By buying $1.25 trillion of mortgage securities, the Fed absorbed a flood of assets that otherwise would have needed buyers. That kept money in
the hands of investors, who went searching for something else to buy. The Fed's underpinning encouraged investors to seek riskier, higher-yielding securities. A natural choice: corporate bonds. ("Bonds Cap Epic Comeback," The Wall Street Journal, March 31)
One of the prime tasks investors must perform is to stay alert to extreme behavior and take hints as to what we should do from what we see taking place around us. This is best expressed in Warren Buffett's helpful reminder: "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs."
Investor behavior between 2003 and mid-2007 was sending some very worrisome signals. It's obvious in retrospect that all one had to do was take heed and lean in the opposite direction. But observations regarding the past are no help for purposes other than education. For observations to be profitable, they must relate to the present and the future.
Investors have made a substantial move back in the direction of pre-crisis behavior. That behavior has to be recognized and monitored. The pendulum has moved away from the depression, panic, skepticism and excessive risk aversion we saw in the fourth quarter of 2008, and with the disappearance of those characteristics have gone the great bargain opportunities.
Uncertainty and fundamental weakness at the depth of the crisis were offset by irrationally low prices and the potential for a rebound in risk tolerance, making most assets a screaming buy. With most of the great bargains gone – along with excess risk aversion – macro uncertainties should no longer be overlooked. Thus the caution, discipline, patience, selectivity and discernment that were so unnecessary in 2009 are absolutely essential today.
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I started this memo in late April, but I didn't get it out before Greece's financial crisis burst into full bloom last week. This gives me an opportunity to discuss the significance of the recent developments (not the substance, however; that'll have to await another memo).
Investing defensively requires that when everything seems to be going well and investors are feeling positive, we must sense the implicit danger and prepare for negative developments.
In the mid-2000s, I began to warn that with asset prices full, investors optimistic and their behavior aggressive, it was important to worry about things that could come along to derail the markets. When asked what they might be, my list of possibilities would go like this:
- recession,
- credit crunch,
- $100 oil,
- collapse of the dollar,
- exogenous events such as terrorist attacks, or
- something else.
The most dangerous possibility, I pointed out, was the last one. Markets and market participants can adjust to things they see coming. What usually knocks them for a loop are things they don't anticipate. "We're not expecting any surprises" is one of my favorite oxymorons. By definition, surprises are things that aren't anticipated, and thus their arrival can be traumatizing.
