In 1936, during the depths of the Great Depression and the fading of New Deal optimism, Bing Crosby starred in “Pennies from Heaven”, as well as sang the eponymous tune, in which he crooned:
Every time it rains, it rains pennies from heaven
Don't you know each cloud contains pennies from heaven?
You'll find your fortune's fallin' all over the town
Be sure that your umbrella is upside down
Trade them for a package of sunshine and flowers
If you want the things you love, you must have showers
So, when you hear it thunder, don't run under a tree
There'll be pennies from heaven for you and me
In other words, celebrate the bad times (thunder and rain) for they bring on the good things (sunshine and flowers). This is just the sort of positive self-talk you need when you are living through an era of high unemployment, low growth, and little job creation in order to keep from losing hope.
Likewise, we note that during the second quarter of 2013, US investors in both stocks and bonds decided that bad news was good and good news was bad with regard to the Federal Reserve’s ongoing Quantitative Easing program . Thus, investors sold stocks AND bonds when it appeared more likely that the Bernanke Fed would curtail and eventually end its $85 billion per month bond buying based on improving or upbeat economic data. Conversely, they bought when downbeat or negative unemployment, growth, or consumer confidence numbers were announced believing that the Bernanke Fed would have to continue its QE purchasing program, pumping a trillion dollars into financial markets annually.
The phenomenon become particularly acute on June 19 when Bernanke held a press conference in which he said that if the economy continued heading in its then apparent mildly positive direction, tapering, i.e. gradually reducing the size of Fed bond purchases, might begin as soon as yearend. Stocks in the U.S., and those of Asia and Europe, declined significantly, offsetting many of the year-to-date gains, in reaction. In contrast, just a week later when news that the initial, and semi-impressive, 2.4% growth number for U.S. economic growth was to be revised down to 1.8%, markets were cheered by the speculation that the end of QE might not be in sight after all.
Two aspects of “bad news is good news” phenomenon fascinate us, in addition to being supportive of our disbelief that investors are the full-time rational thinkers of mid-20th Century investment theorists’ collective worldview.
First, the idea that monetary stimulus is preferable to an economy growing under its own power in the minds of stock investors, strikes us the poster child of investor irrationality. It is understandable that bondholders would dread rising interest rates, after a 30 years bull market in bonds, though they too are lacking in perspective if they haven’t been structuring their holdings over the past couple of years in anticipation of rates moving against them. But there is no excuse for any stock investor at this stage not to prefer real to feigned growth in the U.S. and other major economies.
It was understandable in the 2008 to 2010 that the Fed would undertake “QE1”, when local and global financial markets were still staggered by the Lehman/AIG Collapse, providing immediate liquidity to prevent an even more dire set of circumstances. But the credit emergency has long since passed, and yet we are in “QE4” with no certain end and having spent 40 of the past 56 months in a state of monetary ease courtesy of the Fed. And if QE4 holds to course, ending, not just tapering, sometime in mid-2014, the U.S. will have spent 4+ years out of the past 6 living on monetary stimulus. And, all the while continuing to pile up ever more claims against future prosperity because Fed bond purchases are ultimately another form of fiscal borrowing and such borrowing must be paid back at some stage or inflated away and the cost of reducing the Fed’s balance sheet will also need to be included in that total because the Fed will incur losses selling its bond and its capital base is incredibly thin. Either way, future growth and spending power must take a hit. Stock investors should be cheering and buying when Bernanke hints at a future tapering of QE, rather than booing and selling, because it frees up more of our collective future prosperity for discretionary consumption.
A future with lower government debt servicing requirements, freeing up societal spending for other needs and wants, rather than saddling the future with the obligation to pay off past needs and wants should accrue to the benefit of today’s stockholders, if the concept of saving and present value are to have any validity.
As to our second point of fascination, that no new “information” was revealed either by Bernanke in his June 19 press conference or by the Commerce Department in its June growth or employment numbers, also aims at a core tenet of mid-20th Century economic thought: informational certainty and its endless utility. Informational certainty is a crucial component of modern financial theory because of the hypothesis that more information and transparency leads to greater certainty in the minds of investors which leads to more accurate pricing of assets.
Though quoted in the context of financial statements, an article published by the Financial Standards Accounting Board entitled “The FASB and the Capital Markets” encapsulates this notion: “More information always equates to less uncertainty, and… people pay more for certainty. In the context of financial information, the end result is that better disclosure results in a lower cost of capital.” In other words, a lower cost of capital should mean greater profits and, in a reasonably equitable society, greater widespread prosperity.
Over the past two decades, greater transparency across almost all facets of modern societies has been a widespread, mainly positive phenomenon. In sympathy with this trend, Ben Bernanke has made real-time transparency a central policy of his chairmanship of the Fed. Undoubtedly, key pieces of substantial information provided in a timely matter do improve the functioning of not just capital markets, but also societies as a general matter. Yet, it should also not be doubted that information saturation may reach flood proportions, that the “pennies from heaven” coming down in the form of repetitive or ambiguous data points can result in the recipient drowning. Even short of drowning in information, there is the potential for cognitive flaws stemming from overconfidence that “all that needs to be known is known” based on the huge volumes of information an analyst or investor may take in.
We propose a new word for this phenomenon of more information changing from a solution to becoming itself a problem for the investor: “dys-information.” This is short for “dysfunctional information” and, rather than implying deliberately deceptive information, we think it captures the problem where each bit of information may be reliable, but the volume, direction, and rapidity of new information is too complex for thoughtful analysis, yet the compulsion to take action overwhelms the investor.
The whipsawing at the end of the second quarter in U.S. and foreign markets is an excellent example of this phenomenon. At a June 19 press conference, Bernanke laid out possible scenarios under which tapering of Fed bond purchases might occur over the next 6 to 12 months and global stock markets promptly fell 2% to 3%, producing a $1.5 trillion diminution of global wealth while the 10 year U.S. Treasury jumped from 2.18% to 2.44%, a 12% increase. The violence of this reaction is particularly notable since Bernanke went to great pains to repeatedly point out the tentativeness of his scenario and ending with, “I think one thing that’s very important for me to say is that, if you draw the conclusion that I’ve just said, that our policies—that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion because our purchases are tied to what happens in the economy.” [emphasis ours]
It did not take long for Bernanke to be proven right, that, indeed, his hypothetical tapering scenario met its demise just seven days later when the Commerce Department announced on June 26 that first quarter U.S. growth was not, as originally reported, a respectable 2.4%, but instead an anemic 1.8%. The Dow Jones responded by surging upwards and gaining 150 points on the day and stock markets have been on an upward path ever since, many, including the Dow, reaching all-time highs in mid-July.
It is the absurdity of this moment to moment, transitory event to event, short term orientation which we seek to avoid in our investment approach. A reactive posture in this age of investments is costly, in terms of execution and advisory costs, and exhausting, thanks to the 24/7/365 information cycle. We believe there is now fairly solid evidence that more information, at this point in time, does NOT lead to greater certainty, a point well-made in two papers by Professor D.J. Johnstone of the University of Sydney Business School, "The Effect of Information on Certainty and the Cost of Capital" and "Information, Uncertainty, and the Cost of Capital in a Mean-Variance Efficient Market".
While “more information equals better decisions” may have been true when Markowitz and Sharpe spawned Modern Portfolio Theory in the 1950’s and 1960’s, and it can be argued that even into the 1990’s there was a relative dearth of immediate and substantial information. But, from 2005 onwards, a lack of available information to feed into the various equations and ratios in order to analyze the value of a stock or bond is no longer an issue. This is not an argument for ignorance of current events, but rather a recognition that volume of and accessibility to information has increased exponentially over the past 30 years and we now live in an era of a plentiful, largely superfluous, information.
Back in the day, an investor could always use more information, but today, investors have more information than they can use. Furthermore, the ease and reduced cost of transacting has taken away some of the hesitation which might have prevented actions for the sake of action. The incredible increase in information available to investors has undoubtedly been a great blessing over the past 30 years, but, by the same token, every silver lining has a cloud, and sometimes clouds foretell a storm.
© Neosho Capital