Friday, January 9, 2009

Rules and Betrayals in the New Year

The major conundrum for investors these days is that many "Rules of Thumbs" that've worked for years and years no longer worked this past year. After witnessing the collapse of major firms: AIG, BSC, Lehman and then seeing Citigroup go begging for funds, the investors' set of comfortable believes were devastated.
Collapse of basic markets such as CP, money market, Repo, which almost all companies rely on for daily operations destroyed the faith Main Street once had for Wall Street. Thus, all assumptions are called into questions.

Investors feels betrayed and either do nothing or want to review every contingencies. This is rational. Yet Rules of Thumbs are really useful. They hid complexity and speed transactions. The more deeply one looks into a business, the more uncertainties one will find. For example, Reliance on Authority is a useful Rule of Thumb. It usually works quite well and is still the dominant decision making mode for individuals when it comes to complex subject such as medicine. It works by reducing complexity to a level that we're comfortable with in handling on a casual basis.

Rating agencies were set up to be Authorities who boiled down the complexities to a simple set of rankings. Yet this year, ratings no longer worked to predict credit risk. Consider the Seasonal Pattern, a common assumption in various retail business. Just because we sold 2000 coffees the same time last year, how do we know we'll sell 2000 today? May be there'll be a medical studies showing linkage to some serious illness? Are such fear probable? Very likely not. However, by using this Rule of Thumb, we got used to assessing these probabilities at zero. Now that we don't trust the rule of thumb, we'll give them a substantive probability, which is likely to be higher than a realistic estimate.

Alternatively, we might freeze in indecision. If we considered all the possible events that could go wrong, would we ever drive on a freeway? For new drivers, they have to muster up a large measure of courage and trust to go up that first on-ramp. It is no different for investor wading into an environment without rules of thumb that they trust. Until new rules of thumbs are developed and trusted, the investment process itself will be slow.

What might the new rules be like?

OLD RULE - US government will never nationalize banks, that's for third world socialist countries.
NEW RULE - US government has a constructive and active role to play in the economic system.

This mean we need to become more like "Kremlinologist", who read the subtle signs and portents to interpret future policy trends of the various US government bodies: regulators, executive branch, the conress, as well as the Federal Reserve. More specifically we need to look at President-Elect Obama's choices and priorities:

- energy
- global warming
- education
- health care
- infrastructure stimulus

By Obama's choices of appointments, we can see how these priorities will be funded. Biofuels industry, in particular, could get a lot of government assistance. At the same time, we need to consider the bailout's boundary effect: that is, the US government is selecting specific key companies to support and letting the rest find their own ways. A long queue of industries has formed to tap government assistance, but many of them will be turned away. Weak hands become take-over targets. Correct bets on where this boundary of support will be extended or withdrawn could be handsomely rewarded.

Many Rules are evolving and being redefined. Understanding these changes are essential to understanding where an active investor base can form. Let us explore how they are changing and what they may look like in the future in this and other forums.
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