Terza Rima

Story Highlights:

• As recession talk abounds, today's report on US pending home sales was widely misinterpreted
• Free market economies are built to create maximal efficiency—a process that includes periods of dormancy
• Specific segments of the economy are constantly in flux—while those in decline are grabbing all the headlines today, most of the economy is growing nicely

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Midway upon the journey of our life
I found myself within a forest dark,
For the straightforward pathway had been lost.

The opening to The Inferno describes today's investor sentiment nicely, doesn't it? Granted, Dante probably didn't have capital markets in mind when penning the Divine Comedy, but given investors' pervasive feeling we've entered the dark woods, headed toward the never ending fire of Inferno, the comparison seems apt.

Into the Woods
By Bill Donoghue, MarketWatch

All sorts of hellish, underworld language abounds: Bear markets, the dark woods, gloomy outlooks, and so on. Something like pending home sales falling seems more like a descent into Hades than an economic report.

Home Sales Sink, Outlook Darkens
By Chris Isidore, CNNMoney.com

So, homebuilders built too many homes in a big boom period and now relative sales are smaller versus a year ago (and even that's dubious since these reports are often revised up well after the fact). Ok! This is one step back, not a regression to the beginning. Folks seem to forget all the homes built, mortgage loan innovations, and new homeownership over the last boom won't be wiped out. The housing market hasn't ceased functioning, it's just stopped its very rapid pace of growth many were accustomed to. Things build to excess, then the market corrects itself, and growth continues onward.

If you were to look at the charts of growth for any segment of the economy—especially over a twelve month period—you'd see highly erratic growth everywhere. Industries never—ever—just move straight up in a nice, tidy line for long. There are many mini-declines along the way. Yet, just about all of them seem to end up growing over time. If you panicked and sold out of the market every time a housing index dipped for a bit, you'd be very poor indeed.

Sometimes backwards is ok. It's how capitalism works. It moves forward, innovates, tries new stuff, makes mistakes, corrects those mistakes, then keeps moving forward. Joseph Schumpeter called it "Creative Destruction." The times of stepping back are the times capitalism's at its finest—clearing out the stuff that doesn't work to pave the way for more growth. It is a sometimes painful process, but we should at least recognize the ultimate redeeming powers it holds.

Dante certainly did. He wrote the entire Divine Comedy in a poetic form called "Terza Rima." Terza Rima is a three-line rhyming pattern: a-b-a, b-c-b, c-d-c, d-e-d. Each stanza moves forward one rhyme, but always looks backward one too. It's a process of moving two steps forward but also taking one back, perpetually. Dante wrote nearly 100 cantos in this extremely rigorous form. It's so difficult most English translators don't even make the attempt.** Dante believed this is how the psyche grows with knowledge—moving forward with new experience but always reflecting on what's passed.

It turns out this is how free markets work too. Terza Rima is the stuff of well-functioning capitalism. Two steps forward, one step back. The housing industry took many steps forward, now it takes a step back to correct its excesses. But the result is good. More folks own homes now than ever before and still likely will despite this downturn. The same is true for securitized mortgage products. Think of it this way: If 15% of subprime borrowers defaulted, then 85% didn't. That's huge progress and makes subprime lending an overwhelming success. That's two steps forward and one back. The key is not to forget those two steps of progress even as we take a step back.

Industries work in Terza Rima, even during economic expansions. Only annual GDP looks like a smooth line upward the last six years, and even at that the rates of growth on a quarterly basis are all over the place. Why? Because, GDP is an aggregated and weighted measure of all the different sectors of the economy, so results are smoothed out. When we see headline GDP growth, we're not seeing all the little industries and sectors regressing and growing, we're just seeing the overreaching result.

Just like GDP, markets are an aggregate of many stocks. So, while Homebuilders and Financials were hit hard in 2007, the overall market result was just fine because other sectors performed very well. Most of the economy is in that "two steps forward" phase, but all the headlines are grabbed by those taking "one step back."

Dante gets through hell and even makes his way to heaven taking one step back every single stanza! That's an arduous process, but the right one. Today's economic environment is no bearish Inferno, it's the poetry of capitalism.

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*Translation of the Inferno by A. Mandelbaum.
**An example of Terza Rima from the opening lines of Inferno in Italian:

Nel mezzo del cammin di nostra vita
mi ritrovai per una selva oscura
ché la diritta via era smarrita.

Ahi quanto a dir qual era è cosa dura
esta selva selvaggia e aspra e forte
che nel pensier rinova la paura!