What If I’m Wrong?

By The Sizemore Letter

I’ve been steadfast throughout the last two months of volatility that we are not on the verge of another 2008-caliber meltdown. The conditions simply are not there this time. Our banking sector, though still impaired with legacy mortgage securities, is not facing a liquidity crisis. You could argue—as I have (see link)—that our banking system is populated with insolvent zombies. But those zombies are, alas, too big to fail, and they will be haunting us for a while. We all saw what happened when Lehman failed in 2008. The Fed and Treasury will not allow that to happen again.

Still, it’s only fair to ask: What if I’m wrong?

I tend to be a knee-jerk contrarian, in that I instinctively take the opposite view when I see sentiment too one-sided. And given the sense of gloomy pessimism that pervades the market these days, I believe that it’s right to err on the side of bullishness. In following the timely advice of Warren Buffett, the time to be greedy is when everyone else is fearful.

But what if everyone is right to be fearful?

Or—and this is what worries me the most—what if the fear turns out to be a self-fulfilling prophecy?

George Soros may be something of a political pariah these days, but he understands a thing or two about finance. And his Theory of Reflexivity should be taught in every MBA program across the globe.

Reflexivity is Soros’s answer to the Efficient Market Hypothesis (EMH), which has dominated the world of academic finance for the past half century. The various forms of the EMH all basically say the same thing—market participants rationally set the price of assets based on their understanding of the underlying fundamentals.

Soros rightly points out what we all instinctively know—the EMH is fundamentally flawed. Buyers and sellers in the capital markets are not disinterested observers who coolly react to changes in the fundamentals by adjusting prices. As active participants, their actions actually change the fundamentals and create a never-ending cycle of self-fulfilling and ultimately self-defeating prophecies. Soros ought to know. He almost single-handedly broke the Bank of England in 1992.

During a boom, lenders and investors provide capital at ever-more-attractive interest rates oblivious to the fact that their actions are creating the boom that they use as justification for their investment decisions. And during a bust, precisely the opposite happens. Lenders and investors snap their wallets shut, pull liquidity out of the market, and the house of cards implodes.

This is what worries me. I fear that investors could cause their own worst nightmare in Europe.

Try Googling “Europe contagion” and see how many hits you get. As I write this, my browser shows over 56 million hits.

Greece is bankrupt, and everyone knows this. Yet there is no reason why a default by Greece should mean that Spain and Italy will tumble too. Spain, though suffering with economic conditions out of the Great Depression, has modest levels of sovereign debt by Western European standards, and its budget deficit—though still yawning—is being effectively hacked down to size. The austerity moves haven’t killed tax receipts—at least not yet. Across the Mediterranean, Italy is actually running a primarily budget surplus. Though its debts are excessive, it should be able to service them indefinitely.

Yet none of this matters if investors panic and dump the bonds en masse, sending interest rates soaring to the point that a collapse is all but unavoidable.

Let me repeat that I do not believe that this is going to happen. But I think it is only prudent to acknowledge it as a possibility.

Given the uncertainty, where should investors hide? Here are a few suggestions:

• Avoid traditional “crisis hedges” like gold and Treasuries. This may sound counterintuitive, but hear me out. Treasuries already yield so little, they appear to be pricing in the worst. At this point, even if the world ends bond prices can’t go too terribly higher than they are now. And gold appears to be in the late stages of a bubble. Interestingly, even as Europe appears closer than ever to a meltdown, gold’s price has eased of late. That should be worrisome for anyone turning to the metal as a safe haven.
• Avoid highly-speculative sectors, mining and materials stocks, commodities, and banks. Should the current state of fear subside without major incident, these sectors will likely enjoy a monster rally. But if we do have a crisis, they will get utterly slaughtered. Given the uncertainty, it’s best to sit on the sidelines here.
• Buy “boring” blue chips that you know will survive anything. This is where it pays to be selectively bullish.  Given sentiment and valuation, you want to be in stocks right now.  The question, of course, is which ones.  Lately, I’ve been attracted to the old “Wintel” duo of Microsoft (MSFT) and Intel (INTC)—see “The Ugly Sister.” I also like consumer products maker Procter & Gamble (PG) and healthcare giants like Johnson & Johnson (JNJ). If we have another 2008-caliber meltdown, these companies will survive it intact and will continue to pay solid (and likely growing) dividends throughout. And if we avoid a meltdown, they should at least match the broader market’s upside. Companies like these would seem to give you the best risk / return tradeoff given the unknowns we face.

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