Revisiting the Stress Test

Early this summer we raised a number of questions in our Summer Quiz.  The objective was both to enlighten and to help investors make wise investment decisions over the summer.  As we hoped, anyone who took the quiz seriously has had a profitable summer.  (We'll try to wrap up the answers and award the prize, since we are now beyond Labor Day).

In Question #7 we asked:

The government stress tests for financial institutions have something
called an "adverse scenario."  The conditions from that scenario have
already been met, or nearly so.  (True or False)

At the time we posed the question, there was a universal fixation on the unemployment rate.  This was the only readily measurable input, and it seemed artificially low.  It was pretty clear that unemployment was going to lag the rest of the economic recovery.  Meanwhile, the other stress test inputs were not very visible.  On a symbolic basis, it was bad politics from the Obama Administration.

This fact was widely known to anyone paying attention.  A month before our quiz, Tom Brown wrote as follows:

But
as unhappy as I am about the stress test, I’m even more shocked by all
the commentators who dismiss the test results because they believe it
wasn’t stressful enough. Some of these people simply believe
the U.S. economy is headed into a death spiral; no how matter how
bearish a given forecast is, they’ll tell you it’s not bearish enough.
Others have lately built a nice business for themselves by being
relentlessly, flamboyantly negative. Still others simply don’t know
what they’re talking about.  Let’s look at a few of these people have
had to say lately:

Brown went on to analyze several bank critics.  These were the people celebrated as "getting it right."  Brown pointed out that the loss reserves in the test were very aggressive.  His prediction of the result?

The
likely result of all this? Just as in the last recession, the big banks
will emerge overcapitalized, over-reserved, while their shareholders
have been unnecessarily diluted.  It’s a disgrace.

Other source fixated on the employment number in the stress test, ignoring the (more important) loss reserve inputs.  Despite their analysis, several of the big banks are paying back TARP funds.

What Happened?

Since our quiz on June 15th, the big banks are up about 30-35%.  Anyone who did the homework could have participated.  Meanwhile, there has been fresh news about bank failures and additional capital requirements for regional banks.  As part of our series about what to watch, we noted that bank failures are not an important economic indicator.  Many blogs enjoy reporting a few more failures each week, adding to the impression that this is significant.  There has also been news that regional banks may need to add capital.  Maybe so, but it is not the crucial point.

As Tom Brown wrote:

In
particular, in the latest quarter, the banks’ NCOs came to 3.16% of
loans, far short of the 4.16% laid out in the stress case. And as you
can further see, chargeoffs under the stress scenario won’t peak for
another three quarters, at which point they’ll top 5%.

He produced the following chart.

090805stress


We remain very interested in when banks will be willing to do more lending!

A Crucial Question for Investors

A common theme among many pundits is to say something like "X was wrong on subject A, so why listen to any future predictions?"  Some of the more aggressive pundits extrapolate.  If an expert was wrong on "A" you should ignore him/her on "B".

That was the dubious logic for missing one of the biggest rallies in history.

A Dose of Reality

The subject really requires a more extensive article (forthcoming), but the stress test issue highlights the main theme.  Every time we cite Tom Brown we get critical comments, since he "missed it," while Meredith Whitney and others "got it right."

Predictions are not so simple.

Those who "called the crash" are not all geniuses.  The others are not all dummies.  Experts use widely varying methods.

The biggest investor mistake is chasing performance, thinking that someone has a hot hand.

We are about to see this play out in many sectors.  The stress test is a good example.

[Full disclosure — Our accounts hold GS, BAC, and held at various times, regional bank ETF's.]

Don’t be Stubborn!

Near the top of investor mistakes is the stubborn adherence to something that has been proven wrong.  The error might be a strategy, an economic viewpoint, a market opinion, or the choice of favorite pundits.  You need to step back and reevaluate when there is important new information.

Here are two key examples:

  • The failure of Lehman.  Many thought that the big investment banks were too big to fail.  It turned out not to be true.  While some still think that the government should have acted, those in power felt they lacked authority to act.  In the aftermath we all learned what would happen to the economy if there was no confidence in any financial institution.  What we call "normal and sensible lending" came to an end.  Most mainstream economists adjusted their forecasts to account for the extreme reaction of corporate leaders.
  • Massive government intervention.  Many thought that the government would be powerless or ineffective.  This turned out not to be true.  While some still think that the government actions were wrong, those in power saw a responsibility to act very aggressively.  In the aftermath we all learned what would happen when there is aggressive action and intervention by the federal government.  Most mainstream economists adjusted their forecasts to account for the extreme reaction of government leaders.

Ironically, many observers who were accurate on one of these key points missed the other.  In a further touch of irony, economists who adjusted forecasts in both cases (notably those in the mainstream) are now frequently criticized for "missing" the first move.  The implication is that their current forecasts will be wrong.

The Three Doors Problem

We anticipated this situation in June when we asked the following question:

You get the chance to be on a game show.  The host lets you pick one of
three doors for a prize.  One door has a great prize and the others
have trivial rewards.  You make your pick.  The host (who knows where
the real prize is) reveals one of the two alternatives and offers you
the chance to switch your choice.  Should you do so?

Top traders with whom we have been associated use this question as a screening test for new recruits.  Getting it right on the first pass (easy for bridge players, who are experts at probability) is excellent.  Since most people fail on the first pass, the question is how long it takes them to accept the answer.  Some of the most intelligent people in our universe could not accept the solution.  That is a bad trait for a trader!

The Solution

The problem is a simple probability question, but the answer is counter-intuitive.  The best simple explanation comes from Leonard Mlodinow, whose book, The Drunkard's Walk,  we recently recommended.  The explanation comes from an excellent quiz presented by The Numbers Guy, Carl Bialik.

Answer: Yes. When you initially chose door No. 1, you had a one
in three chance of picking the car. The other scenario, in which the
car is behind one of the other two doors and so only one of those two
doors hides a cow, has a probability of two-thirds. Let’s focus on that
scenario, and assume — since we don’t have any information to the
contrary — that the host always opens a door that reveals a cow. In
that case, the door he didn’t open and that you didn’t choose always
contains the car. So if you switch, there’s a two-thirds chance that
you’ll win the car. If you don’t, you’re stuck with a one-third chance.

Bialik goes on to note the recent featuring of this problem in the poker movie, 21, which we recently saw on Netflix.  We might have chosen a different problem, since many readers now seem "clued in" to this specific answer while missing the concept.  Readers who want more such questions should look at his original quiz, especially #3, which has a similar theme (also a layup for bridge players).

The issue of stubbornness is highlighted in the reaction to Marilyn vos Savant, who presented the question in her popular Parade Magazine column.  Many "experts" disputed her answer.

Current Relevance

We see many economists and pundits who stubbornly adhere to a viewpoint that "called the crash" or had some method of market valuation that seemed, in retrospect, to be accurate.

Forecasts must change with facts and new data.  There is no substitute for keeping current on the best indicators.  We try to balance our fundamental analysis with market indicators from our disciplined trading system.  It is a reality check.  Many of the most popular financial websites have an ongoing commitment to finding the worst possible interpretation of any reported data.  There is a need for balance.

Data and Perceptions

Interpreting data requires special skill and training.  Hardly anyone has developed these skills, but that does not stop them from offering opinions.  Here at "A Dash" we have highlighted some of the most popular errors.  Today provided some examples.

This is America!  Let the games begin….

Public Opinion on Stimulus Plan?  Thumbs Down!

It is the six-month anniversary of the passage of the stimulus plan.  This was a classic political compromise.  Any and all observers could criticize the plan.  The symbolic language — shovel ready — conjured up the wrong image.  The announced plan suggested that there would be a lot of visible jobs from construction.  The actual plan relied upon macro-economic spending principles, and was scaled out over two years.

The unsurprising result is that the economy has still not recovered and most Americans believe the program is not working.  This includes plenty of intelligent people and Obama supporters.  To understand the impact, one needs to grasp the concept of the counterfactual (which we explained in easily understandable terms here) and the economic impact of policies like helping the states and extending unemployment benefits.

Anyone who understands economics knows that the stimulus has already mitigated a difficult situation.  It is to the political and personal advantage of many to attack the program.

Pundit Opinion on the Economy

Most of the punditry understands behavioral economics.  They know all about confirmation biases and the temptation to see each data point as support for a pre-conceived idea.

It makes no difference.

The market is looking hard for signs of economic growth, reacting to each twist and turn of the data.  Participants are missing the big lesson: What constitutes normal progress in an improving economy.

It is unrealistic to expect each economic indicator to show progress in lockstep.  The data will provide mixed signals — partly because of differences in sectors and partly through measurement errors.  If one chooses to look at the worst news or find the worst interpretation of data, one can be in denial for a long period of time.

It is all about finding the best indicators in an objective fashion.

What is Normal?

In our summer quiz, we highlighted a question about data interpretation which few understand.  We ran this article in June.  We expect that our quiz questions will eventually be recognized as the key market issues.

Here was Question #1.

We have an honest coin which we flip 20,000 times.  We keep a running
count of whether heads or tails is in the lead.  How many lead changes
would you expect?  (A good ballpark answer could be the winner here).

In his excellent book The Drunkard's Walk:  How Randomness Rules Our Lives, (now added to our recommended list) Leonard Mlodinow explains how people — smart people — fail to understand data because they do not understand probability.  His example involves a test of two movies, but the application is equally valid for many applications.  Two theories, two investment managers, two pundits…..

He writes as follows (page 14):

Because the coin has an equal chance of coming up either way, you might think that this is experimental box office war each film should be in the lead about half the time.  But the mathematics of randomness says otherwise:  the most probable number of changes in the lead is 0, and it is 88 times more probable that one of the two films will lead through all 20,000 customers than it is that, say, the lead continuously seesaws.  The lesson is not that there is no difference between films, but that some films will do better than others even if all the films are identical.

Mlodinow is a physicist who has written for popular entertainment like Star Trek and MacGyver.  He is excellent at making difficult concepts accessible to average intelligent readers.  He provides many other examples of normal random data, consistent with the work of the behavioral economists.

The key here is that a concept in the lead (the weak economy) will seem to retain the lead.

Our Take

We have attempted to highlight the important indicators. — ECRI, initial claims, and the ISM — and we will work to highlight others.  These important measures have been positive.  Many other measures that we follow — employment, Michigan sentiment — are giving a negative signal.

For stocks, it is all about earnings.  Bearish pundits dismiss the last round of earnings because the results were based upon cost-cutting rather than revenue growth.  (What would they have said if earnings had disappointed?)  We believe that revenue growth will soon follow with stimulus impact. Companies that have good cost control will show good earnings gains.

Meanwhile, those emphasizing trailing earnings can fixate on forced write downs from last year and the post-Lehman cessation of normal lending.  These pundits will miss the resumption of normal and sensible lending.  It is time to look ahead for opportunity.

Or one can fixate on last year.  Your choice.