Persuasion Time

Eyjafjallajökull

Anyone who flew to Europe last week for a short trip was no doubt surprised that a volcano in Iceland would cause their return flight to be cancelled.  After all, the volcano had been dormant since 1823, and besides, when was the last time a volcano interrupted air travel?  Mount St. Helens (1980)?  Mount Pinatubo (1991)?  Granted, “Eyjafjallajökull” doesn’t exactly roll off the tongue, but that mighty mountain’s effect will be remembered by a lot of folks for a long time.

This surprise eruption underscores the uncertainty inherent in our world.  Unexpected things sometimes happen, and often their impact can be widespread and may persist for longer than seems reasonable.  I suspect we will soon be hearing about how this volcano‘s output will be affecting the weather, carbon gases in the atmosphere, global ocean patterns, and so forth for months or even years to come.  One thing can make a big difference.

For the capital markets, the Security Exchange Commission’s (SEC) charging of Goldman Sachs with civil fraud related to mortgage securities is something akin to a volcanic explosion.  The stock market’s decline on Friday seems wholly linked to this one event.  Above all else, the markets fear uncertainty.  This action by the SEC has raised fear in the marketplace.

Not being a lawyer or an expert on SEC regulations, I will not comment on the merits of these charges.  I will note that Goldman Sachs and the other big banks tend to have very good legal teams and every single security they sell and every single research report they publish has been vetted, examined and reviewed by these top-notch legal groups.  So, I would be somewhat surprised if this case has impact as long and deep as the market may fear right now.  Time will tell.

On Thursday I was discussing the market with a junior colleague, who suggested one might want to “go long volatility.”  He noted that the markets’ volatility (as measured by the VIX) was very low and seemed to be cheap, in his opinion.  Buying the VIX seemed like a good trade, in his view.  I, in my role as the know-it-all senior investment guy, pooh-poohed his idea and said something to the effect of “I can’t imagine anything de-railing this recovery or this bull market.”  Well, the very next day his VIX trade (had I not talked him out of it) would have made him 15.5% — not a bad for one day!

I still think that this single event is unlikely to de-rail the recovery; it has nothing to do with corporate earnings, interest rates or cash on the sidelines, but it has raised the risk profile of the markets a bit.  Yet, I learned (or more precisely re-learned) a couple of important lessons from this experience.  First, I don’t know everything.  Yes, that may be obvious to the rest of the entire universe, but after a good run in the market, anyone can get sucked into the illusion of market mastery.  As I often say, humility is a necessary trait for anyone who wants long-term success in the market.  I need to remember it, not just say it.

Second, respect all opinions and sources of information.  This is another fundamental truth of investing which I ignored last week.  My colleague, despite his youth, is very sharp and often sees things that I miss.  So I know this rule (generally), but sometimes the weight of my experience gets in the way of seeing this.  I am not suggesting that all opinions are valid or even useful, but dismissing any because you think you know better is a recipe for missed opportunities.  Balancing one’s own views with the myriad of data out there is ultimately one of the big challenges of being a professional investor.  The market usually rewards independent, contrarian thought, and my colleague’s opinion was a classic example of this.

I continue to think that we have entered a new bull market which will take stock prices much higher from where we are right now.  In bull markets, corrections of up to 10% are normal and actually provide investors the opportunity to test and re-test their ideas and opinions about the market.  I don’t know if this SEC-Goldman Sachs thing will lead to a full-blown correction or not, but I think I would rather be buying stocks now than selling them.

This entry was posted on Monday, April 19th, 2010 at 7:06 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.