Wednesday, August 15, 2007

Neither Alfred E. Neuman nor Chicken Little Be

As what-me-worry battles the sky-is-falling, a visit to the land between greed and fear might be useful.

For far too long, members of the Alfred E. Neuman club dominated investment thinking as risk was ignored and Goldilocks was crowned an immortal goddess. The Great Moderation lent support to this view and productivity/globalization juiced double-digit earnings gains were promoted as the norm. While some did puzzle over conundrums, the rah-rah crowd proclaimed the death of the business cycle and equity valuations found a new metric to replace the P/E (price to earnings) ratio – the PE (private equity) ratio. Then, along came realty reality.

The housing bubble began to deflate. And nasty surprises sprang out of the credit derivatives black hole as assets that were valued at par on Monday were declared worthless on Wednesday. Volatility returned with a vengeance, spreads widened, and sanity crept back into asset pricing. For their part, equities did what equities are supposed to do in a bull market – they corrected. In the process, valuations began to return to some semblance of normalcy. Except, of course, to the Chicken Little crowd, as they seek vindication for years of being on the wrong side of insanity.

At the moment, the market momentum is clearly on the side of Chicken as literally no one can predict what other shoe is going to drop. Reason, therefore, dictates that caution is the better part of valor. But Chicken, like Neuman, does not subscribe to cautious thinking. Rather, Chicken, like Neuman, sees things as black or white, which is another way of saying that they are both colorblind to the nuances of economic and financial reality.

In the Land Between Greed and Fear

As long as central bankers can prevent a credit squeeze from becoming a credit crunch, exorcising the Greenspan put through the exercising of the market discipline will help wring out much of the excesses that have built up over these past five years. As long as solid global growth continues to serve as a counterbalance to anything short of an economic implosion in the US, sustainable earnings growth can be expected. And as long as no mega shoes drop out of the credit derivatives black hole, risk re-pricing can proceed and equity valuations can continue their march to normalcy.


To Neuman I say – you have ignored risk for far too long and the chickens of bad decision-making are coming home to roost.
To Chicken I say – don’t count yourself before you hatch.
And to equity investors I say – I think this is what a correction is supposed to look like.

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