Friday, July 18, 2014

To Panic or Not To Panic?

I'll keep this post short as I shake off the rust on my blog after a 2-month hiatus. It seems to be a day for serious geopolitical news with word coming that pro-Russian forces have mistakenly shot down a Malaysia Airlines passenger plane at the same time that Israel has launched a ground offensive in Gaza. Tren Griffin has wisely counselled investors to focus on their process and stay rational by tuning out noise, echoing the excellent advice Meb Faber offered 8 days ago.

I can't agree enough with that statement. Equanimity and the ability to step back from one's emotions are crucial parts of investing that aren't sufficiently cultivated. Yet this doesn't mean ignoring geopolitical news. Investors need to find a way to incorporate geopolitical shocks into a methodical framework. Frankly, this is easier said than done. Financial markets are complex adaptive systems, and one of the characteristics of such systems is non-linearity, i.e. the propensity for small inputs, physical interactions or stimuli to cause large effects or significant changes in output.

Another reason we have to wrestle with geopolitical news is that these events can be genuine shocks within an AD/AS framework. For example, Lars Christensen noted the aggregate supply shock resulting from the Russian invasion of Crimea. Aggregate demand shocks, too, are rampant. I recently saw "Five Years From The Brink", a documentary focusing on Hank Paulson's role as Treasury Secretary during the panic of 2008 (I wouldn't rush out to get it, although it does offer the benefit of hindsight). One thing that struck me was his point that each of the beleaguered financial institutions would have constituted a full-blown crisis on its own, and that policy-makers from Treasury and the Fed (to name a few) had multiple balls of crisis up in the air at the same time. This, undoubtedly, prevented the Fed from acting sooner in its role as monetary policy-setter as it went instead into crisis mode. The revival of geopolitical tensions requires the attention of policy-makers who may therefore neglect the importance of monetary policy (weakening AD) or investments in education and infrastructure (weakening AS). None of these things is good.

The reality is, therefore, that investors need to incorporate geopolitics into their frameworks, either by setting out various scenarios and assigning probabilities to them, or by demanding a buffer of safety in their investments. My suspicion is that the current bad news is not sufficient to derail the global economic recovery. Those who are bearish today, however, may turn out to be right for the wrong reasons. Ambrose Evans-Pritchard warns of a possible dollar squeeze in the offing, as Lars Christensen is rightly concerned about the Fed's stock-picking. I had to wonder today on Twitter if biotech and social media stocks will prove to be the magnets making the Fed's monetary compass malfunction, as oil did in 2008. I certainly hope not, for if so, the modest expectations for growth that I and other investors hold may still prove to be too optimistic. So, to answer the eternal question - to panic or not to panic? - I offer the measured, "It depends on your framework." But I hope you have one, because it may soon be challenged.

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