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Going Nuclear on News?

November 9, 2006 By:
Fred D. Snitzer
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If you did not already know the answer, how would you respond to the following question:

Which event will cause a bigger drop in the market -- an underground nuclear explosion by North Korea or a worrisome inflation report?

Much has been written about the amazing resiliency of the economy and the financial markets in the throes of so much turmoil during the last six years. The bubble burst, terrorists struck, Enron collapsed, and the markets stumbled but then recovered. Worldcom blew up, mutual funds cheated with hedge funds, oil prices rose, Iraq faltered, and the markets shrugged.

As if there weren't already enough problems, North Korea then decides to generate an underground nuclear explosion. Ho-hum, said the market, which went up on signs of benign inflation.

Nukes? No problem -- as long as there isn't a bad inflation report.

The obvious irony implicit in the juxtaposition of a nuclear bomb to an inflation report brings up the issue as to whether the markets today are suffering from an unhealthy dose of complacency. Like Alfred E. Neuman from Mad Magazine, the markets appear to be responding to every miserable mess in this world with, "What, Me Worry?"

Is this resiliency warranted? Is the economy behaving like a foam mattress -- absorbing shocks and adjusting to bad news -- when it really has a lead filling? Will it eventually snap like a pencil, or continue to bend like a rubber band?

Lazy Susans and Sols?

Flexible labor markets, innovations in financial engineering, benign regulation (at least compared to Europe), technological progress, productivity growth, globalization, and (some would argue) the right mix of monetary and fiscal policy -- all of this has contributed to the American economy's ability to weather financial setbacks.

But at what point does this resiliency become complacency? And at what point are the markets behaving like a clueless child rather than a realistic adult?

No doubt there have been substantial improvements in the organization of the economy and the sophistication of monetary policy during the past 30 to 40 years. But the economy is still a function of flawed human beings, and despite the improvements in the financial markets, there will never be an economy or an economic policy that can cure the phenomena of self-deception, excessive optimism, greed, envy, fear -- and then panic.

And let's not forget psychotic dictators.

Another problem: the limits of human knowledge. Many economists warn about the growing dependency of the economy on the Chinese purchase of Treasury bonds.

Others say: no problem. It's a great deal. We buy their stuff, and they get paper dollars. Stop all the worrying.

It's the same thing with the decline in the housing market. What will the effect be? It depends on which economist you hear on television.

Who is right? We'll find out eventually, if the markets during the fall of 2006 were realistically assessing the newfound ability of the economy to absorb problems and the threat posed by a poverty-stricken wasteland with nuclear weapons, or if these same markets were suffering from the human tendency to assume the best ("That couldn't happen here").

In the meantime, all we can do is control risk through our allocation and investment choices.

The rest is in God's hands.

Fred D. Snitzer is chief operating officer in the investment-management firm of Prudent Management Associates, specializing in high-net-worth and tax-deferred asset management.

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