Value Investing using Economic Value Added (EVA)

Stories Are Not Facts. Stop Telling the Middle Class They Have Failed.

Today, Vice president Joe Biden was officially appointed to head a new middle class task force whose job it apparently is to increase union membership and continue to make sure most Americans resent rich people, Republicans and success.  Of course, the President, in front of a bunch labor leaders, suggested that organized labor is the solution to the problem, not the problem.  What problem? The problem is not a diminished middle class, the problem is dwindling union membership, union dues and the power of the labor leaders, it seems.

And now on CNBC, they are talking about the "demise of the middle class".  What on earth are they talking about?  As many psychologists tell us stories are not facts.  Human beings are not rational in the sense that they are born numerate.  Shaped in a world of campfires and stone tipped spears, our intuition is terribly lousy with numbers but it is really good with stories.  It appears that the boomer left, those in power in the modern Democrat party, are rubbing raw the resentments of the people and fanning their latent hostilities to the point where facts and rational discourse have been replaced with stories.

Let's consider the facts.  If you look at the chart below.  No doubt that median household income since 2001 looks like it hasn't gone anywhere at best.  And as the story goes, something is really, really wrong with our growing economy if it leaves the median household out of all that growth.  And this is the story that the Democrats have been using to suggest that the middle class has disappeared and that the rich receive all the benefits of the growing economy over the last seven years.

But wait one minute.  Which company do you know writes checks to a household?  A household is a group of people that live together. The Census Bureau tells us that most of those groups contain at least one specific person who earns a paycheck. Those people are called "earners". The amount of income earned by a household depends to a great degree on the number of "earners" in that household. 

Now if the amount of earners per household over say the last 30 years have not changed that much then the number that is being used called "household income" would be relevant.  But look at the red line below. Since the late 60s the average number of persons living in a household has declined from around 3.3 persons to 2.6 persons.

And that means that the real median household income has indeed stagnated from the end of the technology bubble until the end of 2007.  In other words, household income went down. And then went back up to the place that it started before the recession of 2001.

But the average household size keeps declining. What about the real median income per earner?  The real median income per household member declined much less during the Bush years than it did during the Clinton years and has indeed recovered to pre 2001 recession levels.

The question that we all should be asking rationally Is, did the middle-class income earner participate In the overall economic growth?  It's a better question because it takes away the confusion caused by differences in the number of earners per household over time.

The chart below shows the result for the period-2007.  Note that any possible definition of the "middle-class" which shows that the middle-class earners' incomes did not stagnate or decline.  In fact, they have grown in tandem with the 3.3% average growth rate of overall disposable income per capita.

It is simply false to claim that the middle income earners' wages did not grow at the same rate as GDP growth. Therefore, middle income earners have participated In the economy's growth equally.  In fact, the lowest quintile has experienced 3.9% growth, faster than quintile two, three or four. 

This from  Professor Mark J. Perry's Blog:

Bottom Line: ... between 1994 and 2007, the rich have gotten richer, the middle class has gotten richer, and the poor have gotten richer, all at about the same rate.

BERK

NY Times Reports: Stimulus Package Rewrites Social Contract - No Stimulus There

“We won.” ~ Obama
“No apology” ~ Pelosi
“You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things you think you could not do before.” ~ Rahm Emanuel

And now the New York Times reports that "For Democrats, it (trillion dollar stimulus plan) is also a tool for rewriting the social contract with the poor, the uninsured and the unemployed, in ways they have long yearned to do."

54% to 46% or so - those "rich" people who never really understood Obama due to the press' obfuscation are about to get a brutal lesson in politics and "organizing methods".  No wonder the stock market and credit markets are so unsettled- it's not every day that a country "rewrites a social contract".

The stimulus bill working its way through Congress is not just a package of spending increases and tax cuts intended to jolt the nation out of recession. For Democrats, it is also a tool for rewriting the social contract with the poor, the uninsured and the unemployed, in ways they have long yearned to do.
…
As Congress rushes to inject cash into a listless economy, it is setting aside many of the restraints that have checked new domestic spending for more than a decade.
…
The economic stimulus bill prevents states from enforcing a means test. … Republicans said this proposal would take a big step toward federalizing Medicaid. For their part, Democrats said the changes took a major step toward their goal of coverage for all Americans.

Link Here

Obama's Stimulus: Bush on Steroids What change?

If government spending and more regulations are the ways to prosperity, then why do small government countries like Hong Kong grow so much faster than large government countries like France?

If government spending aka bigger government increases growth and jobs then why didn't it work during the Great Depression when Hoover and Roosevelt tried it?  And then why did Kennedy's and Reagan's tax cuts and spending cuts usher great prosperity for years?

Cato Institute's Dan Mitchell explains why Obama's so-called stimulus is good for the government, but bad for the economy:

Mortgage Rates Fall to Record Low of 4.96%, Housing Affordability Surges to Record High

Can you feel it coming?  There is a foundation being built.  Lower heating costs, lower gasoline prices and soon lower payroll taxes.  And now look - highest affordabilty for houses on record.  Check out the whole post from Mark Perry's Blog

Mortgage rates fell today to an historic record-low of 4.96% (see chart above), "the lowest marksince Freddie Mac started tracking the data in 1971." That should help push the Housing Affordability Index (HAI) to a new estimated record high level of 163.1 in January (see chart below). The National Association of Realtors (NAR) has HAI datathrough October 2008, and I have estimated the HAI for November, December and January using the NAR methodology.

Feeling Flush, Exxon Fuels Speculation Deal Is on Tap

At Berk Advisory we very rarely invest in business models whose revenues and/or costs are tied to unpredictable commodity prices.  Therefore, we don't own many oil and gas companies.  There are a few that have enough discipline to conserve cash when everyone is investing at high prices.  Often these companies are chastised by analyts and investors and in some cases the press and politicians, because they seem to be reaping the rewards of high commodity prices without "growing" by investing at high prices.

Well Exxon is not one of those companies.  It is the only major integrated that has consistently earned well above its cost of capital through the ups and downs in the oil market.  And now Exxon is sitting pretty - ready to invest at depressed prices. 

Today the WSJ recognizes this positive development.

The Texas oil behemoth finds itself in such an enviable place because it never chased oil's recent bull run, though it earned heavy criticism for its restraint. In the past two years, as oil climbed near $150 a barrel, politicians called for Exxon to spend some of its riches ramping up production to drive down prices. Other oil companies grabbed expensive new assets that now will be a drain on operating income with oil selling below $50 a barrel.

Exxon Chief Executive Rex Tillerson chose to sit on the sidelines, saying he thought oil prices were unrealistically high and would inevitably fall. As a result, he remained fiscally disciplined, giving the company ample room to weather the plunge in oil prices as rivals flounder.

Americans Figure Out They Don't Need New Cars Every Year

Michael Santoli makes a very good point in this week's Barron's.  He argues that Americans have been conditioned for awhile now to shop intelligently and to get quality for the cheapest price possible.  The last 3 months of fear have been the catalyst that permanently changes the American consumers from splurgers and spending machines into spendthrifts.  Instead of buying a new one - we'll mend it. (Except when you can buy a new one for the price of the mend) 

My wife just informed that she purchased a $70 (her estimate of retail value) coat for my daughter for $15 at the Gap.  My daughter's current winter coat needs a new zipper that would have cost her $13 to fix.  (No, I did not ask her how much it would have cost if she did it herself.

Santoli notices that its easier to defer purchases of new cars because they last longer.  This does not bode well for a return to a pre-crash level of consumer car demand in the US.  Keep it longer and fix it when it needs to be fixed.  No need to get a new one when your current car is dirty.  Santoli says:

The average age of cars on the road has been rising for decades and is up 50% since the 1980s, because they simply don't fail as readily. So it's become easier to defer the purchase of a new set of wheels, which may seriously pinch auto volumes and pricing for years

Which brings me to AutoZone (AZO). 

AutoZone is the largest specialty retailer of automotive parts and accessories to do-it-yourself individuals and professional installers. As of August 2008, the firm had 4,092 stores in the U.S. and 148 in Mexico. The company operates its commercial program out of 2,236 of its stores, offering delivery of parts to local, regional, and national repair garages, dealers, and service stations. The firm also sells ALLDATA automotive diagnostic and repair software.

We own AZO.  We like it because:

1. AZO has high and rising economic profit and among the highest returns on invested capital above its cost of capital in retailing anywhere.

2. Variable compensation is tied to returns on invested capital. 

3. Every dollar spent is subject to getting a 15% pre tax return - which means the company effectively only invests when it expects to receive positive economic value added.

4. With the average age of cars on the road at 9.5 years and rising, the $200 billion automotive after-market should benefit from increased demand. Sluggish new-car sales amid the uncertain economic climate also bode well for this trend.

5. Sales to professional installers represent a largely untapped source of revenue for the firm. AutoZone holds only 1.3% market share in this segment, leaving plenty of room to expand.  This initiative will steadily add to returns on invested capital as increased capital turns more than makes up for thinner margins.

In spite of a very challenging macro environment, we believe our industry remains much more resilient than most. The two statistics we have consistently highlighted as the keys to our industry’s performance are the number of vehicles on the road and specifically the number of seven year old or older vehicles, or our kind of vehicles or OKVs as we call them, and miles driven. At this point, the number of new vehicle sales have declined significantly, while scrappage rates have not changed significantly. This leads to an aging U.S. fleet, which historically has been beneficial to us and our industry. William C. Rhodes, Chairman, President and Chief Executive Officer,Q1 2009 Earnings Call Dec. 9, 2008

AZO's stock was up 15% last year.  We have owned this stock since we started Berk Advisory in 2002. 

Its commitment to profitable economic growth since Eddie Lampert's ESL became a large shareholder has confounded analyst after analyst who consistently had prodded the company to spend more on stores and on expansion and on acquisitions for fear of market share losses.

But analysts do not understand that AZO's goal is not growth for growth's sake or market share's sake - the growth that matters is economic value growth.  And that's really nice.

BERK

 

 

 

Hays Advisory Says Stock Market Extremely Overbought—AND THAT IS VERY GOOD NEWS

The following is a copy of today's Morning Market Comments by Don Hays. 

www.HaysAdvisory.com

 

Haysadvisory.com is a service of Hays Advisory. The website is designed to educate subscribers about the stock market and the economy beyond the headlines. Haysadvisory.com provides readers with a Market Commentary two times-a-week. Hundreds of money management institutions and thousands of individuals all over the world read Hays Advisory's weekly insights on the market and the world economy. 

   

Along with the Market Commentary, the website provides subscribers with Sector Studies and Industry Analysis updated weekly.

 

In its Charts section, the website provides subscribers detailed charts of what Hays believes are the most reliable market indicators for the three most important stock market variables: Monetary, Psychology, and Valuation of the markets.

This is such an important time in the stock market and the history of our country that Hays has given his subscribers permission for this day only to send this report to any of our friends or associates, with the hopes that many suffering investors today will not lose hope, but get excited about the ensuing opportunity.  We highly recommend that any advisor or broker or portfolio manager subscribe to his service - we read his charts everyday and eargerly await the commentary.

January 09, 2009

Stock Market Extremely Overbought—AND THAT IS VERY GOOD NEWS

History Shows Extreme Overbought Market Never Has 6/12 Month Loss

By Don R Hays

 

Summary:          Admittedly, this old Dog didn’t understand the message, but the stock market was telling us in late 2005 and 2006 that the Secular Bull Market had changed its stripes, and that something special (different from the prior 24 years) was happening.  I hate myself when I see something in hindsight, and find I got suckered in just like everyone else.  Such is the feeling in these last few months as we worked through the process to develop our new “fail-safe” trend analyzer that we are invoking into our Asset Allocation Process.  The many hundreds of hours studying the major trends of the past revealed to us certain historical trends that need to always be recognized as possibly putting into place a new and different set of market conditions than those of the recent secular (20-year) norm.  Our psychology indicators as well, in hind sight were starting to show in 2005 that something was amiss—something very different from the prior 25 years.  The stock market is still in that process of correcting the fraud, the excesses, and the massive leverage built up from the greed of those previous 26 years (1974-2000).  In many ways I could argue that the prior secular bull market that kicked off in 1974 ended in 1998 instead of 2000, but the exact timing is not that important.  I believe this “correction” phase has now been in process since 1998, and now we are receiving signals much like those of 1974, that a new major secular bull market is not too long from being born……if it hasn’t already.

                        As you know, we rarely get conditions such as we received on October 9^th when our Psychology Composite moved to its most bullish P1 reading.  The same extremes were shown in our oversold indicators, reaching levels only reached in a very few rare bottoming occasions.  Then when the Value-Line Appreciation Potential moved to a level that had only been seen at the pivotal 1974 and 1982 bottoms, it was obvious that something special was being presented. 

                       That was October, 2008, and we believe strongly that October 10^th WAS THE INTERNAL BOTTOM of the 2008 bear market, with the external final bottom on November 21^st.  But now our Psychology Composite has moved to P2.  On Friday, our overbought indicator moved to 90—and on first blush it produces an instinctive..UGH!!  This is a level reached very rarely in the last 40 years. 

                        As I said, on first blush, that is scary, but don’t fall into that trap.  You will see in the table on the next page that this is a sign that this bull market—just barely out of the starting gates—has so much power that it was able to catapult the market into that rare stratosphere.  In fact, there is not one time in the last 40 years that an overbought condition such as this has created a loss in the next six months OR 12 months.  It is very rare that investors buying on the exact day of the overbought extreme would have lost money even in the next 13 weeks.

Here’s the complete table of each of those overbought conditions above 80.

         

 

To show the most recent periods when we’ve had this extremely >80 overbought condition you can see in the following graph.

Here’s the slightly shorter-term one we update each morning on our website for you.

We don’t like to overemphasize the very short-term, even those trading cycles under 3 months, but if you observe that prior table again, you will see that even in the next 2 weeks, the rare loss was very minimal.

 

The temptation is to wait for a correction after the S&P 500 has rebounded by 24% off its panic bottom, but history tells us that is not playing the odds in your favor—more is to come. 

 

I am tempted to really pour a long one on you this morning, but will save that for next week some-time as I get into the long-term secular trend, and the application of our Trend Analyzer.  But as a teaser, let me show you a couple of secular trends of the past.

 

                        From an historical basis, prior to the latest one that started in 1974, the previous long secular bull market started in 1942, right in the midst of America entering the Second World War, and didn’t end until 1966.  In the topping-out of that prior secular bull market, it was not generally recognized by very many pundits either, until the peak years in 1972, but 1974 certainly woke up the brain-cells.    The correction process of that one started in 1966 and ended in the despair of 1974.  It certainly was not recognized as such until 1982, but it was there in 1974 for those that understood the message of the market.

You can see that there were many cyclical bull and bear markets in that long 22-year secular bull market, but except for that Missile Cuban Crisis in 1962, the secular bull market rose unabated without violating our red Trend Analyzer line.  It paid investors to remain basically bullish taking advantage of the cyclical declines.   But that changed with the peak in 1966, and really changed in 1974’s devastation.  Most people say the years 1966 to 1982 were a flat market, and in some ways that was the case, but in our case the infrastructure of the next mighty secular bull market started in August 1974’s internal bottom.  Now remember, the Value-Line service Appreciation Potential only was originated in the mid-1960’s, but the last 40 years show you very decisively the kind of bargains that became available at that 1974 trough, when essentially the greed and corruption built up during that prior 22 year bull market had to be cleansed.  The cleansing only started with the county fully in support based on the trauma and pain of 1974.  We hope you see the similarity.

Now let me show you the most recent Secular bull market.

Our new Trend Analyzer, that we will be giving some basic details on in the next few months, is definitely only useful in extreme cases--when something extraordinary is happenin--vastly different than the most recent 10-20 year secular pattern.  It is designed so that in strong secular bull markets, it will be used very infrequently if at all and should depend on the normal cyclical variations to avoid those pit-falls that seem to come around every 2-3 years.  But then in others—when the market is in the midst of only preparing the ground-work for  the next major secular bull market cycle (such as has been happening since 1998-2000—it might flash regular caution lights as cyclical markets play around a flat line as they did in that 1966-1979 era, and in many ways since 1998.  This is definitely not a “wiggle” indicator, but only a safety net that will help to buffer (not eliminate, but generously buffer) the massive losses such as came last year. 

 

Is this locking the gate after the horses are gone?  We don’t think so, we are working very hard now at corralling a new set of horses, such as we were able to do way back in the late 70’s, and boy did those horses run when we put our Asset Allocation bridle on them—a controlled run.  We’re excited about the herd of horses now lolling around in the pasture that are so cheap and eager to join our herd.  So with that basic description, we’re excited about the potential this stock market has over these next 20 years as the next great secular bull market starts to show its head. 

 

The first referenced bull market that started in 1942 was nothing more than the realization that the Industrial Revolution had been born, and that the U.S. Super-Power would lead the world into a new cultural era. 

 

The 1974-1998 (maybe some into the 2000 bubble) secular bull market was similar, in that it was showing and measuring the positive impact of the Technology Revolution and the effect it had on productivity and communication.  It was bringing a new flat world, and now (with the shackles removed from my old, blind eyes) we now believe the next secular bull market that will become obvious in these next 2-10 years will be a bull market that is based simply on measuring the growth of that new flat world with the billions of new consumers. 

 

Yes, all three secular bull markets have a connection.  So now as the U.S. auto industry (Industrial Revolution) is dying or dead, we see old Microsoft still very profitably updating Windows 7.  But Oracle’s Larry Ellison (who may or may not be right) seems now to be pretty savvy, when he said a few years ago that the successful Technology companies had reached a state of maturity when those that were able to consolidate and merge with others would be the most successful.  So maybe that premise—if it proves true, could be a sign of the state of the large Technology Companies to be much like G.M. in 1966.  So we’ll continue to observe and expand this theme, hopefully for the next 22 years of exciting global expansion, as Democracy and Capitalism expands throughout the world. 

 

Let me briefly show you something that really caught my attention yesterday.  Our associate Mark Dodson is very active in the CFA program in Nashville, and he had cited a speaker of a few months ago who studies, writes and speaks on the important topic of Demographics.  His name is Richard Hokenson of Hokenson & Company (www.hokenson.biz) and Richard was kind enough to give us permission to copy one of his graphs that in his words show “the age change demographics of the US population continue to be very supportive for housing demand.  Further thawing of the credit crisis could well mean that the consumer downtrend is short-lived and that the ensuing recovery could be more robust than currently expected.”

 

As you know, stock markets typically bottom out well before a recession ends, and since it is our belief this last bear market bottomed out on November 21^st, we are hungry for news that will pull the herd along when it becomes apparent.  Richard included this very intriguing graph of age demographics with the exciting portion being that growth of the 20-29 year old segment of the U.S. population.  Here—with his permission—is his graph and excerpts of his commentary.

He has more interesting observations, and I’m sure if you have an interest in receiving more of his work he would be happy to furnish you details.  But I think Richard may very well have the kernel of un-recognized news that might set the stage for this next economic and  housing resurgence.

 

That’s if for this week friends.   I cannot apologize any more for the terrible technology glitch yesterday in our webcast to our managed accounts.  We appreciate you so much, and will attempt to make sure you get all that hoped-for information from that call.  But we  thank you for your indulgence, and you can believe that this malfunctioning webcast company has lost a client.

 

Thanks for listening my friends, we’ll see you on Monday—God Willing. 

   

This is such an important time, so with the hopes that many suffering investors today will not lose hope, but get excited about the ensuing opportunity, you have our permission for this day only of sending this report to any of your friends or associates. 

 

Thanks again,

Don

Hays Advisory LLC does not guarantee the accuracy or completeness of this report, nor does Hays Advisory LLC assume any liability for any loss that may result from reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are for general information only. Hays Advisory LLC, 301 Seven Springs Way, Suite 150, Brentwood, TN. 37027

©2008 Hays Advisory, LLC. All rights reserved. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without prior written consent from Hays Advisory LLC.

It's Back. Value Investing Is Out-Performing When the Markets Go Up!

It seems that everywhere we turn, journalists and market bloggers are taking great pleasure,it seems, in letting all of us know that the "Value" style of investing had a really, really bad year in 2008.  Look what Fred W. Frailey, editor of Kiplinger.com wrote back in December in his article entitled, "Where Are The Wise Money Managers?":

You quit believing in Santa Claus long ago. Ditto for the Easter Bunny. Later on, as you grew up, you learned that life isn't always fair and that bad things really do happen to good people. Perhaps now is the time to lay to rest an article of faith among investors and own up: There are no geniuses in this business, after all.

R.I.P., Bill Miller (Legg Mason Opportunity fund, -59% for 2008 through October 30). And Mason Hawkins (Longleaf Partners, -47%), Bill Nygren (Oakmark Select, -36%), Chris Davis and Ken Feinberg (Selected American Shares, -36%), Ron Muhlenkamp (-37%) and the guys and gals at Dodge & Cox Stock (-41%).

Have no fear, all those guys mentioned will be back. The newest evidence is from our friends over at AFGview.com and their Value Expectations Blog. They just released a study on which style worked on a relative basis as investors panicked during the last three months and which styles did not work.  Value investing works when saner heads prevail - when the markets recovered over the last few weeks, value stocks with strong fundamentals but selling at prices that imply very low expectations, performed the best.  We see it in our portfolio.

Consider what the AFG folks found:

As investors panicked and hedge funds delevered, it seems that stock prices over the last three months were heavily influenced by short-term earnings, dividend yield, and price momentum as some investors looked for safe havens in the stock market, and others simply followed macro trends. Despite poor performance during the market decline, we believe that a long-term valuation approach will perform very well as an investment strategy as the stock market stabilizes, and the following article will summarize what we have observed during the stock market decline (9/19/2008 - 11/21/2008) and the recent recovery over the last six weeks.

After the focus on the recession, earnings, credit crisis, housing market, stimulus packages and bailout by expert opinions and media reports over the last three months we are wondering “what do we do now?”.   After all, we are certainly no genuises (but we do believe in the Easter Bunny).

We spent the last several months examining every part of our investing process so we could retool and be ready for the upswing. I am excited to say that our philosophy has not changed at all , but we have tweaked a few parts of the process and added a separate momentum overlay to help warn us of the large hidden risks like we saw in the last three months.

Other than that, we are still value investors who buy EVA Companies,  meaning we buy stocks of companies that are the best stewards of our capital and whose management's are focused on long-term intrinsic value growth of our shares,  All that is meaningless if we do not have the discipline to buy the great companies at attractive prices - that has not changed, and many great companies are now selling at 50 - 70% off. 

We treat lower prices as heaven sent.  We get to trade undervalued stocks for really undervalued stocks and since we and our clients are mostly still savers and regular buyers of stocks, we get to buy more and more shares of great companies at lower prices raising our lifetime expected return from this point on.  We want to accumulate as as many bargain priced shares as we can BEFORE THE SALE ENDS!

So regardless of the media and other traders and investors who scoff at Value Investing because of one horrible year where there was no place to hide, we don't care what worked when the market was going down.  We only care about what has ALWAYS worked - buying great companies' shares at deep discounts to the shares' intrinsic value.

BERK

Banks Don't Need to Be Forced to Lend (by Congress especially)

PLEASE DON'T LET CONGRESS ALLOCATE CREDIT!  They don't need to from the Mark Perry's Carpe Diem blog we see that per the Federal Reserve data bank lending is UP 4+% since just before this panic started in September.

 

Third, while a TARP investment increases a bank's lending capacity, lending mandates -- such as that a bank must increase its outstanding loans by some multiple of its TARP investment -- could force banks to make new bad loans.

Unfortunately, banks accepting TARP investments must, under the contract governing Treasury's investment in the bank, agree that Treasury can "unilaterally amend" the agreement "to comply with any changes . . . in applicable federal statutes." Through this provision the new Congress can impose on banks with TARP investments lending mandates or other obligations and restrictions, such as barring the use of TARP funds to acquire weak banks. Even worse, Congress may legislate credit allocation, such as directing that a certain percentage of a mandated lending increase must go to a favored class of borrowers.

Banks are in the lending business: They do not need to be forced to lend. And contrary to popular and political opinion, banks have not stopped lending. Despite the recent financial market turmoil, a declining GDP, and an increase in loan-loss reserves, commercial bank lending actually grew $336 billion, or 4.9%, from August to Dec. 24, according to Federal Reserve data. While lending dictates or other restrictions may be tempting, the Obama administration must discourage Congress from imposing them on recipients of TARP investments.

Bert Ely in the Wall Street Journal - "Banks Don't Need to Be Forced to Lend"

In a Crisis, Perverse Behavior Often Motivated by Information Asymmetry

The their book "The Panic of 1907: Lessons Learned from the Market's Perfect Storm", Robert Brunner and Sean Carr describe the characteristics of a panic.

A financial system has two vitally important characteristics that can serve as a foundation for a financial crisis. First, the very existence of a system means that trouble can travel.  The difficulties of one financial intermediary can spread to others.  Second, the complexity of a financial system means that it is difficult for all participants in the financial system to be well-informed - this is called "information asymmetry" and may motivate perverse behavior that can trigger or worsen the financial crisis.

Brunner and Carr go on to explain that this type of information asymmetry played a major role in the panic of 1907.  The authors are struck by how little the average depositor - even JP Morgan himself - could know about the hour to hour financial condition of banks,brokerage firms and trust companies.

If you read history, none of these financial panics, runs on leveraged institutions and the like, has been met with a cohesive strategy nor are the regulatory regimes in place at the time capable of handling the unexpected because there is too much asymmetry of information.  The credit system is a system based on "trust" - in people, in leaders, in institutions and in regulations.  When "confidence" is fragile, leaders have a very difficult time figuring out where the next leak is going to come from.

Berk