{"id":23811,"date":"2011-09-13T16:09:36","date_gmt":"2011-09-13T20:09:36","guid":{"rendered":"http:\/\/countingpips.com\/fx\/2011\/09\/13\/what-if-im-wrong\/"},"modified":"2011-09-13T16:09:36","modified_gmt":"2011-09-13T20:09:36","slug":"what-if-im-wrong","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/fx\/2011\/09\/13\/what-if-im-wrong\/","title":{"rendered":"What If I\u2019m Wrong?"},"content":{"rendered":"

By The Sizemore Letter<\/a><\/p>\n

I\u2019ve been steadfast throughout the last two months of volatility that we are not<\/em> on the verge of another 2008-caliber meltdown. The conditions simply are not there this time. Our banking sector, though still impaired with legacy mortgage securities, is not facing a liquidity crisis. You could argue\u2014as I have (see link<\/a>)\u2014that our banking system is populated with insolvent zombies. But those zombies are, alas, too big to fail, and they will be haunting us for a while. We all saw what happened when Lehman failed in 2008. The Fed and Treasury will not allow that to happen again.<\/p>\n

Still, it\u2019s only fair to ask: What if I\u2019m wrong?<\/strong><\/p>\n

I tend to be a knee-jerk contrarian, in that I instinctively take the opposite view when I see sentiment too one-sided. And given the sense of gloomy pessimism that pervades the market these days, I believe that it\u2019s right to err on the side of bullishness. In following the timely advice of Warren Buffett, the time to be greedy is when everyone else is fearful.<\/p>\n

But what if everyone is right<\/em> to be fearful?<\/p>\n

Or\u2014and this is what worries me the most\u2014what if the fear turns out to be a self-fulfilling prophecy?<\/strong><\/p>\n

\"\"<\/a>George Soros may be something of a political pariah these days, but he understands a thing or two about finance. And his Theory of Reflexivity<\/a><\/strong> should be taught in every<\/em> MBA program across the globe.<\/p>\n

Reflexivity is Soros\u2019s answer to the Efficient Market Hypothesis<\/strong> (EMH), which has dominated the world of academic finance for the past half century. The various forms of the EMH all basically say the same thing\u2014market participants rationally set the price of assets based on their understanding of the underlying fundamentals.<\/p>\n

Soros rightly points out what we all instinctively know\u2014the EMH is fundamentally flawed. Buyers and sellers in the capital markets are not<\/em> disinterested observers who coolly react to changes in the fundamentals by adjusting prices. As active participants, their actions actually change<\/em> the fundamentals and create a never-ending cycle of self-fulfilling and ultimately self-defeating prophecies. Soros ought to know. He almost single-handedly broke the Bank of England in 1992.<\/p>\n

During a boom, lenders and investors provide capital at ever-more-attractive interest rates oblivious to the fact that their actions are creating the boom that they use as justification for their investment decisions. And during a bust, precisely the opposite happens. Lenders and investors snap their wallets shut, pull liquidity out of the market, and the house of cards implodes.<\/p>\n

This is what worries me. I fear that investors could cause their own worst nightmare in Europe.<\/strong><\/p>\n

Try Googling \u201cEurope contagion\u201d and see how many hits you get. As I write this, my browser shows over 56 million hits.<\/p>\n

Greece is bankrupt, and everyone knows this. Yet there is no reason why a default by Greece should mean that Spain and Italy will tumble too. Spain, though suffering with economic conditions out of the Great Depression, has modest levels of sovereign debt by Western European standards, and its budget deficit\u2014though still yawning\u2014is being effectively hacked down to size. The austerity moves haven\u2019t killed tax receipts\u2014at least not yet. Across the Mediterranean, Italy is actually running a primarily budget surplus. Though its debts are excessive, it should be able to service them indefinitely.<\/p>\n

Yet none of this matters if investors panic and dump the bonds en masse, sending interest rates soaring to the point that a collapse is all but unavoidable.<\/strong><\/p>\n

Let me repeat that I do not <\/em>believe that this is going to happen. But I think it is only prudent to acknowledge it as a possibility.<\/p>\n

Given the uncertainty, where should investors hide? Here are a few suggestions:<\/p>\n