The Inscrutable Federal Mind

Story Highlights:

• Today's volatile markets mean stocks are discounting uncertainty, not risk.
• Discounting risk is the name of the investing game in normal times. But uncertainty reigns when the rules keep changing.
• At some point, the feds will stick to a plan and rhetorical tone, allowing stock investors to resume discounting risk, not uncertainty—and intense volatility should diminish.

Some folks accustomed to a pothole-strewn morning commute will soon see a smoother ride subsidized by the stimulus. We'd hazard stock investors wouldn't mind a dose of the same—they've been navigating bumpy markets since fall. And while sharp down moves have dominated, investors have seen their fair share of steep up moves too. (Last week's strong gains.)

The volatility's wide bandwidth may be a sign stocks are reacting to uncertainty rather than discounting risk. Discounting risk is the name of the investing game. Investors shade probabilities and take what they believe to be measurable risk. Maybe they're right, maybe they're wrong—sometimes the risk pays off, other times it doesn't. But known risks are at least somehow measurable.

Uncertainty is a different beast altogether. Uncertainty means market participants can't shade probabilities as effectively. How can they if the rules keep changing? For example, the feds' recently have kept private capital out of Financials and even the broader market. Those still willing to take risk are left to guess at the unpredictable whims of government—and extremely erratic stock prices have resulted. It's rather like, as points out, you're trying to play roulette, but mid-spin, the house arbitrarily changes the rules. What're the chances you'll play again? Probably not too good. If you do play again, will your actions have any regularity? Nope. They'll instead reflect the impulsive nature of the house as you try to guess what move it'll make next.

So it goes with the US government of late—be it the wavering objectives and requirements of TARP or the desire to simultaneously punish and fix the financial sector. The feds have propped up insurer AIG since September. Yet the government's aid is as fickle as public opinion. We see a cash injection one week and intense criticism of how they or the next. That's no way to nurse a business back to health—or markets for that matter. It's got to be one or the other. (And if you believe a business's success or failure hinges on the quality of its talent—then limiting its ability to attract or retain the best employees is a sure path to ruin.)

We don't know when it'll happen, but at some point, the feds will stick to a plan and rhetorical tone. That plan and tone may be smart or dumb—doesn't really matter—but consistency will allow stock investors to resume discounting risk, not uncertainty, and intense volatility should diminish.