Et Tu Lehman? The Contagion of Fear

There are many events, and more importantly RUMORS of events, putting the market on edge.

There has been a surge in the MarketPsych Fear Index, in part due to Lehman's potential implosion, this time due to excessive and illiquid leveraged positions. With Lehman's request for $6 billion to fill in the hole dug by CMOs and excess borrowing, the market is back on the brink.

All this in the context of early summer. Recall from a prior blog post that there is truth in the saying "Sell in May and Go Away" - here is a great graph of the effect.

The specter of world oil and commodity price shock, inflation, flooding in U.S. agricultural regions and drought in Australia's, war with Iran, and general purpose catastrophe has reared it's head again. I don't mean to be glib. There is danger afoot. This isn't one of those merry "buy on the pullbacks" type of markets. Or is it?

There is indeed a developed world deleveraging happening. Will that spread to the developing world? It appears to be anticipated in recent stock market performance, but then, that may have been developed world money fleeing those markets, which is my opinion. And that doesn't mean the sky is falling.

The "sucker's rally" Frank and I predicted in March has come and gone. The DJIA passed 13,000 and then dropped back again. So here we are again, down 8% for the year.

So it's not looking good for anything except commodities and oil? No, that's not what I'm saying. I'm fairly interested in technology, pipe (yes, steel tubes for drilling), recycling, shipping, land, and many mining stocks. India and China aren't slowing their growth much, even though the US is, and they use lots of raw materials still. One land and oil trust that I've held for years, and plan to hold for many more is Texas Pacific Land (TPL), and also a pipe company, WEBC. Yes I own shares in these, and if you try to buy WEBC, you'll move the market, so please don't.

But wait, I need a legal DISCLAIMER here of some sort. Hmmmm..... (nervously scratching my head)... OK, so don't buy TPL or WEBC. I'm not recommending them. I'm just saying they're out there. I don't want to get sued because someone bought one now and sold it when it fell or went bankrupt and they lost money. Like I said, "DON'T BUY TPL OR WEBC!!!!!" Please don't, really.

I think I'm covered now. Whew!

And here's what's interesting: when investors are primed to be cautious because of one bad event, they often extrapolate that danger into other spheres (in my case, fear of litigation). When in fact they might want to find inflation-hedged stocks, which will continue to perform over time. But this is very difficult to do when you're afraid, because of neural "priming" in the anterior insula of the brain.

A fascinating study which we profiled here, by neurofinance geniuses Brian Knutson and Camelia Kuhnen, demonstrated that activation in the brain's anterior insula predicted excessive risk avoidance in an investing task.

Building on this finding, Greg Larkin, Brian Knutson, and collaborators found that anterior insula activation appears beneficial for learning which dangers to avoid. See their paper here. A light summary in Psychology Today is here. Interestingly, people who are more constitutionally "neurotic" (nervous) have more insula activation when faced with monetary losses. While being "neurotic" isn't usually seen as a personal positive (especially by neurotic people, who are already predisposed to worry that something isn't right anyway), it turns out that neurotic people (with their greater reactivity of the insula), are better at learning to avoid financial losses going forward. Insula activation did not affect learning to pursue or avoid financial gains. So I didn't do the study justice here, but hopefully more on its implications later.

While perma-bulls buy on the dips, more anxious investors may be rightly on the sidelines, waiting for these storms to pass. And their sitting out the volatility has now been proven right a few times over the past 12 months. Yet, then they might get stuck sitting and never acting. The market is always a balancing act.

In our in-house research, it's not the absolute level of market fear that predicts a market rally, but a retreat from a high level to a lower one. That's what you'll want to look for before buying. And for the past 12 months we've had historically high levels of fear.

What causes such retreats from peaks to lower levels? It's usually a resolution of some dangerous anticipated event. For example, the collapse of Bear Stearns and the Fed's willingness to step up and put a floor under the CMO market. That resolved a tremendous amount of uncertainty.

If Lehman can raise $6 billion, at a not horrible price, then I think another level of uncertainty will be resolved.

If the Iranian government stops declaring they plan to wipe Israel off the map (fat chance!), then there's another level resolved.

So it looks like the fear will continue for a while..., but we'll still hae some ups and downs that present good buying oppotunities in select sectors.

Happy Investing!

Richard

The Fiddler's Green: Curse of the Adjustaholic

It was Blaise Pascal, the brilliant French mathematician, physicist and philosopher who said:

"All of men's miseries derive from a single source; his inability to sit peacefully in his room."

Pascal was not referring specifically to investing -- but he certainly was including it. We love to tinker, adjust and monkey with. At least I do.

My name is Frank, and I am an adjustaholic.

My affliction began early in my youth. I would fiddle incessantly with the old rabbit ear antennae on the "television set" in a futile effort to achieve picture perfect clarity on a 1974 Magnavox. I would indulge in impulsive, hare-brained schemes such as throwing the football in an effort to knock the frisbee out of the tree. And then throwing the tennis racket at the football.

By 5 o'clock the tree on my lawn looked like Dick's Sporting Goods.

Sure. I could have waited patiently for my dad to come home and retrieve the offending object. Could have for 2 minutes that is, before the restlessness set in.

I'm older now. I have an HD TV and I don't play much frisbee anymore. But I am still a fiddler.

It raises to mind a behavioral finance question: What is to become of the Fiddler's Green? I'm not referring to the traditional Irish song (which is great by the way), but to the financial portfolio of the modern adjustaholic. If you are an adjustaholic like I am, there are some days you have an urge to fiddle. Somedays you just wake up, get a cup of coffee... and you just really feel like buying a stock.

Any stock.

I'm gonna do it. I'm gonna buy... geez, I dunno... something in the IBD top 10! Like SYNL! And why not? It's # 1 on their list for crying out loud! What exactly does SYNL do? They print $$$ for their investors, THAT'S what they do! It's up to 45. Have you seen the chart! It's a rocket ship! Besides, I'll just cut my losses at 8% if it drops. (And I really will this time too.) But it won't drop! That's the beauty of it! You may say I'm joining a game of Musical Chairs at the Greater Fools Social Club, but they're playing the live version of Freebird - and they haven't even gotten to the guitar solo yet!

Do I really need to tell you what happened next? Suffice it to say I capped my losses at 8% this time. (Okay, 10%). And the fiddler loses some more green.

I recently had a conversation with my colleague, Dr. Peterson. I stated that we cannot change human nature, but that we could plan around it.

Dr. Peterson pointed out that the same human nature that bedevils our investing process is equally apparent in our planning processes.

He has an undeniable and somewhat depressing point.

Well, I still believe we CAN plan around human nature, but it is not easy. It requires honesty with ourselves and self-awareness. It requires having, at the ready, a behavioral alternative that is less self-destructive than placing a buy order. Sometimes it may require help. One of the best things a busybody investor can do is to have a partner - a financial advisor, a friend - someone they can call in his/her moments of weakness.

I'm serious. Alcoholics Anonymous, Gamblers Anonymous, Smokers Anonymous -- one of the most effective methods of stopping a destructive behavior is to reach out to another person when your will is faltering. It helps.

Pascal was right. I cannot sit peacefully in my room, the one with the computer in it... and the access to my brokerage account.

Next time I feel the urge to buy SYNL, maybe I'll call Rich. Or maybe I won't bother to sit in my room at all, and I'll go for a long, long walk instead.