24/05/2010: Investing when liquidity rules

Does the recent correction mark a return of a bear market or is it just another dip in an impressive rally? We analyze recent market behavior and offer some advice on how to invest in this unsettled environment.

Between March 2009 and April 2010, equity markets, as measured by the Dow Jones Industrial index, have enjoyed their most impressive rally since 1932. But this spectacular surge has also been interrupted by several steep market declines. So far these slides could be seen as pauses for breath rather than real corrections. Whether the latest correction conforms to this harmless pattern remains to be seen. We think it's high time to look behind the data and see what's driving this rollercoaster.

First, we would point out that the market's penchant for volatility lately results from two conflicting forces, one robustly positive and one darkly negative. On the plus side, after a deep recession, a vigorous economic recovery has been unfolding globally since mid-2009. On the dark side, markets remain extremely nervous and prone to panic. There is certainly no lack of things to worry about: European sovereign debt, potential monetary tightening in China or stricter US regulations on the financial services industry, as well as a generous supply of wars, threats of war, and natural and manmade disasters. The world indeed appears to be boiling.

Behind the struggle between good fundamentals and real or imaginary fears, we see one common thread: liquidity. Why are we so convinced that liquidity is all that counts? Let’s take another look at the rebound that began in March 2009. It was not restricted to the equity markets. All asset classes were carried along in the rising tide.

Anyone who bought gold in March 2009 will tell you, "It was simple. I saw that central banks were printing money. I realized we would be facing huge inflationary pressures, so I bought gold. Looking at how well gold has done since then, it was a smart move."

An investor in government bonds (with the notable exception of those who bought Greek debt) will be just as proud: "In March 2009 I felt we were facing a spiral of deflation and depression so I fled into US, German and Swiss government bonds. It was a good move; not only did I receive the coupon, I even made a capital gain on the principal."

An equity investor can say, "In March 2009 Warren Buffet started buying stocks again. I always do what he does, so I bought stocks and I have done nicely. Market indices are up 60-80%. The Sage of Omaha came back to stocks because he just felt things were bound to return to normal."

We have a tendency to ascribe our investment successes to our sharp intelligence, our good judgment and our flawless knack for timing market movements. Our failures, of course, are always due to external factors.

Our three successful investors each tells a story that makes sense in isolation, but the factors they cite are in fact mutually exclusive. Inflation, deflation and normalization simply do not all occur at the same time.

To reconcile the rises in assets as diverse as bonds, gold and equities, we need to take a step back. What else happened in this post-credit-crisis timeframe? The answer is simple: the billions of dollars, euros, pounds, francs and yuans printed by central banks to fight deflationary pressures after the financial crisis in 2008 have been invested across all asset classes, pushing all prices upward.

In the last 20 months, most investors have seen their portfolios exposed to two shocks. The first (negative) shock came from the financial crisis, which most people would rightly say was external; the second (until now positive) shock was the liquidity rally, which most people wrongly put down to their skills as investors. As a result of these two events, many portfolios feature major imbalances and bear no relation to investors' risk profiles or objectives.

Judicious investors should review their asset allocations and accept the truth the spectacular rebound between March 2009 and April 2010 was due to a flood of liquidity globally and not their perspicacity as investors. Now, we feel it is imperative that portfolios should be actively rebalanced, not only to reflect the risk profile and objectives of the individual investor, but also the risk/return characteristics of assets that might have changed during the last 20 months of erratic market performance.

Finally, it is important to remain flexible. The investment environment is still dominated by liquidity and this means it will remain volatile. The VIX index, a broadly cited measure of the implied volatility of the S&P 500, has again reached levels last seen prior to the Bear Stearns debacle in March 2008. In this context, we believe a buy-and-hold investment strategy could prove disastrous.

Until we are sure that the aftershocks of the financial crisis are truly over, it is essential to exercise caution. This demands rigorous discipline. Our rule of thumb: every investment should have a price target and a stop-loss, and both must be kept up to date. Above all, investors need to know when to sell, whether to take profits or to limit losses.

21/05/2010: The Financial crisis for everyone

The world changed on May 9 with the Eurozone's trillion dollar bailout plan. With governments squeezed between the politically unacceptable remedy of inflation and the dubious medicine of covering debts by printing money, the path ahead now seems clear.

The sovereign debt crisis in Europe is not an isolated event. It is merely the second act of a tale that started in mid-2007 and reached its dramatic peak in September 2008 with the fall of Lehman Brothers. The jargon employed by many experts to explain what happened when credit stopped flowing can be daunting for the layman. This is unfortunate since the crisis followed, and continues to follow, a rather simple pattern that is common to the bursting of most financial market bubbles. Like a classical tragedy, the credit crisis that still roils markets today has a prologue and unfolds in three acts.

Prologue: Living large till the bills come in
Financial bubbles are as old as history itself. Whole libraries are filled with lively, funny and sometimes shocking tales of past financial follies. With the benefit of hindsight, we are often puzzled by the recurring madness of crowds.

How could it come to pass that one bulb of an exotic flower could sell for ten times the annual income of a skilled craftsman, that the park surrounding the emperor’s palace in Tokyo could be assigned a value equal to that of California's entire property market, that a back-of-the-napkin business plan from a couple of teenager whiz-kids could be worth more than a hundred-year-old blue chip company with solid earnings and tens of thousands employees? We are seduced again and again by the four most dangerous words in the financial industry: "This time is different," which is also the title of a compelling history of financial bubbles by US economists Carmen Reinhart and Kenneth Rogoff, published last year.

Indeed, even as we grapple with the consequences of the latest excesses, the next bubble is probably already in the making, as we shall see.

That we are so ready to believe the false promises of financial bubbles defies mainstream economic theory, which assumes human beings are rational and markets are efficient. But it now seems clear that economists need to look to other disciplines – psychology, sociology and history – to better explain our dangerous gullibility.

Buying into a bubble is certainly not a sign of stupidity or lack of economic education. Former Fed Chairman Alan Greenspan didn't recognize the Tech bubble, bloated by its fantastical valuation metrics, because he liked the narrative of a new economy spurred by technology-driven productivity gains. Current Fed Chairman Ben Bernanke argued as late as 2005 that pumped-up US house prices "largely reflect strong economic fundamentals." These examples show that even sharp economic minds succumb to the mirage of bubbles.

But just as a fire needs oxygen to burn, financial bubbles need money and the promise of more money – that is, credit – to inflate. And fear that the ample liquidity and credit might dry up can cause a bubble burst. After this prologue follows a tragedy in three acts.

Act 1: Suddenly the air left the bubble…
Once a bubble bursts, balance sheets suddenly take on a grotesque appearance as asset prices plummet while liabilities remain constant. Both sellers and potential buyers fear the fall in asset prices, and even if assets could be sold, their reduced values would not cover the seller's liabilities. This was experienced in the first act of the credit crisis. Many households and many financial intermediaries became insolvent. While the insolvency of private households may not pose a massive threat to the economy, failing financial intermediaries can have very disruptive consequences, as we have seen.

Governments' rescue plans took the form of bailouts and even of nationalizations of some banks and the purchase of banks' toxic assets by the state. In general, governments took the most toxic and fragile elements of the financial sector’s balance sheets into their own accounts.

These were drastic, even shocking actions but they succeeded in stopping a dizzying flow of events that could have spun out of control. Reinhart and Rogoff calculate that over the last 200 years a banking crisis of the size we have just experienced consumes roughly 40% of GDP. This matches well with the International Monetary Fund's estimate that the public sector's debt-to-GDP ratio in developed economies will have surged from 80% in 2007 to 120% by 2012.

While the economic recovery has been uneven, our good fortune is evident if we consider an alternate history – one in which, after the Lehman bankruptcy, other financial intermediaries were not rescued: first, our credit cards would cease to function, and then the automatic teller machines would freeze. Lines would form in front of closed banks and transactions of all sorts would break down. In short, economic activity would have screeched to a halt.

In any case, even with the rescue of so many financial intermediaries, many developed countries have suffered the worst recession since World War II.

Act 2: The public sector quakes
The financial crisis could have stopped at the end of Act 1. The US saving and loan crisis and Swedish banking crisis at the beginning of the 1990s ended right there. Despite the surge in public debt and its possible long-term burden growth and boost to inflation, many financial crises have petered out before the second act. However, during this financial crisis, three major problems arose that ultimately shook the halls of government.

First, while recent financial crises were confined to a few countries, the latest convulsion affected both the US and Europe, which together still account for over 50% of global GDP. Over the last forty years, only the Asian crisis of 1997-98 can be compared in importance although not in sheer size to the events of 2008. The new debt raised by the US and the European governments is immense. According to The Economist World Debt Clock in 2009 and in 2010 roughly 5 trillion US dollars in new public debt will have been raised worldwide. For 2011 and 2012, debt increases in similar order of magnitude can be expected.

Second, this new debt comes at a moment when the government debt of developed economies is already extremely high by peacetime standards. On top of that, most governments in the developed world are facing the challenge of aging populations, a demographic shift that will further stress public finances. In fact, adding the so-called "unfunded liabilities" implicit in various government programs to current public debt, these "off-balance-sheet" liabilities create a financially unbearable situation.

Finally, this surge in new debt has hit countries that have no authority to monetize it. Debt is said to be "monetized" (turned into money) when a government issues debt (bonds) to finance its spending and the central bank then buys that debt, printing more money to do so. That is one reason why we have a European and not a US or a UK sovereign debt crisis today. Greece is insolvent and at risk of defaulting because its debt is calculated in euros and it cannot use the printing presses to monetize it. This is a choice that countries like Japan, the UK or the US still have. Which leads us to the final act of this financial drama.

Act 3: The big flush
Reinhart and Rogoff assert that there is no empirical relationship between public debt and inflation. While this might be puzzling at first glance, it will not surprise monetarists, who see inflation purely as a monetary phenomenon. According to this view, inflation would follow high levels of public debt only if that debt is monetized, that is, if the printing presses were used to repay the debt. Given their massive debt problems, several countries, including the US, might be tempted to print their way out of trouble since it hurts too much to swallow the bitter medicine of depression.

Indeed, this is how we think the current financial crisis will end. Why? For one thing, economic policy is made in a political and social context. This reality adds a layer of considerations to the remedies that governments select. It requires a brief outline of how these forces interplay:

The credit problematic can be seen as a conflict between lenders and borrowers that can be solved by favoring one side or the other. Creditors are the savers, the pensioners and older people generally. Germany is the creditor to the Eurozone while China plays that role for the world. Debtors include entrepreneurs and younger people. The US, the UK and the Mediterranean countries of the Eurozone are clearly in the debtor's camp.

Since governments are also usually borrowers, they inherently favor debtors over the creditors. This is somewhat counterbalanced by the fact that older people are more inclined to vote than younger people; hence the usual posturing of governments against inflation.
Favoring creditors would lead to defaults and increase the likelihood of a deflationary, Depression-like situation. This, it must be said plainly, is the outlook for the Eurozone's Mediterranean countries, which have committed to drastic austerity measures.

On the other hand, economic wisdom says that favoring debtors will lead to inflation. Given that not only the government but also many households are heavily indebted in the US and the UK, it is very likely that inflation would be the most acceptable outcome, at least in those two countries. Until two weeks ago, this was not at all clear for the Eurozone. After all, the European Central Bank was formed with one clear mandate: to fight inflation.

However, we think the balance of power within the Eurozone and the ECB shifted from Germany towards the Mediterranean countries on 9 May. By agreeing to buy the sovereign debt of distressed Eurozone countries, the ECB has adopted the so-called "quantitative easing" measures that were undertaken by the Fed and the Bank of England. That is, in layman's terms, the ECB is also monetizing debt and massively increasing liquidity.

And the show goes on
Act 3 once again shows why economics is known as the "dismal science." A hangover usually follows a wild party, and after the roaring 2000s we see only two possible remedies: deflation/depression (this is how Japan's playbook got stuck since 1992) or inflation. Cost-cutting is universal in our globalized world. Last year's Great Recession left many countries with high unemployment and a lot of unused capacity. In such a pinched environment, creating inflation is a challenging task, one that we do net expect to occur anytime soon.

More likely, in our view, the global liquidity flood that was so massively boosted on 9 May will succeed in raising asset prices again, and along with it, overall market volatility. Ultimately, this surge in money may well pave the way for the next bubbles, just as the excess liquidity after the Tech bubble set the stage for the housing and credit bubbles. The show, it seems, must go on and on….

11/05/2010: One trillion for an addicted “wolf pack"

For its Monday evening news show, the French-language national TV station in Switzerland invited me on May 10th, to comment on the rescue plan hammered out over the previous weekend by the European Union and the International Monetary Fund. The plan commits 750 billion euro (roughly a trillion US dollars) to rescue... hmm, to rescue what exactly? The euro, bankrupt Greece, or its endangered peers Portugal and Spain, the global financial system? I must candidly admit that I have been unable to figure out the goal of this much praised intervention.

The only clear message I got from very satisfied European politicians was that this vast sum would "tame the ugly speculators." So would the threat that the European Central Bank could (if not contrary to the letter then surely to the spirit of its strict charter) buy public debt on the secondary market. Anders Borg, the Swedish Finance Minister, allowed no room for misinterpretation when he described market participants as a "wolf pack."

The first question from my TV interviewer was disarming: "Could you please explain to our viewers what one trillion Swiss francs or dollars actually means?" Trying to come up a smart comparison, for example, it is actually more than two times the Swiss GDP, I suddenly felt dizzy. Is a trillion dollars really what it takes today to stop market participants from panicking?

Like Alice in Wonderland, we’ve grown accustomed distorted reality. Scale has lost its meaning as the numbers grow ever larger. Whenever markets falter, calm can only be restored by a vast flood of liquidity, it seems. But let's be clear about something: Behind the smokescreen of jargon and crypto-technical explanations, as they struggle to reassure the public that everything is under control, the central banks and governments – all of them, even the European Central Bank since last weekend – are simply trying to print their way out of their misery. By printing money they hope to soothe the market.

Consider just one example of the new reality: countries that themselves could be next in line for aid can use an EU Special Purpose Vehicle to support countries under fiscal stress. Will this make the European Union stronger? It reminds me of Baron von Munchhausen, who tried to pull himself out of a swamp by his hair. Of course, the profligate countries will now loudly approve severe austerity measures. But unless the EU is really willing to send those countries hurtling back towards the Stone Age, I doubt that these measures will ever be implemented in full.

Ultimately the solution will be inflation. The fever of higher prices eats up debt and liabilities and hence helps to repair the stressed balance sheets of households, financial intermediaries and governments. However, in a world with overcapacities and deleveraging pressures, creating inflation is a daunting task. So for the time being those large amounts of liquidity thrown at the markets will increase a certain form of volatility. Impressive rallies will be followed by abrupt corrections, whenever market participants feel the aches of liquidity withdrawal.

In this very volatile world broad buy and hold strategies will continue to underperform the returns of agile investors, who take on risk selectively but who are also willing to sell sometimes, when the tide turns.

04/05/2010: The Spanish curse

Economics is a dismal science. Oftentimes, a situation that looks at first glance to be an economic blessing ends up being a curse. The so-called Dutch disease is one example of this. In the early 1960s, the discovery of oil in the North Sea was hailed as a stroke of good luck for the Netherlands. The euphoria ebbed, however, when oil exports began pushing up the exchange rate of the guilder as well as overall Dutch labor costs, thereby bankrupting many of the country's exporters and manufacturers. Another example of this sad phenomenon is when a country suddenly gets access to easy money. Such was the case of Spain during its Golden Age (roughly between 1550 and 1700).

When conquistadores Hernán Cortés and Francisco Pizzaro set out to conquer the Aztecs and the Incas, they were driven by their belief they would find tremendous riches in the New World. El Dorado and the Cities of Gold might have remained a legend, but unheard of wealth was nevertheless unearthed in the silver mines of Zacatecas in central Mexico and Potosi in Bolivia. It is estimated that out of the latter alone 45,000 tons of silver were sent to Spain between 1550 and the late eighteenth century. At today's prices, this would equal roughly USD 30 billion, while Spain's average gross domestic product (GDP) during this period is estimated to have been less than USD 7 billion.

This substantial influx of precious metals should have tremendously enriched the Spanish Crown and its subjects. But while it allowed Spain to become the major European power in the sixteenth and the early seventeenth centuries, other nations managed to profit much more from it. According to the estimates of late economist Angus Maddison, Spain's per-capita GDP increased by roughly 30% between 1500 and 1700. Spain's main rivals during those two centuries, Britain and the Netherlands, grew their per-capita GDP by 75% and an astonishing 180%, respectively.

In fact, coaxed on by the easy money pouring in from its American colonies, Spain began living far beyond its means. Constantly at war with the English, the French and the Ottomans, facing independence struggles from the Dutch and the Portuguese, trying to defend the Catholic faith against the Reformation, and building landmarks like the Escorial in Madrid, Spain's Golden Age became an era of imperial overreach.

Despite all its New World wealth, the Kings of Spain defaulted six times in less than a century: 1557, 1575, 1596, 1607, 1627 and 1647. Moreover, many contemporary observers complained about how much Spain was importing from other countries. This fact makes it very likely that Spain was actually facing a twin deficit during its Golden Age. Not only the government but also the whole country was living above its means. Finally, the influx of precious metals from the Americas led to a surge in prices in Spain and ultimately Europe as a whole, by a factor of six over 150 years. When this influx finally ran out, the Golden Age of Spain was over. Britain, France and the Netherlands became the ascending European powers.

While not as dramatic as past history, events in Spain since it joined the euro show a modern day reflection of the infirmities of its Golden Age. It is true that this time the Spanish government remained quite frugal until the financial crisis let its deficit explode. But the whole country has been on a spending spree boosted not by an influx of precious metal but by fiduciary money printed by the European Central Bank. In the decade before joining the European Monetary Union, Spanish real interest rates averaged 5.5%. In the ten years with the euro, those same real interest rates dropped to an average of 1.5%.

While inflation was contained, this easy money and the low costs of taking on debt led to a housing price bubble and then a bust of even larger proportions than the ones hitting the US and the UK. Unit labor costs were increasing much faster in Spain than in many competitors in the North and especially in Germany. In synch, the Spanish current account deficit, which averaged roughly 1.5% of GDP in the 1990s, ballooned to an average of 6% in the 2000s.

This Spanish curse shows that a sound fiscal policy is only one prerequisite for a currency union to work. The other, much more difficult, prerequisite is that due to the sudden boost in money supply and the sinking costs of credit, a member country does not start to live massively above its means. This makes optimal currency unions so difficult to achieve and currently does not bode well for the future of the euro.