Sunday, August 17, 2014

Ebola, and Reflecting On 2007-2008

Twitter's excellent Sober Look pointed me towards the WHO's disconcerting warning that the current Ebola outbreak has been underestimated. The WHO believes that the number of reported cases and deaths is being underestimated, as is the time expected to fully contain the outbreak. This caught my eye because I had earlier insisted on Twitter that news consumers were overplaying the risks of Ebola, while ignoring the potential significance of China's hukou reforms in improving the social and economic lives of millions of people. I don't know if the Ebola outbreak is cause for concern for those outside of West Africa, especially as other commentators like Dan Drezner decry Ebola scaremongering, but I was reminded of another time when I was wrong in assessing the risk of a situation, i.e. evaluating the economy and financial markets in 2007-08.

Seven years after the onset of the Great Recession, there are many competing theories about what happened to produce such a financial and economic catastrophe. I wrote a post praising Ed Catmull's "Creativity, Inc." last week, and this quote stood out to me, among other gems: "Hindsight is not 20/20. Not even close. Our view of the past, in fact, is hardly clearer than our view of the future. While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited. Not only that, because we think we what happened clearly  - hindsight being 20/20 and all - we often aren't open to knowing more." I won't even attempt to rehash the arguments, but will merely state my view that financial fragility caused by high leverage, poorly understood products and contagion effects interacted with some pernicious monetary policy decisions to create the crisis. Despite my deep interest in prior financial panics, I believed that the subprime debacle in the US would be contained, leading to a recession but not the mini-Depression that ensued. Suffice to say I was wrong. I had an insufficient appreciation for the hidden leverage throughout the financial system and the potential for contagion. I also failed to foresee that major central banks were allowing monetary conditions to tighten like a vise around their economies. 

I'll let myself off the hook slightly by conceding that it is the very nature of complex adaptive systems that leads to such surprising outcomes. Furthermore, I'm certainly not saying that this Ebola outbreak is the health equivalent of 2007-2008. I'm merely recognizing that there is more to be worried about when contagion is involved. This is in contrast with that other recent favourite of scaremongering journalists, the spate of air crashes worldwide. While I view the air crashes as largely independent and random events, the contagion characteristics of an epidemic offer greater cause for concern.

So what would have been the appropriate response in 2007-2008? This is a more difficult question than it seems. As Kissinger says in his book "On China", "Analysis depends on interpretation; judgments differ as to what constitutes a fact, even more about its significance." An omniscient trading genius would have been heavily short by May 2008, and would have reversed course in Mar 2009. This is highly unrealistic, and much easier said than done, since anyone smart (or nervous) enough to have sold in May 2008 would likely have had an aversion to re-entering the market even when it was cheap (relative to fundamentals) in middle to late 2009. The hardy few will suggest that the best path would have been to do absolutely nothing. After all, if Lehman's bankruptcy had put you in Rip Van Winkle state on 16 Sep 2008, you could have woken up on Apr 23, 2010 to find the S&P 500 unchanged at 1213. Of course, this ignores the opportunity cost of maintaining your holdings - you could have sold on 16 Sep and had the opportunity to buy at lower levels. 

Thankfully we have two tools that can aid us in this difficult task, namely (a) valuation and (b) scenario analysis. Valuation provides an anchor while the investor is buffeted by waves of events and information. Scenario analysis allows us to consider various possibilities and incorporate them into our valuation. Both have to be subject to rigorous scrutiny, because "valuation" can ossify into dogma, ignoring changing facts and the multitude of assumptions under the surface of purported precision. I suspect using these two tools in 2007-2008 would have led an investor to be less long (it takes a different mindset to short successfully), and would have allowed the investor to gradually increase his exposure throughout 2009 (and indeed, through 2013, when I think stocks went from being cheap to being fairly priced). 

These are not easy judgments to make, and this, after all, is why truly talented investors deserve to be compensated accordingly. Combining the relevant financial analysis with a subtle appreciation of the sociology of markets requires an unusual calibre of investor. If you find that person, I suggest you hold on to her - and suggest equally that you prevent her from undertaking any non-essential travel to the affected West African countries until we better understand the extent of this outbreak.

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