The following is reprinted with permission from the October 2008 issue of the Investor Advisory Service, published September 26, 2008 by ICLUBcentral Inc.

Investment Comments

The Hubris of 95% Certainty

We have been wondering for more than a year how so many supposedly brilliant minds on Wall Street can get it so wrong. In the fall of 2007, we were writing about large institutions such as Citibank, Merrill Lynch and UBS (Union Bank of Switzerland) writing off mortgage securities $10 billion at a time. Then came the government's $30 billion guarantee of Bear Stearns' debt when that company was sold to JP Morgan Chase in March. September has been in a league entirely of its own with capital infusions of as much as $300 billion for Fannie Mae and Freddie Mac and now $85 billion to American International Group. We'll repeat the question: How can so many supposedly brilliant minds on Wall Street get it so wrong?

We've often said that investing is about probabilities, not certainty. Wall Street coined money for twenty years by packaging and selling esoteric securities.  Then, the market for many of these fell apart starting in the summer of 2007. Financial institutions operated with such high degrees of leverage (borrowed money) that they appear to have assumed that they were safe under almost any circumstances. How else can one explain using just 3% of one's own money and borrowing the other 97%? This actually sounds like the ridiculous loans banks were making to homeowners in recent years, the loans that have blown up. However, this is the same degree of leverage used by many Wall Street firms, the ones that are now footnotes in history. To think that one could get away with such a high degree of leverage indefinitely displays the degree of hubris that existed on Wall Street.  

Undergrad and MBA-level statistics classes cover an analysis of outcomes known as "normal distribution." Normal distribution (also known as a "bell curve") refers to an orderly clustering of outcomes where extreme deviations from the average are very rare. The title "The Hubris of 95% Certainty" comes from the idea that 95% of the time any outcome will be within two standard deviations of the average. We believe that these Wall Street firms were constructed to be successful under any reasonable, normal operating environment, that is to say, 95% of the time. It doesn't appear that they gave any thought to their own survival in an abnormal period, that is, 5% of the time when things go terrifically right or frighteningly wrong.

Throughout this decade, Wall Street and Main Street have been at odds. Main Street consumers have been affected by skyrocketing energy costs and subdued wage gains. Wall Street continued to coin money while this was going on. Gross Domestic Product continued to rise as corporate America flourished while consumers suffered.

Interestingly, the dynamic appears to have reversed somewhat. Government intervention has helped prevent the spread of Wall Street contagion into Main Street. Not many consumers engaged in foreign currency swaps with Lehman Brothers or credit default swaps with American International Group. Consumers with a brokerage account at Lehman or an insurance policy through AIG will probably not be affected by their declines, nor will the millions of households with mortgages insured by Fannie Mae or Freddie Mac. In the meantime, however, the price of a barrel of oil has declined to the $90-$100 range, about one-third off the price of $147 that existed just a few months ago. Consumer confidence has risen significantly as a result. Hopefully, retail sales will rise as well.

Weak consumer activity has been holding back the economy, but improvement in our trade balance helped Gross Domestic Product rise at an annual rate of 3.3% in the second quarter. The government had previously estimated growth at 1.9% in the quarter. An improving foreign trade picture is helping large multinational companies, but weakness in real estate, financial services and retail is pushing unemployment higher. Inflation came down significantly in August due to falling energy prices. The "core" rate of inflation (excluding food and energy) rose at about the same modest rate that it has over the past year or so.

Many wonder why we frequently recommend stocks of small and mid-size companies rather than their giant brethren. With giant companies, it becomes quite difficult to understand what one owns because the company has exposure to so many different factors. Smaller companies tend to be much more narrowly focused, and it is easier to get one's arms around the company's business. We believe that you are well served by our insistence that we understand the opportunities and risks of the companies we invest in. We'd rather engage in healthy skepticism than the hubris of 95% certainty.

© 2008 ICLUBcentral Inc.