Thursday, January 15th, 2009
back to normal

As part of the analytical process, investors routinely gauge where things are respective to history.  The comparisons can be qualitative or quantitative, with the latter often represented graphically by a data series, its long-term average, and some upper and lower boundaries that have been helpful indicators in the past:

Yes, that was then and this is now.  The tumultuous change in the markets has left us with a great big question mark.  Or, perhaps a series of them:

Which relationships that we have relied upon in thinking about the markets in the past can be relied upon today?  Are there normative characterizations still alive in the marketplace that will likely prove to have been transitory?  Do we share them?  Do we regularly examine and challenge the assumptions that support our decision making, even the “little ones”?

For each chunk of the analytical foundation, we make judgments of reasonableness.  The problem is that convention has been ripped apart and lies in pieces on the floor.  What’s a low rate of interest for this bond; what’s a high one?  Should this margin estimate get a five-point trim or a ten-point scalping?  Is it possible that my trading rules for what is oversold or what is overbought don’t apply anymore?

To try to find out, we go farther and farther back.  What happened in the eighties?  What happened in the thirties?  How can I use those time periods of stress to gauge my new expectations and form workable cognitive rules?  Some of that perspective can be helpful (although it would have been at its most useful when it was least sought), but those trying to estimate unit growth rates for cellphones or lattes during a consumer retrenchment may not have a lot of data points.

In such an uncertain environment, a “margin of care” is required.  That’s different than the standard “margin of safety,” which is often interpreted in a narrow and formulaic fashion.  A historical discount to intrinsic value based upon an old methodology isn’t good enough.  Each step must be examined and care must be given to each level of uncertainty.  The first part of the process, a collective stepping back, has occurred throughout the market.  Now comes the hard work of determining whether it has all gone too far or not far enough.

We desperately want to get back to normal, it’s just that we don’t know where or what it is.  It is unlikely to be discovered, however, by doing the same old things.  Are your assumptions proper?  Are your methods sound?  Are you living in yesterday’s world or tomorrow’s?