Like many others, we waited this morning with great anticipation for the release of the 2008 Federal Reserve transcripts. Considering 2008 proved to be one of the most momentous periods in modern US (and global) history from an economics and market standpoint, it’s fascinating to get a true blow-by-blow view of what policymakers were thinking ahead of and during some of the biggest events during that period.
What strikes us the most, however, looking through some of the excerpts, is how little many of the Federal Reserve board members and others truly understood or anticipated the deceleration of the economy throughout 2008. Even as late as September 2008 in the immediate wake of the Lehman collapse, there was some talk about signs of stabilization in the housing market and broader economy. Many of these highly respected economists couldn’t come close to agreeing whether or not the economy was in recession well into 2008, despite the fact we now know that the recession started “officially” in late 2007. Some references to potential recession appear in early 2008 from Tim Geithner and Janet Yellen, but they seem to be few and far between. Only after coincident economic indicators began plummeting in the fall amidst a global credit freeze do we start seeing talk about a recession of historic magnitude.
Since 2009, we’ve heard many a post-mortem that there “was no way we could have ever anticipated a recession of that magnitude” or “a housing crisis as severe as experienced.” This got us thinking back not only to those crazy times from late 2007 to early 2009, but to some of the themes we’ve discussed here in the past, namely objectivity, narrative, process, and cognitive biases. In reality, looking back, the signs for a potential recession, a deep one at that, were apparent as early as late 2006. Many happened to ignore those signs or explain them away because they didn’t fit a broader narrative.
For instance by early 2007, leading economic indicators in the US had begun to deteriorate and show classic signs that an elevated probability for recession existed. Meanwhile, the Treasury yield curve inverted in mid to late 2006, a classic sign of trouble, and remained in that condition for nearly a year. Policymakers and analysts told us this wasn’t a cause of worry and was the result of a “global savings glut.” Because the yield curve at the time was a part of the leading indicators index, we were told that the leading economic indicators were being “distorted” and that this time might be different. Turning to housing, this writer will never forget sitting in a MBA seminar in early 2007 and having David Lereah, the former chief economist of the National Association of Realtors, show up to speak and assure all of us students that a). the fundamentals of the housing market were A-OK, b). even if they are deteriorating, homes were fairly valued, and c). that the underlying demographics were highly supportive of future gains. These statements were made despite clear quantitative evidence, such as price to rent ratios, price to income ratios, and other data, that real estate prices were far above fair value levels. Of course, the demographic assertions were suspect. Several students called him out on this, but he never wavered.
Again, many of the people driving the policymaking ship at all levels say they were “blindsided” when there happened to be plenty of cause for worry and reflection. We have to suspect there were plenty of folks in the Fed and elsewhere privately concerned during 2006 and 2007 that the situation was unraveling. Why didn’t anyone in official quarters speak out or act forcefully on any of the cracking data throughout 2007? Why were so many willing to explain away increasing signs of deterioration? These are very intelligent and highly accomplished people.
We’ll venture a guess. We’ll blame it on the typical human behavioral biases that doom us as investors and “deciders.” Groupthink and herding probably came into play. Very few in an official capacity want to go against the grain or rock the boat, especially when negative news is involved. This could also be an issue of “loss aversion”, i.e. holding onto losing positions, or in this case losing arguments, in a futile hope that things are going to get better. Recency bias also certainly played a role and continues to play a role. Instead of skating to the puck, we place too much value on lagging or coincident data to make decisions. Going back to the Fed minutes, policymakers seemed to be unwilling to come to the “major recession” conclusion until the data had actually deteriorated, in effect closing the barn doors after the horses had escaped. The Fed members, like most humans, tend to take the “don’t shoot until you see the whites of their eyes” approach. Finally, we’ll also guess that biases related to narrative played a big role. We overemphasize information, stories, and data that confirm our hopes or worldview, and bury information that contradict them. Naturally, most economic policymakers would much rather operate in a environment that is positive, stable and reasonably worry-free. Ben Bernanke, Federal Reserve officials, and other top economic policymakers surely didn’t have a fun late-2008 pulling all-nighters, begging Congress for help, and patching the credit system together with duct tape and glue on the fly. Playing armchair psychologist, and knowing the power of confirmation bias, we can only imagine that many policymakers subconsciously buried developing signs of recession and kept all fingers and toes crossed that everything would move back in the right direction in hopes that the life of the policymaker would remain relatively painless.
Moving back to markets and investing, there are lessons from this situation that pertain to us as investors, whether individual or institutional. We’ve been over these several times before, but there worth reiterating again and again.
- Of course, we should always strive to achieve completely objectivity in our investing approach. This is easier said than done, though. Why?
- We are all subject to the same biases as investors that we observed above with some of the smartest policy makers around.
- When considering new investments we tend to chase recent performance, overemphasize the most recent narrative, and extrapolate trend in a straight line. At the same time, we ignore evidence that goes against the narrative and assimilate evidence that supports it. “XYZ stock at $100 is going to $1000 because recent trends X, Y, and Z will continue forever to the moon. Sure, the stock is trading at 100x normalized earnings, but it’ll grow into the valuation. Anyway, the only way to value this company is using ‘price per eyeballs,’ and that ratio shows me it’s extremely cheap.” This happens in reverse. “XYZ company might be trading at 6x normalized earnings and low valuations across the board, but have you read that series of articles in the Journal about what a stinker this one is? I can’t let anyone see that I own this black hole. It was down 50% last year! The balance sheet is strong, you say, and the new product is showing promise? Who cares? Did I mention those articles??”
- When evaluating existing investments, we consistently engage in loss aversion. “I know I’m down 50% in XYZ and that the situation has become much worse. If the stock just gets back to $50, I’ll let it go.” Months later, XYZ is sold 50% below these levels because the investor “can’t take the pain anymore.”
- How can we overcome these biases and become better investors? Discipline and process. We believe it comes from developing a solid process and sticking to it through thick and thin. A process can be very complicated or very simple. A process as simple as rebalancing a portfolio bi-annually or annually or employing other simple asset allocation techniques can make a world of difference performance-wise in the long run. More sophisticated investors employ tactics such as deep-dish fundamental analysis and technical analysis to manage risk or identify undervalued opportunities. Whatever the methodology, it’s key to override the part of your human brain that pushes you into buying tech stocks in 1999 with valuations at ridiculous levels, or selling the entire portfolio at the bottom in March 2009.
Ultimately, as we saw with policymakers and the economic situation throughout 2007, 2008, and early 2009, we as investors have a significant amount of data staring us right in the face telling us that there’s a strong probability of long-term success or failure with a particular investment or course of action. Yet, we consciously or subconsciously choose to ignore and discard the data. US markets were trading at over 40x on a CAPE basis in early 2000. How many were willing to go against the frenzy knowing the evidence was overwhelming that future returns would be subpar? Numerous stocks were trading in the low single digits in early 2009. How many were willing to commit capital knowing that historically those valuations have led to outsized returns?
Yes, hindsight is 20/20. It’s a cop out in our opinion, though, to always say, “If I’d known X, Y, Z, I would’ve done A, B, and C.” Many of the best investors in the world aren’t much smarter in the traditional sense than anybody else. They are, however, disciplined and process-oriented, which allows them to override the emotional pull and tug that leads to poor decisions and take advantage of opportunities before they become “obvious” to everyone else. Perhaps policymakers in the political realm don’t have that luxury; maybe 2008 would have been just as ugly economically if every public figure at the Fed had expressed concern early in 2007. In fairness, they operate in a complicated fishbowl. We do have the luxury as investors, however, of developing these skills and acting on them.
