For example, right now there is a back-and-forth between Nobel Laureate Paul Krugman and other economists about the utility of the IS-LM model. That was a distillation by John Hicks of what he thought John Maynard Keynes was saying in the 1930s. Hicks was not satisfied with his formulation, and it has fallen into desuetude in macro-economic circles. But the more sophisticated mathematical models that have replaced it have offered no better traction in the current economic crisis. So Krugman defends it as an ad hoc way of thinking through the investor mindset.
What is the investor mindset? They prefer cash now to the potential returns on risky investments. Cash pays 25 basis points. Even mattress manufacturers make more than that. But better some money than none.
Occupy Wall Street sets an interesting counterpoint. It sets no demands. There’s really no manifesto. (I owe this insight to Kevin Press at Brighterlife.ca). But there is the experience that something is not right. The economy is not working. What the solutions are, however, cannot easily be grasped. But it’s always good to ask questions – to allow, for once, the wisdom of the crowds rather than the certainty of mathematical models.
All the more so in investing. We think we know where stocks should trade, based on fundamentals, comparators of relative value, even chart patterns. When those expectations are upended, we can point to black swans. We can point to political interference. We can point to just plan dumb irrational behaviour. All of these things upset our models. But we are at the mercy of the wisdom of crowds.
Let’s take Greece, for example. The headlines are getting worse. The debt is a hopeless situation. In the end, there will be haircuts all around – enough, one surmises to put hairdressers out of business. With or without repudiation of the debt. That is the wisdom of a market crowd.
But there’s always Ireland. Is it different? As commentator John Mauldin wrote recently,
“When you press politicians and establishment types (and I did) who are against unilaterally disavowing the debt, a strange thing happens. I kept asking, ‘But the voters seem to want to forego the debt. And the math suggests that Ireland can’t pay back these foreign bankers without great sacrifices.’ At first, they would point out that Ireland is doing what needs to be done: cutting spending and payrolls. We are not Greece, they say; there is a need for ‘respectability.’
“But when pressed, they would come around to admitting that, ‘Yes, Ireland will get a haircut.’ Everyone I met expected it to happen. The difference was the path to the haircut. But while the politics matter, the destination is the same. Some favor doing it outright. Others truly believe they will be offered a haircut when Greece and Portugal get theirs. They fully expect it. In a meeting with an establishment-insider economist (off the record), who was at the table when the first deal was done, he said there was an implicit understanding with the IMF (and ECB) that whatever was offered to Greece, et al. would be available to Ireland. So Ireland went along with the bailout to keep from imploding the euro and averting a crisis that would have been biblical in proportions. The future of the euro is now not in their hands, because by taking on the debt they did not blow the euro up. Which could have happened, because European politicians were not ready for such a crisis.”
So Europe is in a situation now of distributing the pain efficiently, fumblingly, and perhaps unwisely. The crowds may baulk.
But the pain is also getting worse in the U.S., where President Barack Obama commented about the severity of the recession – meaning it hadn’t ended in June 2009 when the National Bureau of Economic Research said it did. But that’s crowd wisdom.
More worrisome is that consumer demand will remain remain weak for the next four or five years. Even without the government austerity contemplated in Europe, the post-recession period has seen U.S. consumer incomes plummet by more 6%, far greater than the 3% that occurred during the official recession. Unemployment, meanwhile, is expected to remain high until 2015, and the Fed has held off on interest rates until 2013.
What does that mean for stocks? We don’t know. We think we know what they are worth. But we can never be sure the market will realize the value we see. We depend on the wisdom of the crowds.