In case you missed it, hell just about froze over last month. That's because James Grant, editor of Grant's Interest Rate Observer and perhaps the best-known bear since Yogi, made the case for a "barn burner" recovery.
Wryly noting that he is not exactly a “glass half-full sort of fellow,” Grant surprisingly asserted in the Wall Street Journal that “I am (for once) — bullish on the prospects for unscripted strength in business activity.” That would be newsworthy simply for the fact that it runs counter to what we’ve come to expect from Grant, whose analytical rigor has earned him plenty of Street cred over the years. But it becomes even more intriguing — confounding perhaps — when butted up against the widely held belief that we face a hangover after the party years of over-leveraging and deregulation. Most experts predict an extended period of slow economic growth in the United States, an outlook that the investment pros at Pimco have labeled the “new normal.”
Though Grant’s bullishness is indeed a few standard deviations removed from the new normal consensus, Grant has some weighty company in outlier land, including Neal Soss, Credit Suisse’s chief U.S. economist, and Brian Wesbury, chief economist at First Trust Advisors. Moreover, Grant’s assertion that “the deeper the slump, the zippier the recovery” referenced research from MKM Partners’ chief economist Michael Darda, who says that, dating back to 1929, the preceding recession’s depth is the most important determinant in the velocity of the subsequent recovery. Grant also cited the well-respected Economic Cycle Research Institute, whose index of economic indicators is now signaling the strongest bounce since the 1983 recession.
To be clear: even if we were to get a Grant-ian economic recovery, it’s not a given that the markets will rally in kind. David Rosenberg, chief economist at investment firm Gluskin Sheff, points out that the 60 percent rally from the March low puts the market today at a level usually not seen until the second year of a recovery. That means there’s already a lot of good news baked into current market valuations.
But the mere fact that Grant has ventured out onto a limb he is not known to frequent, replete with backup that makes his case impossible to dismiss, creates an intriguing challenge. Might Jim Grant be right and the conventional wisdom all wrong? Moreover, how exactly are you supposed to digest this counter-argument to the new normal?}
Another Black Swan?
“If you feel instinctively that Grant’s right or wrong, it’s probably your confirmation bias kicking in, in your preferred direction,” says Tim Richards, who pens the illuminating behavioral finance blog Psy-Fi. For the same reason liberals aren’t tuned to Fox and conservatives don’t spend much time watching Keith Olbermann on MSNBC, investors tend to hold fast to their beliefs and filter new information through their preset prism. “The fact that he’s been right for a long time by being contrarian doesn’t mean he’ll be right this time. It doesn’t mean he’ll be wrong either. We just don’t know,” Richards says.
That the new normal spin seems more rational and fitting than Grant’s thesis should provide you no confidence or comfort. It’s the “black swan” — those unforeseen, unexpected events that can and do occur, and often with profound impact — we need to keep an eye out for. While the recent financial meltdown has given rise to the notion of black swans as bad-news surprises, the concept, popularized by writer Nassim Nicholas Taleb, allows for huge surprises to the upside as well as the downside.
Nor is overconfidence in the rightness of the masses advised. Mat Johnson, a portfolio manager at Quantum Capital, warns of “the risk of consensus.” It has a funny habit of being wildly off base. From the relatively mundane, such as the frequent news that corporate earnings beat the Street’s estimates, to the tectonic miscalculation in 2007 that the mortgage mess would be confined to the sub-prime market, conventional wisdom can be a dangerous mistress. One common problem is that the consensus often is stuck on what has just been lived through, and thus forecasts often overemphasize current market conditions. So, in the wake of the recent meltdown, Johnson says we are predisposed to “focus on what could go wrong rather than think about the possibility of what could go right.”
With respect to what could go right, as Darda’s research points out, there is evidence to support a stronger-than-expected rebound. But more importantly, we have no way of knowing what slice of history will play out this time around. “It is true that we have possible patterns to draw on for this recovery,” says Meir Statman, a professor of finance at Santa Clara University who studies the intersection of human foibles and sound investing principles. “It may be a V[-shaped recovery], a W, or an L,” Statman says “They have all happened in the past, but the honest answer is that we will not know which one this will be until we view it from hindsight. The real problem is that people are unable to stop themselves and admit the future is unknowable.”
OK, so how do you not get fooled again? Harold Evensky, principal at Evensky & Katz Wealth Management in Coral Gables, Fla., suggests adopting “uncertainty is reality” as your investing credo. At best, you have probabilities to lean on in making financial decisions, and of course, you must base your choices and decisions to some extent on assumptions about what you think will happen. But at the same time, make room for the possibility that your assumptions are, well, faulty.
“I always operate under the terms of Pascal’s Wager,” says William J. Bernstein, author of The Four Pillars of Investing: Lessons for Building a Winning Portfolio. “I look at different operating assumptions and ask what happens if I’m wrong about each.” Blaise Pascal was a 17th century mathematician/philosopher who posited that in the face of something factually unknowable — in his wager, it was the existence of God — it makes a whole lot of sense to consider the consequences of being wrong. In terms of investing, one way to think about Pascal’s Wager might be the following:
|Guess Correctly||Guess Wrongly|
|Gamble on Future||Very Rich||Very Poor|
|Don't Gamble on Future||Comfortable||Comfortable|
For Evensky, the choice is clear. “The goal is not simply to get rich, it’s not to get poor,” he says. All-in bets on any single outcome are ill-advised. If your Plan A plays out as envisioned, great. But how will you do if Plan B is what materializes instead? In terms of your investments, making room for the uncertainty that is reality is an argument for a well-diversified asset allocation strategy. A 60/40 or 70/30 mix of stocks and bonds won’t generate the same gains when the market skyrockets, but nor will it leave you impoverished when it tanks.
As Grant was quick to stress in the first paragraph of his essay making the case for a sharp recovery, “the future is unfathomable.” Best to proceed accordingly.
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