Inaugural Thoughts

I spent a fair amount of time yesterday watching the inaugural festivities.  My interest was personal, political and even professional.

My personal interest is pretty straightforward.  Two of my children and their spouses leave in the area.  They attended the Inauguration Ceremony (as shown by the picture below, which my daughter took) and the Inaugural Parade.


Even better, the next picture shows my son-in-law marching with the United States Air Force Band in the Inaugural Parade.  It was also taken by my daughter.  Later, he was at the Commander in Chief’s Inaugural Ball, where he performed along with some lesser lights like Jennifer Hudson, Alicia Keys, Brad Paisley and Stevie Wonder.



Although I generally try to keep politics out of this blog, some of the President’s choices about what to include in his Second Inaugural Address have implications which should directly impact economic and tax policy and thus the markets.  Examples include his focus on climate change, his lack of focus on debt and deficits and his suggestion that entitlements can and should be maintained at current levels without the middle class (however defined) having to pay any more for them.  Sadly, it seems clear that we have consensus among virtually all of Washington (including both major parties) that entitlements should be generous and that government should be big and should continue to grow but that we the people should not have to pay for such things.   

My professional interest relates primarily to the week-end’s talking head discussion on pretty much all the news shows about the President’s alleged first-term failings and the prospects of his being able to avoid the “second term jinx.”

In his terrific book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” Initially, the planning fallacy was seen as the tendency for people and organizations to underestimate how long they would need to complete a task, even when they have lots of experience. The concept was first proposed in a 1979 paper by Kahneman and his long-time collaborator, the late Amos Tversky.  As with bias blindness generally, the planning fallacy only affects predictions about one’s own tasks. When uninvolved observers predict task completion times, they show a pessimistic bias, overestimating the time taken.

The planning fallacy is a corollary to optimism bias (think Lake Wobegon – where all the children are above average) and self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault). It’s the key reason why every building project tends to have cost overruns and why my week-end chores take at least twice as long as I expect and require three trips to Home Depot.

In 2003, Dan Lovallo and Kahneman proposed a broadened definition of the planning fallacy so as to include the tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits of those same actions. It’s a kind of hubris.  We thus overrate our own capacities and exaggerate our ability to shape the future.  It’s largely why the results we achieve aren’t often as good as we expect and why we so routinely underestimate bad results.

Sound familiar?

Even though American presidents may well have more power than anyone else on earth, it should be no surprise that they are susceptible to behavioral biases like the planning fallacy too.  Neither are any of the rest of us.

A Chart is Worth a Thousand Words

Virtually everyone agrees that we have a budget and deficit problem.  The Democrats would have us believe we have a tax problem while the Republicans would have us believe that we have a spending problem.  As the following makes clear, we need both more tax revenue and lower spending.


Source: J.P. Morgan

The Fiscal Slope

The so-called “fiscal cliff” – a term coined by Federal Reserve Chairman Ben Bernanke – refers to the combination of tax increases and spending cuts scheduled to be implemented automatically next month without peremptory Congressional action.  As things stand now, the payroll-tax holiday will end, which means a tax increase for workers of as much as 2 percent of wages. Income-tax rates will also revert to pre-George W. Bush levels, raising taxes for nearly all taxpayers. Across-the-board cuts in domestic and, particularly, defense spending are triggered as well.  The spending cuts will go into effect because Congress couldn’t reach a deal last year during the debt ceiling crisis to reduce the deficit by at least $1.2 trillion. 

If Congress does nothing, the good news is that these three factors will likely drive the budget deficit to less than 1 percent of GDP by 2018 and then stay below that level through 2022, at which point demographics and health care cost issues lead it to start rising again.  The bad news is that these same three factors will be a major drag on an already weak economy, triggering a recession and the loss of about 2 million jobs, according to a Congressional Budget Office report issued in August.

Based (at least) on the political theatre on offer by the Sunday news shows yesterday (Tim Geithner was seemingly everywhere), the movers and shakers assume that the U.S. would not be so foolish as to pull a “Thelma and Louise” and drive off the fiscal cliff.  In other words, politicians in Washington won’t be that stupid, self-destructive and shortsighted as to let that combination of the expiration of the Bush tax cuts, the end of the reduction in Social Security taxes and the imposition of automatic budget cuts send the U.S. economy back into recession.

Moreover, a number of excellent commentators (led by Barry Ritholtz in The Washington Post; more here) are banging the drum for the idea that the fiscal cliff is more of a slope than a cliff and thus isn’t that big of a deal. Many (such as Eddy Elfenbein here) also insist that a deal pretty much has to happen.  I only disagree with the likes of Barry and Eddy with great trepidation, but I think they’re missing an important point.

While I think that the effects of going over the cliff (or down the slope) are likely to have a greater impact on a soft economy than Barry suspects and that the likelihood of a deal is somewhat less than Eddy believes, my primary and overall concern relates to something barely mentioned in the day-to-day coverage.  Notice how the Obama administration’s opening bid last week in negotiations to avert the alleged crisis included a demand for authority unilaterally to raise the U.S. debt ceiling. 

The debt ceiling is where the real fight will be and where the real risk lies (note Bruce Bartlett’s careful analysis here).  The CBO estimates that given current spending and revenue trends, the existing debt ceiling will be reached before the end of the year.  Since far too many Republicans seem willing to allow the federal government to default on its debt in order to exact further concessions on spending and entitlements (recall what happened last summer), I think the overall risk to the markets remains substantial. 

The overall strength of the U.S. economy and (especially) our ability to print money means that the likelihood that owners of U.S. debt won’t get paid should be essentially nil.  However, markets generally do a dreadful job of analyzing political risk.  One’s ability to pay is much easier to deal with than one’s willingness to pay. Such an unwillingness to pay — even if the default is only temporary and “technical” — could have enormous repercussions with respect to U.S. borrowing rates as well as to the overall strength of what is (for now, at least) the world’s reserve currency. The U.S. dollar has remained the world’s default currency and U.S. Treasuries have remained the world’s default securities largely because investors have always been entirely confident that the money invested there was safe from political machinations.  I don’t think it entirely far-fetched to wonder if those days may be numbered.

I hope Barry and Eddy are right.  But I’m plenty nervous just the same.

Vote (and some related implications)

As regular readers already know, I am deeply concerned about the deep polarization and dysfunctionality of our political process (see here, for example).  I also expect that, irrespective of which candidate wins tomorrow, it will be extremely hard for him to govern.  Moreover, the depth of our problems do not portend easy solutions anyway, even if the president really had as much power over things (and especially the economy) as people generally think and even if Congress cooperates.  All that said, I strongly encourage you to vote.  I generally resist writing about politics and I assume that you are as sick of people everywhere trying to tell you how to vote as I am.  I won’t try to tell you how to vote but I will beg you to vote.

I also encourage you to pick-up some investing insights from the current political landscape.

The Project for Excellence in Journalism studied the slant of media coverage of the current presidential election and found that with “horse-race” stories removed (which would skew the results toward the candidate the polls show to be winning at any given moment), media news coverage of the presidential election was generally balanced.  With respect to President Obama, 15 percent of campaign stories were positive, 32 percent were negative and 53 percent were mixed. With respect to Governor Romney it was 14 percent positive, 32 percent negative and 55 percent mixed (these numbers have been rounded). 

The study also reveals the degree to which the advocacy media — predominantly MSNBC and Fox — stand out from other mainstream media outlets even when the so-called “opinion shows” (such is O’Reilly and Maddow) are not considered. On MSNBC, 71 percent of the “news” segments about Romney were negative in nature, compared with just 3 percent that were positive.  That’s a ratio of roughly 23-to-1 negative. On Fox, 46 percent of the “news” segments about Obama were negative, compared with 6 percent that were positive.  That’s a ratio of about 8-to-1 negative. These results make MSNBC and Fox unusual among outlets that identified themselves as news organizations.  For example, CNN’s coverage was roughly balanced (after “horse race” stories were removed).

The obvious take-away is that MSNBC and Fox News are dreadfully biased organizations such that any use of “news” in connection with them probably requires scare quotes.  But that’s hardly a surprise to anyone who has watched them.  I’m struck, instead, by the extent to which the public at large is intentionally seeking out “news” sources that actively cater to their biases.  All the evidence points to the idea that we want to stay within our chosen echo chambers where we won’t have to hear anything that threatens our preferred ideology.  Fox is the clear leader in cable news ratings, but MSNBC crushes CNN (and all others) too.  In the aggregate, the public rejects cable news coverage that purports (or even tries) to be impartial. I suspect that consumers of finance news and information, both professional and amateur alike, are prone to the same problem.

Our behavioral biases make it difficult for us to discover anything approaching objective reality even when we are consciously aware of them and are actively on the look-out for information that might question our preconceived notions.  If we are going to succeed at investing, which necessarily focuses on what works rather than on an overarching ideology, aggressively seeking out data and viewpoints that conflict and contrast with our own is vital.  The current environment provides a glut of media and investment outlets and sources.  It’s easy to read/watch/interact only with those that agree with us and are on “our side.”  However, to reiterate a point I make often, information is cheap but meaning is expensive.  Staying within one’s bubble of comfort when it comes to understanding the markets — no matter how strongly we feel like doing so — is a recipe for disaster.

Finally, I am struck by how few people actually vote.  Despite some controversy about how to measure who can vote, there is no dispute that roughly 40 percent or more of potential voters don’t bother to go to the polls in presidential election years.  There is no reason to expect tomorrow to be significantly better.  Far fewer people vote in “off-year” elections.  That’s a national disgrace.  Yet, if anything, we in the investment world are even worse when it comes to using our ownership clout to impact the governance and management of the businesses in which we have ownership interests.

American businesses do a number of stupid and even evil things to the detriment of their shareholders’ interests.  To pick an easy example, take a look at executive pay.  It has increased wildly over the past few decades with no evidence that the current obscene pay levels impact corporate performance positively.  Yet the mutual funds, money managers and pension funds that are the primary holders of stocks (beyond a few notable exceptions) are complicit with this theft of shareholder value by refusing to be active contributors and voters at shareholder meetings and otherwise. Corporations and their executives have a fiduciary obligation to maximize shareholder value.  Over-paying executives directly damages the company’s bottom line.  Much of that money could be better used for investment in a new product line (for example) or simply by paying dividends to shareholders.  That we don’t actively work to protect our interests in this regard is both dreadful and inexcusable.

As Jack Bogle points out, the move from ownership capitalism to management capitalism has had dramatic and deleterious effects on shareholders.  Even so, Vanguard (Jack’s baby and a huge owner of corporate shares) has failed to institute positive corporate governance policies that could really help in this regard too.  We need to vote and to take a more active interest in the process both with respect to politics and to corporate governance alike.  Our future success (or simply our future) depends upon it.

Deep Bias

I was watching storm coverage on CNN last evening and was intrigued by all the praise that was heaped upon New Jersey Governor Chris Christie simply for complimenting President Obama’s work in dealing with the crisis and for lauding federal relief efforts in the midst of a closely contested presidential race in which Christie supports the President’s opponent.  Christie was surely right to say what he did, but it’s a striking illustration of how deeply polarized we are as a nation when mere common decency is deemed worthy of great praise.

Jamie Barden, a psychologist at Howard University, ran an experiment (reported in The New York Review of Books) whereby he gathered a group of students, both Republicans and Democrats, and told them a story about a political fund-raiser who had a serious car accident after a wild night at a fund-raising event. A month later he makes an impassioned appeal against drunk driving on the radio. Barden then asked the students whether they think the fund-raiser is a hypocrite or changed man.

It turns out that the students (Democrats and Republicans alike) were two and a half times as likely to think the fund-raiser was a hypocrite if they were told he belonged to the other party. As if you didn’t know already, this study provides yet more evidence of how deeply divided and biased we are. 

It should go without saying that both politics and investing demand careful and objective analysis to give us the best possible chance of success.  Unfortunately, we aren’t capable of it very often.  Indeed, we see it so seldom that we are prone to praise it disproportionately when we do.