For as long as I can remember (and probably longer than that), there has been a sizable bearish contingent in the investment community at large. And I'm not talking about people expecting a run-of-the-mill recession or a normal correction in some over valued asset class. I'm talking about a major recession/massive market repricing to correct a (perceived) deep imbalance.
Anyone who peruses popular blogs, online forums, etc., will find no shortage of ultra-bears. Even here at Accrued Interest, there have been many commenters in this category. Over the years I've read dozens of well-written, well-reasoned arguments for ultra-bearish scenarios. Since starting this blog I've read a few well-reasoned ultra-bearish arguments online or in the comments. Of course, I've seen many more poorly argued cases, but I digress. I'm fascinated by the ultra-bear phenomenon. Particularly since I can't remember the last time I talked to a professionally money manager who was seriously bearish. In other words, you talk to people all the time who are mildly bearish about some asset class or sector, but usually they're talking about anemic earnings growth or spreads reverting to long-run averages. Rarely do you hear a professional money manager make a claim like the S&P 500 will be lower in 5 years, or Treasury rates will rise to 10%, or anything along that line.
This is not to say pros are always right. The tech bust of 2000-2002 is a great example. A lot of money managers were negative on technology, but no body seriously expected the S&P 500 to lose 50% of its value peak to trough. I wasn't surprised when Pets.com went bankrupt, but I was personally long stocks the whole time.
So anyway, why do ultra-bearish scenarios hold such sway over such a large number of people? Why do financial market disaster stories capture the imagination of so many? And at the same time, why do professional money managers seem to never think things will go badly? Here are my thoughts.
The financial markets always seem like a house of cards. We've seen time and time again stories of companies suddenly falling apart: Penn Central, Barings, Drexel, Enron, Worldcom, the S&L's, etc. Countrywide's flirtation with insolvency recently was a great example as well. In many cases, the company seems to go bankrupt either because of scandal or some complicated
structural issue that can be hard to understand. Again using Countrywide as an example, what percentage of college education people who read about Countrywide's problems in the paper actually understood the issue of securitization? Few. One can't help but feel like something fairly small can bring down the whole system.
And there are a lot problems in our economy that don't seem so small. The budget deficit. Foreign holding of Treasury debt. Terrorism. The negative savings rate. The Republicans. The trade deficit. The housing market. Energy prices. The Democrats. The War. Gold prices. Consumer debt levels. I'm sure I could go on.
Unfortunately, politicians and the media tend to use sound bytes to explain these problems and their potential consequences. And its often the case that the quicker, easier, more seductive conclusion is the bearish one. Take foreign holding of Treasuries. Currently about half of U.S. Treasuries are held by foreigners. A commonly quoted Fed paper claims that long-term Treasury rates would be 150bps higher if not for foreign holdings. The easy conclusion is that interest rates are vulnerable. And if real rates rise by 150bps, we know that a deep recession can't be far behind.
But when you start questioning the underlying assumptions behind a bearish conclusion, you realize this odds of this scenario are remote. Why would China decide to dump Treasuries, when doing so would decimate the value of their reserves? Why would they want to cripple U.S. consumers, which is the lifeblood of their export-driven economy? Besides, as long as the U.S. has a trade deficit, the dollars have to be reinvested in U.S. assets. China (or anyone else) simply can't just pull out of the U.S. market. Its nonsensical. By the way, the fear that foreigners would pull out of U.S. markets has been around for at least 30 years, going back to the petro dollar investors of the 1970's. But to hear the media tell it, the phenomenon is some how new.
I find another problem with the ultra-bearish argument is it tends to ignore economic dynamism. The U.S. economic is incredibly adaptable, and financial markets are even more so. The economy is more able to deal with events, such as 9/11, than ever before. And while obviously such things can cause pain in the financial markets, it doesn't threaten the whole system. Even events which have called into question the viability of certain types of investments, from the collapse of Drexel to the Russian default to the current CDO debacle, the financial markets are able to deal with it. There is still a high yield market, a emerging debt market, and there will still be a CDO market in the future.
It is also a fact that more forces are working to keep the financial system going than working to tear it down. For that matter, there are more forces working to keep a given company alive than drive it under. So that tells you that when you bet on the financial system being driven into chaos, you have to bet that external forces like the Fed or the government will be ineffective. Historically the Fed's reflation efforts have been quite effective at least in terms of limiting the broader economic impact of financial market stress. See 1987, 1991, 1998, and 2001. Have there been recessions? Of course. Will we be telling our grandkids about the horrors of the 1991 recession? Probably not.
I've already hinted at why professional money managers are rarely all that bearish. Anyone who has been managing money for a reasonable amount of time has seen periods of severely overblown fears. In almost all cases, its turned out to be little more than a blip on the long-term radar. In fact, if timed right, every bear market in almost every risky asset has turned out to
be a excellent buying opportunity.
So professionally, controlling your fear and keeping your cash invested has almost always turned out to be a good career move. Whereas sitting on large amounts of cash waiting for financial Armageddon has turned a lot of money managers into insurance salespeople.
I'd say that as an industry, the mistake professional money managers usually make is when we start reaching. Particularly in the bond market, where there can be so many complicated structures. Every honest bond manager will tell you that there was some point in their career where they put some money into something that they didn't fully understand. Maybe they thought they understood it, only realizing too late why the yield looked so good. In fact, if you are ever in the position of hiring a bond manager of any sort, ask about their biggest mistakes in trading. If you don't get a straight answer, don't hire them. Anyway, I'd be willing to bet that most of the worst "reach" trades people have made have happened when spreads were unusually tight. In other words, typically at the end of a bull market in spreads.
My simple advice to those who subscribe to an ultra-bearish forecast: think hard about the consequences of a dynamic economy. Its very possible that we go through the worst housing market since the Depression over the next 5 years, but Countrywide still finds a way to stay in business. Or that AAA-rated subprime pools still make investors whole. Because the market just has a way of working these things out. Betting against the economy recovering isn't my idea of courage. For a pro its more like suicide.