need to sell stocks from our portfolio, we tend to keep the dogs and get rid of the ones that are performing well. The reason—we hate to recognize losses.
Our attitudes toward dividends (which we like) are even more bizarre. If corporations had never paid dividends, they would have 90% less debt. They could invest these funds (at an average long-term return of 12%+) or even buy back shares in the market to increase earnings per share and stock prices. If we as investors needed cash, we could sell some of this highly valuable stock and pay relatively low capital gains taxes. Instead, we reward companies for paying us dividends, even though we pay more income tax and receive an asset on which we can typically earn only 2%-4%. The survey I mentioned at the outset is but another example. Despite wisdom to the contrary, we have a measurable tendency to buy when the market is high and sell when it is low.
This pattern impacts much of our lives in other areas as well. We have fears of violent crimes and casualty losses which far exceed their likelihood of occurrence (which has spawned an entire industry). The dramatic reduction in activity in the Washington DC area recently is a case in point; the odds against being a sniper victim in a metropolitan area with millions of people are enormous. We consistently rate a 90% employment rate as good, and a 10% unemployment rate as bad (they are the same thing). I could go on and one, but you get the picture, and I am running out of my allotted space.
I certainly wouldn’t suggest that we are totally illogical beings (nor would Kahneman). After all, at the most basic level, we are the species that has survived and prospered through eons of natural selection. The lessons from these findings are simply that (1) we are not generally as rational as we like to think we are; (2) we can profit substantially from taking a moment to evaluate our actions (economic and otherwise) in this light; and (3) perhaps we have more in common with teenagers than we care to admit.
Rippling Ponds and Butterfly Wings Economic impact analysis, which I do a lot of these days, is often likened to the ripples of water that are observed after tossing a rock into a still pond. The initial splash of, say, a new plant is followed by many succeeding rounds of benefits to suppliers and workers, thus creating a “multiplier” effect. While this analogy is frequently useful, there are occasions when a different image is required.
The recent work stoppage along the West Coast dock is a classic example of non-traditional impacts. The seemingly innocuous failure to unload cargo at Pacific ports is causing dramatic economic disruptions across our country and even around the world. Rather than soft ripples in a serene body of water, the reaction is more akin to the dynamics of chaos theory, where the simple flapping of a butterfly’s wings in China can lead to a massive tidal wave in North America.
The situation is somewhat reminiscent to the 1996 merger of the Southern Pacific and Union Pacific railroads. Because of the difficulties in combining these operations, the merger resulted in a nationwide shipping crisis as goods were left stranded in warehouses, on docks, and on farms all over the southern United States. There was also a notable backlog of cargo from all manner of places stranded at the Port of Houston. The resulting gridlock underscored the role that transportation plays in the nation’s economy, with a measurable negative impact on growth in gross product.
The closing of 26 ports across the West Coast as a result of the lockout of the longshoremen even more graphically illustrates both the global nature of our economy and its dependency on efficient delivery mechanisms. The transportation bottleneck backed up billions of dollars of cargo on the Pacific Ocean and caused extensive disruptions to the complex supply chain that stretches around the globe. Many of the stranded ships carried critical imports from Asian countries. Insiders say that for each day the ports are closed, it takes seven days to get the supply chain moving again (which is probably a bit of an exaggeration). Nonetheless, it will likely take a couple of months to get the flow pattern back to its normal functioning.
In the meantime, merchants are scrambling to move goods via alternate transportation systems or find stopgap suppliers. Others are having to finance inventory brought in early to avoid the situation. These added expenses are causing giant headaches, especially since the nation’s retailers have already been experiencing less than robust sales. With the Christmas season approaching and the economy remaining sluggish, this situation quickly garners everyone’s attention.
President Bush has intervened and obtained an injunction that reopens the docks and establishes a cooling-off period of up to 80 days under the auspices of the Taft-Hartley Act of 1947. Normally, such direct intervention in markets is not a good thing. The free negotiation between labor and management is a time-honored element of our economy. It is not surprising that the Taft-Hartley Act is rarely involved (the last time was in the 1970s). When the President is basically an advocate of laissez faire, the decision is even more difficult.
It is my opinion that the President acted properly in this instance. A proper role of government is to properly balance the public interest against private concerns, and, in this situation, it is not even a close call. Clearly, the stakes in this impasse go well beyond the relatively limited perspectives of the parties directly involved. A prolonged work stoppage would paralyze our economy and those of other countries as well. As an added concern, a bunch of big ships sitting in our harbors in the current environment is an invitation for mischief and a security nightmare.
Hopefully, the cooling-off period will accomplish its goal, although tensions obviously remain high. In any case, we have just seen in microcosm just how interdependent our world economy really is. The lesson for future global policy is quite simple—pay attention to the butterflies.
Taking Our Time and Getting It Right History is replete with situations where policies implemented with the best of intentions had unanticipated negative consequences. Famous examples include (1) the treaty ending World War I which put in motion the forces that led to World War II (as predicted by noted economist John Maynard Keynes) and (2) the efforts to deregulate financial institutions in the 1980s which contributed to a massive debacle among banks, savings and loans, and real estate developments. While I certainly don’t see anything of that magnitude on the horizon in Texas, there is an issue quietly surfacing that does merit due caution and careful consideration.
Specifically, the Texas Department of Transportation (TxDot) is conducting public hearings over the next week regarding a proposal to limit access points along frontage roads and at intersections. The purpose is to promote safety, which is a laudable objective and clearly an issue of highest priority. Like many other good intentions, however, this plan could have serious adverse effects, and better alternatives may be available.
The proposal significantly changes accessibility and can materially affect land-use patterns in every part of the state. The distance between access points and their distance from intersections can impact hospitals, schools, restaurants, shopping centers, and single- and multi-family housing. The proposed rules would likely cause numerous projects which have been in the planning stages for years to be shelved or delayed, thus inhibiting the fledgling economic recovery and depriving the State and its cities of much-needed sales tax revenues. They might also create some safety issues of their own by complicating access to facilities by fire, police, and emergency vehicles.
There are certainly viable reasons to be exploring the best mechanisms to provide ingress and egress to major transportation arteries. It is not at all apparent, however, that a “one size fits all” mechanism best meets the mobility needs of Texas. Rural areas may well have requirements and concerns that are quite different from those of urban and suburban regions. Local safety planning may well offer a better, more tailored approach in some instances.
Obviously, I am not suggesting that safety be sacrificed for economic development. I am merely saying that there may well be ways to achieve both through an open, patient process in which all relevant interests are involved. It does not take much of an artificial disturbance in land use to adversely affect billions of dollars in investment and economic growth. A decision with such wide-ranging implications should be made deliberately and with the advantage of both extensive input from involved parties and research by folks with knowledge of the relevant economics (including me) and engineering (definitely not including me). The only related study I have seen is based on a survey of business owners in affected and potentially affected areas; it does not even address the critical issue of land-use patterns.
Over the course of what I am reluctantly having to admit is a very long career, I have been involved in dozens of matters in which there was a seeming conflict between the economy and some other significant social priority. Without exception, I have found that “win-win” solutions were available. They don’t always happen, mind you, but they are always possible. The failures occur not because of a lack of options, but rather a lack of willingness to creatively engage in proper analysis and dialog.
Texas needs safe roads, and Texas needs responsible development and growth. There is every reason to believe we can have both. It is not necessary to rush to judgment. Getting it done right is far more important than getting it done quickly. Taking the time for thoughtful deliberation and investigation now could pay dividends for generations to come.