Advice to Obama Administration – Less Pro-cyclicality, More Contrarian Behavior

Contrarians are a lonely lot. They sell when others buy and buy when others sell. They are not the run with the herd type.

In the world of investing, herd-like behavior is the dominant form of action and can be seen in many forms – high correlations and animal spirits, for example. A pro-cyclical force that leads to bubbles and busts, in the extreme. And a high degree of mediocre investment performance (often via closet indexing).

Yet, pro-cyclical forces are not limited to the animal spirits of Wall Street. Main Street has its own version, one being played out in the form of layoffs and capex cutbacks as the business cycle runs roughshod over the longer-term secular trends. Understandable but very short sighted. Kind of like the preoccupation with quarterly earnings results.

Even in banking, pro-cyclicality is the way business is usually conducted. Consider the accompanying chart from the Economist re lending standards. Easy money when times are good, tight money when times are tough. More often than not, exactly the opposite of what the economy needs.

Now, easy money during good times is a good thing in the early to mid stages of an economic recovery, however it becomes highly destructive in the latter stages of an economic expansion as dubious projects get funded when a more appropriate approach would be toward prudence. The music is playing and everyone has to dance.

Sadly, as we are all learning with great pain, in the extreme, in all facets of the real and financial economy, privatizing gains and socializing losses becomes the end result.

Investment Strategy Implications

President-elect Obama wants to bring change to Washington. Being forced upon his administration and the global economy as a whole is change across all facets of the financial and economic spectrum. A new financial model needs to be constructed as does a new economic order.

One hoped for addition to the change mantra would be finding ways to encourage less pro-cyclical and more contrarian behavior. Perhaps, then the bubbles and busts will be less pronounced and the socialization of losses less costly.