Just a few months ago, I published a memo called "Tell Me I'm Wrong" (January 22), in which I listed a number of things that worried me. These included our reliance on government stimulus and artificially low interest rates; the uncertain outlook for consumer spending, jobs and state and municipal finances; and the risks pertaining to inflation, exchange rates and interest rates. Here's how I concluded:
My goal in this memo isn't to express a forecast. I know no forecast – and certainly not mine – is likely to be correct. What I do want to do is
caution that the considerable risks I see may be less than fully appreciated by those setting asset prices today. The greatest market risks lie in failure of the macro economy to live up to the expectations embodied in today's prices. . . .
Most people view the future as likely to repeat past patterns, which it may or may not do. They tend to think of the future in terms of a single scenario, whereas it really consists of a wide range of possibilities. (Remember Elroy Dimson's trenchant observation that "risk means more things can happen than will happen.") And to the extent they do consider a variety of possibilities, few people include ones that haven't been part of recent experience.
The uncertainties discussed above tell me today's distribution of possibilities has a substantial left-hand (i.e., negative) tail, probably
greater than at most times in the past. The proper response should be to discount asset prices, allowing a substantial margin for error. Forecasts should be conservative, yield spreads should incorporate ample risk premiums, valuation parameters should be below the longterm norms, and investor behavior should be prudent.
Conspicuously missing from my list of worries was Greece (and all it entails); thus it falls firmly in the category of "something else." Last week it dominated the headlines and depressed markets worldwide. Thus in this short time I have proved two things: first, I know little more than others about what the future will bring and, second, when most investors turn optimistic, it becomes important to worry.
The issue of Greece and its debt has been on investors' radar screens for months, but few people seem to have understood its ramifications and the risks it presented to the markets. Then, in recent weeks, things began to be discussed daily in the media – such as Greece's profligacy and the risks involved in admitting it to the European Union; Europe's lack of an established mechanism for dealing with a problem of this nature; and its reliance on
Germany to contribute voluntarily to a solution – that in hindsight it seems should have been obvious. This tells us a few important things about investing:
- Investors generally overestimate their ability to see the future, and the worst of them act as if they know exactly what lies ahead.
- It's important to worry about what's coming next. The fact that we don't know what it is shouldn't permit us to think there's nothing to worry about.
- Low asset prices allow us to invest aggressively, without much consideration given to worrisome fundamentals and the possibility of negative surprises. But as prices rise, so should our degree of concern over these things.
The bottom line is this: the fact that we don't know where trouble will come from shouldn't allow us to feel comfortable in times when prices are full. The higher prices are relative to intrinsic value, the more we should allow for the unknown.
The recovery of 2009 in the face of significant fundamental uncertainty meant that the markets were reincorporating optimism and thus vulnerable to surprise and disappointment. This in itself should be sufficient to induce caution.
May 12, 2010
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