Warning: Changes Ahead

January 19, 2017

It's pretty safe to say if you've lived in America your entire life you have not witnessed the sort of change our government is about to go through. It is common in Europe and most other countries to see huge swings in leadership, but not the US. Typically the larger the change, the more emotional we become. This week we are going to discuss some of the biases that may develop as we attempt to understand our current environment & make predictions about the future.

 

Many have compared Donald Trump to Ronald Reagan, but most seem to be forgetting Ronald Reagan had already had some training as California's governor from 1967-1975. Yes he was an "outsider" to Washington, but people at least had some idea of who they were getting.  President Reagan also knew how to play the "game" in Washington. This week we are going to discuss the 

 

I continue to warn investors to be extremely cautious in making predictions on how President Trump will impact the economy and markets. The "good" ideas have mostly been priced in, while not enough thought has been given to the "bad" ones. And trust me there are some pretty bad ones floating through that man's head. Don't be like the first guy through on the motorcycle.

Wednesday, January 18

After finishing the CFA program last year I thought I wanted some down time from studying, but I've found myself drawn to spending my nights and weekends studying two topics I believe will have a direct impact on the markets and economy in the years ahead -- The Social Cycle and Behavioral Finance. I've spent a great deal of time talking about the Social Cycle -- it's a topic I first started studying shortly after the tech bubble burst. The Behavioral Finance side is something new I really didn't get a hold of until Level 3 of the CFA materials. It's a brand new topic to most, but something I know will help us add tremendous value to our advisors and clients as I gain a better understanding.

 

I will have plenty more later, but I wanted to bring up a passage from the latest book I'm reading, Misbehaving by Richard H. Thaler. You may remember Dr. Thaler from his appearance with Selena Gomez in the Big Short. If not, here is a short clip on one micro-section of Behavioral Finance.

To say my mind has been blown by this book would be an understatement. I've always struggled with economics. In fact Economics was the only sections of Level 1 & 2 that I failed. It wasn't until Level 3 I finally had the lightbulbs go off after reading about Behavioral Finance.  You see, all the economic models assume plenty of things, but one of them is RATIONAL participants. Once I started putting economics back in the classroom theory of how economist believe people SHOULD act (not how they HAVE or WILL act in the real world) I was able to discuss the THEORIES of the economic models. I guess I had too much experience in the real world from my grandfather's small business, to working retail, to managing a small business, to my 18 years of experience dealing with the markets and individual investors to not let actually actions influence how I believed the real world worked.

 

Anyway, back to my point for today's blog & what I think will be a problem in the days, weeks, and months ahead, Dr. Thaler's findings on the psychology of decision-making and why people make bad decisions:

  1. Overconfidence -- we think our ability is greater than the other participants.

  2. Extreme forecasts -- not understanding reality and how statistics work (not every year can be "above average", let alone a winner, yet Wall Street forecasts always assume growth.

  3. Winner's curse -- the final "winner" valued the asset too much & ended up paying far too much to get it.

  4. False consensus effect -- we believe that other people share our preferences or outlook. The more we find (and we tend to only seek out those that share our consensus), the more confident we become.

  5. Present bias -- we need to "win" NOW and are incapable of thinking about the longer-term when emotions get involved.

Think of the above and what we have witnessed in the markets since Trump's victory in November. The side effect of all of this is when we end up being wrong, their is an equal and sometimes even faster overreaction to the other direction.

Thursday, January 19

Last night I finished up the book Misbehaving by Richard H. Thaler. This book is the first economics book I've read that made complete sense. As I said yesterday it is because Dr. Thaler walks through his career long process of showing why the traditional economic models do not work -- the assume among other things rational behavior at all times.

 

In the closing chapter, Dr. Thaler was discussing the need for a behavioral approach to macroeconomics. Of all the disciplines this has been the most stubborn to adapt to any "anomalies" even though it has the widest impact on the humans that make up the economic eco-system. This is particularly important given the overly optimistic assumptions most people are making regarding the new president and the Republican Congress. Dr. Thaler brings up some points that we all need to take into consideration as we evaluate the policies emerging out of Washington this year.

 

"One important macroeconomic policy begging for a behavioral analysis is how to fashion a tax cut aimed at stimulating the economy. Behavioral analysis would help, regardless of whether the motive for the tax cut is to increase demand for goods (Keynesian) or supply side (aimed at businesses). There are critical behavioral details in the way a tax cut is administered........If Keynesian thinking motivates the tax cut, then policy-makers will want the tax cut to stimulate as much spending behavior as possible. And one supposedly irrelevant detail (according to the rational econometric models) these policy-makers should consider is whether the cut should come in a lump sum or be spread out over the course of the year."

 

"The same questions apply to a supply-side tax cut. Suppose we are contemplating offering a tax holiday to firms that bring money home to the US instead of keeping it stashed in foreign subsidiaries to avoid taxation. To design and evaluate this policy we need an evidence-based model that will tell us what firms will do with the repatriated money. Will they invest it, return it to shareholders, or hoard it, as many US firms have been doing since the financial crisis? This makes it hard to predict what firms would do if they found themselves with a greater share of the cash held domestically. More generally, until we better understand how real firms behave, meaning those run by HUMANS, we cannot do a good job of evaluating the impact of key public policy measures.

 

"Another big-picture question that begs for more thorough behavioral analysis is the best way to encourage people to start new businesses (especially those who might be successful). Those on the right stress reducing marginal tax rates on high-income earners as the key to driving growth. Those on the left tend to push for targeted subsidies for industries they want to encourage or increased availability of loans from the SBA. And both economists and politicians of all stripes tend to favor exemptions from many government regulations for small firms, for whom compliance can be costly. We rarely hear from economists about mitigating the downside risk to entrepreneurs if a new business fails, which happens at least half if not more of the time. We know that losses loom larger than gains to HUMANS, so this might be an important consideration.

 

"Finding ways to mitigate the costs of failures might be more effective at stimulating new business startups than cutting the tax rate on people earning above $250,000 a year, especially when 97% of small business owners in the US earn less than that amount."  - Thaler, Misbehaving, pgs 351-352

 

The bottom line.........a tax cut MAY help spur spending or it may cause people to save more & spend less. Government spending MAY spur economic growth or it may cause people to save more & spend less. A "tax holiday" may boost spending and investment by companies or they may simply hoard it or pay a special one-time dividend. It is all in the messaging, how it is delivered, what other policies accompany these plans, and how it is perceived by the HUMANS in our country. There is no evidence that tax cuts are guaranteed to spark consumer spending or cause businesses to create more jobs. Sometimes they do, sometimes they have the opposite effect. My mind has been blown so many times by this book. If you've ever struggled with understanding the traditional economic models I would highly encourage you to pick up this book.

 

We're going through our own decisions, changes, and self-analysis here at SEM, but I will try to add to this discussion tomorrow.

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