How Do You Invest in a Market That's Fearful and Greedy?

To paraphrase Warren Buffett's aphorism about investing, be greedy when others are fearful and fearful when others are greedy.  In other words, buy low and sell high.

But what do you do when the market is beset by fear and greed?  Market indexes rise to new heights almost every day.  But many investors are increasingly stepping back and hoarding cash.  Indeed, the greedier some get, the more fearful others get. 

There's no established strategy for a pishmi-pullyu market like this.  The fearful, greedy market's bipolar movements defy logic and rationality. 

Much of the market's wackiness comes down to the fact that asset values today are determined as much by government policy as anything else.  We live in the era of the Great Central Bank Accommodation, spiced up with bailouts of one sort or another as ad hoc government policies are slapped together in response to the crisis du jour.  Even though the central banks mutter disquietingly about withdrawing accommodation, they don't really get around to it, because they remain the only show in town when it comes to economic stimulus.  Investors know that government intervention is likely to continue indefinitely, so some invest.  They are also fearful because they know that government support cannot continue forever.  So some hoard cash. 

You can't rationally invest on the political process or government policy.  You can diversify.  That's simply another way of admitting you don't know what's happening or what's going to happen.  Then again, no one does.

How To Stop the Too Big From Failing

Congress, and financial regulators in America and other nations, have struggled endlessly with the problem of financial institutions too big to fail.  Capital requirements have been increased, and regulation has been tightened (somewhat--much of the implementation of the Dodd Frank Act remains unfinished).  But the problem remains.

There is a simple way to seriously reduce the possibility of another taxpayer-funded bailout.  If a financial institution needs a government bailout, force the CEO, COO and CFO, and the members of the Board of Directors, to pay to the government the value of their entire compensation for the preceding five years.  This would include salary, bonuses, stock options, restricted stock, fees, country club memberships, company cars, and all other perks and compensation.  This payment would be required without regard to whether or not the executive officer or director was proven to have participated in any wrongdoing or neglect.  It wouldn't be a penalty for misconduct.  It would be an incentive to avoid sticking the government with the costs of mismanagement.

Any such proposal would, of course, provoke howls of outrage from financial institutions and their free-roaming packs of mouth-foaming running dog lobbyists.  Such a measure would be unfair if the officer or director hadn't been shown to have engaged in misconduct, it would be argued.  However, the SEC already has the legal authority to force a company's CEO and CFO to pay out all their compensation for the 12 months following the issuance of financial statements that are subsequently modified (in a form called a restatement)--see Section 304 of the Sarbanes-Oxley Act.  The SEC isn't required to show that the CEO and CFO did bad things.  They can be forced to make this payout simply because the original financial statements were wrong and needed to be restated.  The courts have upheld this authority.  There's nothing unfair about requiring senior executives to get important things right in the first instance.

Banks and other financial institutions might also object that they couldn't recruit the executive talent they need if this financial Sword of Damocles were to hang over their heads.  But, when we consider the geniuses at some financial institutions in the recent past who steered their firms right over cliffs and into government safety nets, this argument loses its persuasiveness.  Executive compensation arrangements at the too big to fail seem to incentivize risk-taking, even if it might entail unmanageable complexity.  There needs to be a disincentive--and a strong one.

The government has been criticized for not penalizing the high and mighty for the financial crisis of 2008.  Remember, however, that the statutes and regulations governing financial institutions are complex.  Proof of violations can be difficult.  A simple measure like a penalty of five year's compensation for a government bailout offers a way to nail the top dogs for signing a chit the taxpayers have to pay.

Should We Bring Back the Leisure Suit?

The economy in America and Europe is stagnant. Gas prices have risen sharply in recent years, and the Bureau of Labor Statistics reports rising inflation. The job market stinks. Business investment has ground to a halt. America is unwinding from unpopular wars. Young people just entering the labor force believe they face a lifetime of limited opportunity and lower living standards. They envy their parents, who seem to have had it so good. Prospects for the future seem like a blurred swirl in a porcelain bowl. Whether you believe history repeats itself or simply rhymes, the times are looking a lot like the 1970s. Maybe we should bring back the leisure suit.

The leisure suit had many attributes. It was casual, a rejection of the stuffy old formality of the 1950s. It usually came in pastel colors, brightening things up as the lights dimmed for electricity conservation mandated by rising energy prices. It was made of polyester, which thankfully led us to rethink the whole idea of better living through chemistry. It was flashy, ideal for mindlessly dissipating evenings in artificially fogged discos. Considering today's pervasive gloom, a bit of self-referential, sartorial frivolity might be just the thing we need.

But thinking of the 1970s reminds us of how glad we were to escape the malaise of those times. What is worth examining is how we made the escape. The fundamental economic problem then was price inflation. Already a nagging problem in the 3% range at the beginning of the decade, inflation was aggravated by OPEC oil price fixing, which escalated it to 13% by the end of the decade. Wages tended to keep fairly close pace with inflation, but the value of savings was eroded as interest rates lagged (does this sound familiar?). The stock market stunk, worth much less after inflation than it was worth at the beginning of the decade.

As students of economic history know, then Fed Chairman Paul Volcker raised interest rates sharply at the beginning of the 1980s to stabilize prices. In the process, the U.S. economy belly flopped into recession, with unemployment rising above 10% and stocks falling. Despite a tidal wave of criticism from the left, right, Democrats, Republicans, and just about everyone else standing on or about a bully pulpit, Volcker held firm, like a latter day Rock of Chickamauga. And prevailed. The recession of 1981-82 wrung inflation out of the economy, and it has never returned at any level approaching the confidence sapping double digits of the 70s. With inflation whipped, real economic growth resumed, employment levels rebounded, and the stock market took off on an 18-year bull run. The bond market, even more amazingly, took off on a bull run that hasn't ended even today.

An essential, virtually forgotten lesson from the disco era is that real pain had to be endured before the economy could be set on the right track. Investors, workers, businesses, savers, and homeowners all made sacrifices. There was no easy way out. Inflation had created economic distortions that had to eliminated. The relatively lax Fed of the 1970s was replaced by a stern, unyielding inflation slayer who wielded a mighty halberd.

Such is the path America must take today if it is to end today's dreary replay of the 1970s. The economy is distorted by asset bubbles, the leverage that made them possible, the fantasy mortgage loans that can't be collected but haven't been written off by the banks, Fed-prescribed low interest rates that encourage speculation while discouraging savings, and the dependence of the private sector on federal stimulus. Private businesses won't hire or invest unless there is a prospect of more federal intervention. Everyone wants a risk-free environment, or absent that, a federal bailout. Free enterprise, which means taking risk, barely exists any more and can usually be found only in the small business sector, where federal manna is scarce.

If the Fed wants to stimulate risk taking, what it must do is reverse the tide of moral hazard and stop the endless stream of largely futile accommodations. It should force business executives to take risk, not force savers to gamble their hard-earned retirement funds on dodgy financial instruments. When businesses realize that they will have to make their profits the old fashioned way--by taking risks and managing those risks to attain profitability--then we will see organic economic recovery. No amount of Fed coddling of corporate interests, and no amount of Fed punishment of savers and holders of capital, will achieve the spontaneous and self-sustaining growth that produces lasting prosperity.

Before there was a Federal Reserve, there were recessions, and bad ones at that. There were also recoveries from those recessions that led to sparkling prosperity. It's not like America endured an unrelenting stream of recessions followed by more recessions until the clouds parted and the Federal Reserve System was handed down to someone on Mount Sinai. The Fed has a legitimate role in stabilizing the financial system, and has done yeoman's duty in that respect. But it isn't and can't be the progenitor of all prosperity in America. In a free enterprise system, private enterprise must take on that job, and if corporate interests hold back in hope of yet another federal bailout, they must be made to understand it won't be forthcoming.

America is becoming like Japan, moribund and without a vision of the future. We don't want to take risks any more, and we don't want to accept pain. Blame and culpability are denied by the most powerful, even though their responsibility is greatest. The less powerful and the powerless are made to suffer the worst consequences of the Great Recession, even though their ability to cope is the least. Capitalism requires that blame and responsibility be assessed, and that losses be imposed appropriately. Without right and wrong, there can be no morality. And without losses as well as gains, there can be no free enterprise. We can have all gains only if we become one big government enterprise (and those gains would ultimately prove ethereal). We can't escape our current predicament by having the federal government (and, even worse, the EU) artificially support or inflate assets that are in reality worthless. There won't be a revival of sustained economic growth as long as the government holds out the promise of yet another bailout, yet more accommodation. While there remains a legitimate role for government in taking on tasks for which the private sector isn't well-suited, like building and maintaining infrastructure, and funding and conducting basic research (recall that the Internet started off as a Defense Department project), the government should stop trying to alleviate general business risk.

Otherwise, we might as well bring back the leisure suit. A dose of self-delusion as we circle the drain will numb the process of decay and decline. If we're going to stop thinking about tomorrow, we might as well have fun while we can.

The (Second) Summer of Bernanke's Discontent

Today must have been tough for Federal Reserve Chairman Ben Bernanke. In public remarks at a conference in Atlanta, he didn't say anything. For a Fed Chairman who has made a priority of increasing transparency, having no news to announce was bad news.

Bernanke repeated the Fed's standard litany of the past two and a half years. Short term interest rates will remain at zero for an extended time, and the Fed stands prepared to "respond as necessary" to developments in the economic recovery. This isn't news. His acknowledgement of the economy's slowdown shouldn't have been news, either, although it did seem to contribute to a market drop at the close. The big problem, though, was that Bernanke didn't promise to wear a red suit and come down the chimney imminently with another bagful of gifts. No QE3. No other legerdemain that would amount to money printing. No promise to support current asset values.

Let's face it. The market, and economy, are addicted to government bailouts and subsidies. Everyone wants a federal guarantee for everything. Businesses want the Federal Reserve money printing press running 24/7 before they'll add a single person to the payroll. Investors want to see truckloads of cash moving off the Fed's loading dock before putting a penny in stocks. The big banks want the government's too-big-to-fail subsidy, but not the increased capital requirements and regulatory compliance costs that logically come with the unlimited support of taxpayers. Bernanke wanted to encourage people to invest in risk assets, but in actuality he's accomplished just the opposite. No one truly wants to take a risk any more. There's an easier way to make money--get Washington to guarantee profits.

Bernanke offered talk therapy, predicting that the economy would grow in the second half of 2011. He may be hoping that, if he can't add more money to the financial system to buy a recovery, he can psyche Corporate America into hiring more. But we've been stagnant for too long, and the Fed's been wrong on its predictions too many times.

Without financial methadone from Washington, the withdrawal symptoms could be painful. Scant growth, a good chance of rising unemployment, and falling stock prices. If the Fed adds more stimulus, the spectral presence of rising prices would shadow its every move.

Across the pond, the Euro sovereign debt crisis will either end badly, or worse. Wealthy northern Europe will absorb profligate Euro bloc member debt (possibly with a few token pennies thrown in the pot by creditors) and greater political power will be centralized in Brussels, or the Euro will go down in history as a very costly example of wishful thinking. Whatever the case, there won't be any stimulus to the U.S. economy from Europe. Economies in Asia are also slowing. We're on our own. What will happen?

We've already seen this video. Last summer, the same problems were tossing the economy and stock market around like rag dolls in a tornado--fading federal stimulus, sovereign debt crisis in Europe and everyone on Wall Street looking for a federal promise of profits. Ben Bernanke stepped up to the plate at the Federal Reserve's annual August conference in Jackson Hole, promised QE2, and hit what looked for a while like a home run. It's curving toward the foul pole now, but we don't yet have an official ruling from the umpire. If this summer follows the same path of economic stagnation and malaise in the stock markets, expect the Fed to step up to the table, bet its chips on a hard 8, and roll the dice one more time.

Maybe Not Bailing Out Lehman Was the Right Decision

Former Secretary of the Treasury Henry Paulson and the current Chairman of the Federal Reserve, Ben Bernanke, have been well-excoriated for their 2008 decision to let Lehman Brothers fail, rather than bailing it out like Fannie Mae, Freddie Mac and, subsequently, AIG. The charges leveled against them are to the effect that the financial markets expected a bailout, and Lehman's failure led to a massive credit lockup that turned a mild recession into the worst economic crisis since the times of Charlie Chaplin. Paulson and Bernanke are, at least implicitly, held responsible for the layoffs of millions of Americans, the near collapse of the financial services industry and the 50% drop in the stock market.

Now we have a bankruptcy examiner's report on Lehman's demise, which depicts a recklessly managed (or mismanaged, to be precise) firm on a hedge fund-like leverage rampage that artfully (in the Dickensian sense of the term) presented itself as an investment bank. Prominent among Lehman's shenanigans was the sly use of British repo transactions to sweep some of its leverage under the carpet at the ends of quarterly financial reporting periods in order reduce the firm's apparent leverage. Now that this stink bomb has exploded, a lot of former high ranking Lehman executives are denying knowledge of these British repos (called "Repo 105s") or not commenting. The auditors insist they did an acceptable job, although it appears they knew of the allegations of a whistleblower. And one can only wonder if, at its meetings, the board was focused on what would be served for lunch instead of the financial condition of the firm.

The press and blogosphere are now swarming the potential culprits like packs of ravenous wolves with litters to feed. Blame is being avidly and abundantly cast. Very possibly, it is well-deserved.

Perhaps, though, along with the zestful mud-slingarama, we should consider whether anyone comes out looking a little better. Maybe Hank Paulson and Ben Bernanke weren't so far off the mark. With what we now know about Lehman's true financial condition, we can see that a bailout would have been much more expensive than it seemed at the time Lehman collapsed. Outrage over bailing out undeserving Wall Street executives would have been all the more magnified if the shameless gamblers at Lehman had received the munificence of taxpayers. The chattering classes would have fulminated about immoral levels of moral hazard and the witlessness of the government allowing potential wrongdoers (top executives, board members and auditors) to live to fail another day.

It doesn't necessarily follow that a Lehman bailout would have precluded the need to bail out AIG. Perhaps, a bailout would have encouraged AIG to extend its leverage even more in the hope of trading its way out of trouble, like the losing gambler who goes in for a dollar after losing a dime. That strategy could have easily led to mega-disaster in the volatile markets of 2008. Then the taxpayers would have been taken to the cleaners even more than they were.

Did Hank Paulson have an inkling of what Lehman was up to? After all, he would have had access to the top levels of Wall Street, and it's quite possible that others on the Street sensed, if not knew, what was going on at Lehman. Did Chairman Bernanke field enough phone calls from Wall Street execs to get the picture? We may never know for sure everything that Paulson and Bernanke knew, heard, sniffed out or suspected. But, in the interest of Monday morning quarterbacking government officials fairly, let us consider that their decision not to extend the generosity of taxpayers to a bunch of rascals really wasn't all that bad. Indeed, had Lehman not gone into bankruptcy, we wouldn't have the comprehensive examiner's report to provide a better picture of how inept risk management in the financial system has been, and why financial regulatory reform, still stalled in Congress, remains desperately needed.

Why We're on the Road to a Federal Bailout of Lehman and Others

A federal bailout of Lehman Brothers in the near future is a near certainty. It probably won't be the end. More federal bailouts of large financial institution are likely to be in our future. Here's why.

Real estate and mortgage losses continue to abound. A lot of these losses remain unrealized on the books of major financial institutions and may grow as payments pop on option ARMs written two and three years ago. Foreclosure rates are rising and much of the relief provided by the Bush Administration's mortgage aid package from last year simply defers payments instead of reducing them. A lot of people who can't make the payments now won't be able to do so later, not when we have a slowing economy and rising unemployment. So losses are deferred but remain to be recognized. To make things worse, the commercial real estate market is getting uglier by the day.

Losses in commodities trading are rising rapidly as oil, gold, silver, platinum, corn, wheat, copper and other commodities deflate in value. Since commodities trading is heavily leveraged, the banks that financed these transactions, as well as hedge funds and other speculators, stand to book losses. Thus far, little has been said publicly about these losses, although a large hedge fund, Ospraie Fund, has shut down because of poorly performing commodities-related investments. More commodities losses will surface sooner or later and take their toll.

Credit card, car loan and other credit losses are on the rise, just at a time when investors are increasingly reluctant to buy securitizations of all types of loans. Banks have nowhere to go with an ever stinkier loan portfolio.

The U.S. and worldwide economy are slowing and unemployment is rising, making it more difficult for banks and other financial firms to work their way out of their losses.

Last, but certainly not least, the "too big to fail doctrine" discourages private capital infusions. Having booked monster losses, and with even uglier monsters looming in their financial futures, many large banks desperately need to raise capital. The financial sector's depleted capital is like a weakened immune system, and capital infusions are the way to buck up the patient. But the "too big to fail" doctrine employed by the federal government in the recent Bear Stearns, Fannie Mae and Freddy Mac bailouts includes substantial elimination of the interests of stockholders. That policy makes sense. If stockholders are at risk of total or near total loss from federal intervention, they presumably will hire competent management who will prudently avoid the need for a federal bailout. But this policy also means that a seriously distressed bank large enough to qualify for "too big to fail" treatment won't be able to find private capital. Investors will be concerned that they could pony up their money today only to be squeezed out by the feds three months hence. In effect, the "too big to fail" doctrine means that the federal government is the only salvation for major financial institutions when they become seriously impaired. The smart money will wait for the federal bailout, figuring that a year or two from now, when the feds are reorganizing the bailee and selling off its assets, private investors can buy those assets at a better price than investing in the failing banks today.

So, get used to the idea of more federal bailouts, and a bigger federal deficit to pay for them. The stock market seems to be getting used to them. The 290 point gush in the Dow after the announcement of the Fannie/Freddie bailout dissipated the next day. Another day, another bailout.

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