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Waiting for the End of the World


Ross M. Miller
Miller Risk Advisors
May 17, 2004

The title of this week's commentary is cribbed from an early Elvis Costello ditty. Poets and songwriters from T.S. Eliot to Michael Stipe have contemplated the end of the world and so have the financial markets.

The current series of commentaries began with a discussion of two battling memes: the inflationary-boom meme and the it's-all-one-world meme. But there are forces in the financial markets that are so powerful that referring to them as memes does them a disservice. These are powerful forces like the winds and the tides. These forces are fear and greed.

Over the past month, fear has been hard to miss in the markets. Not merely the fear that higher interest rates will dampen the recovery, but genuine fear, even primal fear. At the root of this fear is the sense that things have gotten out of control. As recently as a month ago, the typical investors that I spoke with seemed confident that the Bush administration had rigged things so that the stock market would continue to rise through the elections. The problems in Iraq have undermined confidence that the present administration is competent to rig anything, much less something as vast and complex as the U.S. economy. And, as I have written elsewhere, markets run on confidence. Now the typical investors that I talk to are scared, plenty scared, and worried that things are getting out of control.

There is no end of things to worry about if one puts one's mind to it. No one really knows what is going on inside Fannie Mae and Freddie Mac, and that likely includes the people who work there. Every deficit that the U.S. could have (budget, trade, etc.) has been supersized of late. There's terrorism, China, climate change, bad jobs replacing good, the overextended consumer, and the housing bubble. Whew! (I have not forgotten oil--it gets its own commentary next week.) It seems like the U.S. economy should be dead and buried by now.

In my chosen field of risk management, I have had the privilege of talking with CEOs about just how much nuclear devastation would be required to bankrupt their firms, so I have not only contemplated the ultimate disaster, I have worked through the various scenarios in excruciating detail. Having done all this, there are three reasons that I am not anxious. A tad concerned perhaps, but not anxious.

First, history shows that people only rarely anticipate what will ultimately do them in. Sure, when an "unanticipated" problem arises one can always find a bureaucrat somewhere in the system warned about something similar (and usually got all the details wrong), but then that is what bureaucrats are paid to do. No government or business could function if it heeded all the memos churned out so that someone would have his ass covered in the unlikely event that the worst ever happened. (This assumes that they currently do "function," which I admit requires a leap of faith.)

Second, everyone, not just poets and songwriters, seems to think that the world is ending on a regular basis. I have been listening to snippets of newscasts from New York's WOR radio station from the early 1970s. Between Watergate, inflation, Attica, rampant street crime, streets overflowing with uncollected trash, impended bankruptcy, etc., etc., one gets the impression that the end was near, if not for the world, certainly for New York City. Things had gotten so bad that WOR radio personality and humorist Jean Shepherd suggested that no news be broadcast by any radio or television station in the country for an entire month. Of course, those who scooped up Manhattan real estate back then would go on to realize astronomical gains. Even the stock market turned out not to be such a bad deal.

Third, when the world ends it will take all the counterparties with it. A favorite play of the doom and gloom crowd is to purchase far out-of-the-money put options. However, if things go sufficiently awry and the financial system actually does collapse, let's see those bears try to sell or exercise their options. It is one thing to be right, it is something entirely different to collect on being right.

There is an old saying on the Street that a bull market climbs a wall of worry. There is a good reason for this. The dance of the stock market can be broken down into wiggles and hops. (Statisticians call this combo of wiggles and hops a "jump-diffusion process.") Most every day, the market wiggles. Even the recent disquieting slides in the market still qualify as larger wiggles. Hops are rare. The plunge in bond prices that accompanied the April employment numbers qualifies as a hop.

If you look how the stock market wiggles over a sufficiently long time, you will notice that the major averages tend to drift upward. (Statisticians call this drift--well, "drift"--showing that sometimes they know how to speak ordinary English.) On the other hand, the hops in the stock market averages are more likely to be hops down than hops up. Indeed, the largest percentage moves for the Dow going back to its inception are all crashes.

The mathematical combination of the upward-drifting wiggles with the rare and horrific downward hops means that each day that the financial world does not end the market is pushed up a smidgen. (Try to get a statistician to use the word "smidgen.") A bull market really does, in a strict mathematical sense, climb a wall of worry.

There is that scene in "It's a Wonderful Life"--I've got to be careful of my commas now that the Brits have unleashed the punctuation police on America--where Mr. Potter butters up George Bailey by noting that they were the only two in Bedford Falls who kept their heads and bought while everyone else was selling. (Not that they had any choice in the matter.) Is this such a time?

Still, the stock market can swoon and give the bears cause to frolic even without the world ending. Next week, I'll look at "Black Gold" and the prospects for the wounded bull market in the face of higher oil prices.

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to