Rudi's View | Oct 19 2011
By Rudi Filapek-Vandyck, Editor FNArena
I have asked myself the same question on a multiple of occasions: how come I did not see the Big Correction coming in late 2007?
Sure, I did believe the Australian share market was getting topsy turvy and I did warn investors, or at least those who were willing to pay attention, that I believed it was all starting to look overvalued. Way too much optimism baked in. Remember, those were the days of 20%-plus in annual returns, of unbridled belief and conviction that The Commodities Super Cycle would bring unimaginable riches and wealth and of the Coming Of The New Super Power that was China. Oh, how our lives were about to change…
Anyone who dared to express even the slightest sniff of doubt was to receive hate mail and derision. Others were predicting the index was on its way to 6000 and beyond by Christmas, so why was I being so recalcitrant?
We all know how this story develops. Markets peak in late October/early November, move sideways into the new year and then the selling starts, and continues, and continues, and it doesn't genuinely stop until March 2009 when about half of everything had somehow disappeared amidst the flood of bad news, the margin calls, the panic, the litany of public incompetencies and the general despair.
I did warn investors about their uncontrolled exuberance, but I failed to see why the correction that was to follow would develop into an historical milestone.
Why?
My response: I was too busy. Like most of us, I guess. Too busy building a company. Too busy planning for the year ahead. Too busy attending kids' sporting events during the weekends. Too busy wondering whether BHP Billiton was a better choice than Rio Tinto, or Woolworths better than Wesfarmers. Too busy cleaning up my desk, doing the accounting, the daily household chores, all the extra timewasters life throws at me.
But then again, I don't think I am less busy today. In fact, I hesitate in acknowledging this to myself, but I might actually be busier today than I was in late 2007.
If the "too busy" line is but an excuse, what is it then?
The underlying problem back in 2007 was that I was observing and analysing financial markets from within a too narrow framework. Probably like most of us. If your view only extends to the next bend in the road, you're never going to see what's coming until it is truly in your face and approaching fast. I have learned so much over the past 3.5 years. All it took was a broadening of my framework.
I think all investors will benefit from expanding their daily horizon. Here's me sharing my wider perspective.
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This may seem like an odd statement to make, but, despite all the headlines and commentary about how this has never been seen before and how that is of unprecedented scale, underlying all snapshots of today's history-in-the-making, nothing's truly unique about what we are experiencing today.
Sure, the actors all carry different names, the causes and the numbers have changed, and the time setting is "today" not "sometime in the past", but the world has seen all of this before, and in spades. Banks and governments have gone bankrupt ever since we created them. Mankind has conquered the oceans and the mountains, we can send people to the moon and into space, build aeroplanes and nuclear reactors and provide internet on the go, but somehow we never managed to work out how best to deal with money.
I know it sounds silly. We all use money, every day, and so do the banks, and governments, and about every adult on the planet, but we are not really good at it. Want proof? Have a look at the chart below. It goes back more than 210 years. The grey zones mark every time the UK has experienced some sort of a financial crisis. One would think that ultimately we would get better at it, but is it just my perception or does it look like we are having more instead of less financial crises as time goes by?
The problem we are facing in today's crisis is that the banks are at the centre of the maelstrom and that creates a lose-lose situation, even for individuals and societies not directly involved with the banks. Banks are the middlemen of money flows, no matter where it flows. If banks stop the flow we all have a problem. I think right now we all know we have a serious problem.
It's not a deliberate strategy from the banks. Their modus operandi is simple and straightforward: banking is always levered. Banks only keep a small amount of assets in store but provide many times more flows. When a crisis hits their small base of assets the banks thus have a serious problem. Hurt the banks and you will hurt their surrounding economy. Needless to say that when push comes to shove, the banks are forced to strengthen and to ring-fence their asset base, which means you cannot get your money out (even though it is yours) and no, you cannot get any loans either. (If you already had one, the bank might cancel it).
What all this means in economic lingo, is that the "velocity" of money falls. This has negative consequences. The higher the velocity the more stimulus goes out and this usually translates into more initiatives and a generally higher pace of activity, which leads to higher economic growth. When velocity drops the opposite happens.
The extra problem with a crisis inside the banking sector (i.e. bank balance sheets) is the direct link between the total amount of money and what is available through the banks vanishes. We know why: concerned about their assets and the vulnerability of their balance sheet, banks start hoarding money. The overall velocity drops. As this usually happens after a period of very high velocity, the result is a BIG shock to the system. Alas, this is also one shock that cannot be fixed by increasing the amount of money, because the direct link has gone missing.
Below is a chart by the Bank of Japan which illustrates how the usual direct correlation between the amount of money and bank loans goes missing once we move into a crisis that affects bank balance sheets. Historically this usually happens after a boom-bust cycle in property markets as shrinking collateral for mortgage loans subsequently causes a devastating impact on banks' balance sheets. This, again, raises the question as to why we never learn? Asset prices do not go up indefinitely, no matter whether they are tulips, tech stocks or houses.
The disappearance of the link between the amount of money and what the banks are prepared to provide to their clients puts central bankers and governments in a pickle. The obvious example that comes to mind are the two lost decades in Japan, meaning if this link cannot be reinstated in some form or another, there simply seems no way out of the rut. This easily explains as to why the Federal Reserve in the US has adopted the same strategy as your every day spammer on the internet: if you send out trillions of unsolicited, faceless emails you are bound to see some responses and maybe even a few sending you some money. It doesn't take too much imagination to stretch the comparison to the trillions of dollars the Fed has provided since 2008.
The extra complication to today's problems is that governments have tried to find a way out of this mess by adopting some of the dodgy assets on bank balance sheets. Because of the immense size of today's problems, itself a result of incredible leverage condoned by those governments pre-crisis, none of this has solved the problems, it has simply shifted some of the "cancer" inside the banking system to the balance sheets of central banks and governments. So now they all are battling with that same problem of vulnerable assets and still low velocity.
Admittedly, governments and central banks have a lot more leverage and fire power than commercial banks, but that doesn't make them immune to rising debts and a fall in economic activity. Moreover, it raises risks that tax payers will ultimately be asked to foot the bill. Meanwhile, the risks of creating even bigger problems through government policies remain uncomfortably high. When was the last time you voted for a politician because of his or her economic prowess and credentials?
Apart from constantly raising taxes, one way or another, governments have a long history of trying to cheat their way out of financial problems. Have a look, for example, at what happened to the actual silver content in Roman silver coins when the going got tough for the Empire in the third century.
One could argue the chart above represents an early form of "printing money". In today's context it doesn't involve any physical printing presses either as we are all witnessing the wonders of the digital age. This doesn't mean there are no consequences. One only has to observe the following price chart of gold to see that what originally started off as a come-back for the precious metal, back in 2000, has now morphed into a parabolic rise into the stratosphere. Gold today is as much about the loss of faith in governments and their fiat currencies as it is about the flow of excessive funds ("money") throughout the global financial system.
The key characteristic about money is that it always looks for a way to create more money for its owner. Globally, funds managers and hedge funds are constantly on the lookout to improve their results. Due to the excessive attention and the increasing flows of funds, one would have to consider that gold is no longer the same solid guardian of wealth. Popularity breeds complacency. Money flows create bubbles. Better not to forget that gold remains the ultimate anti-asset. As long as authorities continue making mistakes and creating inflation, gold will continue enjoying its natural attraction.
So how does all of this impact on you as an investor?
Well, let's be frank. If you own at least one property and it's not located in the US, Spain, the UK, in Noosa or in any of the other places where prices have fallen from previously dizzying highs, you have been most likely lucky. How about saying thanks to Dame Fortuna? If you have assets in the share market you have been hit with a gradual but relentless de-rating, probably without noticing it, because of all the ups and downs that have occurred post late 2007. Both of these characteristics will be at the centre of next week's follow-up, so stay tuned.
The above story is the first in a series titled "The Big De-Rating – A Guide Through The Minefields". The second story will follow next week.
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)
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P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
