Tuesday, 2 December 2008

Does index investing still make sense in volatile markets?

John Bogle, founder of The Vanguard Group Inc. and the popular Vanguard 500 Index Fund, is 79, and has seen 10 bear markets in more than five decades in the investment business. Today, amid a US economic recession he is more vocal than ever in urging long-term investors to bet on the market as a whole rather than picking individual stocks. It's a low-cost alternative to actively managed funds, and an approach that Bogle championed during more than two decades as Vanguard's chairman and chief executive.

This is what he had to say in an interview with The Associated Press:

Q: How long do you expect the U.S. recession to last?
A: I believe it will take longer than most experts believe to get through this. I'd say it will be a year and half to two years before we turn upward. The international economy is going to go through a similar phase.
Q: Where should we look for clues that the economy is rebounding?
A: In the U.S., the first signs will come when employment starts to tick up again, and when retail sales pick up. That could be as long as the next Christmas season. It's sure not going to happen this Christmas season.
Q: What's that mean for investors, given stocks' historic returns of about 9 percent a year?
A: I believe in owning the entire U.S. stock market, and holding it forever. Or, to put it another way, to own the entire U.S. business sector, and the stock market will ultimately reflect that sector, forever.
I think it's likely - and here I'm just totally guessing - that the stock market anticipated most if not all of the decline we're facing in the economy. It almost always moves before the economy goes up and down.
I think investments you continue to hold through this decline will give you a return better than you can find in other places. And that is a crucial part of this analysis. We know what bond returns will be in the next 10 years - roughly 5 percent for long-term government bonds, or about 4 percent for short- to intermediate-term bonds. So if stocks produce 6 percent, while you endured the volatility, you increased your total return.
Money-market funds are now yielding less than 2 percent - call it about 1.5 percent. That doesn't look anything like 6 to 9 percent for stocks, especially when you compound them over a decade. I would not flee the market now.
Q: So does it make sense for investors to stay mostly in stocks, even with the high volatility?
A: Any investor who looks at probabilities has got to look at their own consequences. For example, if you are so close to the edge in the value of your retirement plan that you can't afford to have stocks go down one more iota, you have to get out of the stock market. I hate to say it, but if the consequences to you are disaster, you can't be there, it's risky. On the other hand, if you're young and have many years to recoup, you can be there and should be there.
Q: What about for someone older, like yourself? You're 79.
A: If you're older and have taken my eternal advice, and think about a rough rule of thumb that your bond position should be roughly equivalent to your age. I should be 79 percent in bonds. It turns out I'm at about 80 percent. I happened to start this in 2000 when the stock market was absurdly high. I was about two-thirds in stocks when I made the changes in my asset allocation. So I switched to about two-thirds bonds. I haven't changed my allocation since then. But with the bond market having a positive total return in the eight years since then, and the stock market having a fairly substantial negative return since then, that's driven my stock position down and my bond position up to 80 percent. It's not some slavish adherence to a rule of thumb.
I feel like anybody naturally would - stupid to not realize it could get this bad, but on the other hand, I think most people would be envious over my return of the last 10 years.
Q: How do you respond to people who say markets have become so volatile that conventional wisdom to buy stocks and hold them long-term no longer makes sense?
A: They're wrong to question it. Because for all of the last century really, stocks have gone up and down with some frequency. In fact, this is my tenth bear market, and two of them, in 1973-4, and then in 2000-2002, markets went down 50 percent - more than the current market decline.
Q: To what extent is the market decline a reflection of decreased earnings?
A: The total value of the U.S. stock market had dropped from about $18 trillion dollars to about $9.5 trillion. So there has been an $8.5 trillion drop in the perceived value of corporate America. I think that's inconceivable. I don't think the value of corporate America has dropped by almost half. I mean, these are companies with capital - they make useful products and services, they're efficient, competitive, innovative. Does anybody really think the value of American business changes by a trillion dollars a day? Well, they may, but I don't.
It may be the market was overvalued at the beginning of the period. It may have been $1 trillion or $2 trillion overvalued when this thing started. But that still leaves $7.5 trillion to account for.
Q: Does your index fund philosophy still hold up in this economy?
A: The index is the ultimate buy-and-hold, all-American business strategy. It is the gold standard; there is no way around it. Mathematically, indexing wins. And if the data don't show indexing wins, well then, the data are wrong.
Quoted from: "2009 Outlook: Vanguard's Bogle sees long recession" by Mark Jewell, Forbes.com, December 1, 2008.

Where have all the money gone?

The mutual fund industry has gotten demolished this year, losing 21% of its assets in just five months, and some believe that exchange traded funds (ETFs) are the reason why.

As of Oct. 31, mutual funds had $9.5 trillion in assets, compared to $12 trillion under management on May 31. October showed record amounts of outflows from stock funds, a whopping $86 billion, and fixed income funds recorded outflows of $44.3 billion.

A combination of redemptions and huge losses of all stock funds has lead to this dramatic decline, states Sam Mamudi of The Wall Street Journal.

So where have these outflows gone? A huge portion has been shifted to ETFs. Over the first nine months of the year, net infows of $104 billion have been seen in the ETF market. ETFs are versatile, taking power and control away from fund managers and putting it the hands of advisors, states Richard Romney of ETF Portfolio Strategies.
Quoted from: "$2.5 Trillion Leaves Mutual Funds - Where Is It?" by Kevin Grewal, ETF Trends, December 01, 2008.

Monday, 24 November 2008

Commodity Price Directions

Commodity indices have lost 50% of their value since July 2008 in response to the global financial crisis, deleveraging and worsening economic outlook. With many developed economies in recession and emerging economies to follow, it seems quite likely that prices may even fall further, outpacing production cuts.

Those commodities that grew the most expensive in the shortest period have suffered the sharpest price drops in recent months. Metals and energy (oil) led the decline while agricultural commodities fell less as their price climbs were not as excessive. Across the commodities group, inventory buildup and falling demand creates conditions ripe for a continuing current bear market despite the fact that some commodities, such as oil, seem to have fallen below production costs.

Crude oil futures have fallen from a peak of $147/barrel in mid July to around $50/barrel, well below the 2007 average price. U.S. government data suggest that demand is about 6-7% lower than last year, with the sharpest declines in jet fuel. Forecasts from the EIA and OPEC suggest that 2009 might mark make the largest contraction in oil demand in decades, despite the recent price correction. EM oil demand will be insufficient to offset growing declines in the OECD countries. Financial market trends and macro fundamentals point in the same direction, towards weaker energy prices, at least for the foreseeable future.

In the short-term, it might take a major supply shock - say one that cuts off Iran’s oil supply - to boost prices. OPEC's willingness to comply with current production cuts may be the most significant supply side factor. The elevated cost of new oil supplies may lead to future supply crunches. Canada’s oil sands are very expensive at today’s prices and projects are being deferred if not canceled. Demand for alternative energy tends to move inversely to fossil fuel prices, so the deep cuts in oil and coal prices could pose a headwind for alternative energy, unless counteracted by climate change mandates. Fortunately for producers, falling grain prices will help relieve the profit margin squeeze, even if the credit crunch impairs borrowing for expansion.

Base metal prices have suffered even steeper drops than oil. This commodity group is the most sensitive to the slowdown in industrial production. Nickel and zinc initially led the group’s decline, but were succeeded by copper and aluminum. Expectations that supply gluts will mount next year brought metals prices back to levels closer to operating costs. These two metals’ strongest sources of demand - stainless steel for nickel, auto parts for zinc – are withering, and the supply glut will be exacerbated by output from new mines. Meanwhile, copper and aluminium prices have yet to undershoot their historic break-even levels.

Steel prices have nose-dived from above US$1,200/ton in June to below US$300/ton. Prices will likely resume crashing next year, on weakening demand, particularly from China, falling freight costs and lower cost of inputs (coal and iron ore). Like other base metals, the demand collapse has left steel producers with high order books and expensive inventory.

Inflation hedging and flight-to-safety bids drove gold to an all-time high price of $1033 per ounce on March 17, but faded away on deflation fears and broader commodity selloffs. Gold now trades between $700-750, about 30% below the March peak. Slowing inflation and the U.S. dollar’s uptrend diluted gold's store of value. Though gold tends to be less sensitive to a global economic slowdown than industrial metals or energy commodities, deflation is a danger for gold prices. Even physical demand for gold looks likely to weaken alongside consumer confidence.

Agriculturals are the commodity group least sensitive to the economic cycle, but have nonetheless suffered from the deleveraging which has seen investors move into cash. Livestock prices plunged on faltering protein demand as the global growth slowdown reduces incomes. Fundamentals such as biofuel production, population growth, and the rising income and protein demand of developing countries, argue for a secular bull market. In the medium-term though, the exit of speculators and the supply overhang from production growth may bring downward pressure – especially in grains.

Slowing Chinese economic growth has contributed to the collapse in commodity prices, just as expectations of Chinese demand growth drove the recent bubble. Imports of key metals have slowed sharply since July, and the slackening industrial production growth – 8.2% in October, a 7-year low – indicates no reversal. Meanwhile, Chinese electricity production actually fell in October, the first such contraction in a decade, suggesting that China’s slowdown might be more pronounced and that the price of coal, the prime fuel for power plants could fall further.

While the infrastructure focus of China’s recent fiscal stimulus may support commodity demand, especially for some base metals, it may only offset the reduction in demand from the property and manufacturing sectors. Meanwhile, Chinese stockpiles of many commodities may take time to absorb, meaning that Chinese commodity demand might remain weak until the second half of 2009.

Quoted from: RGE Monitor's Newsletter, 19 November 2008.

Monday, 17 November 2008

When Capitalism Failed...

The following story is told by Oliver White, senior investment writer for the Motley Fool Stock Advisor, which may change the way you view the economy, the stock market, and life's fortunes.

"I need to go back 80 years. Back to 1928, in Altoona, Pennsylvania. When a 2nd-generation Irish railroad worker named John Reilly bought a single share of Knight's Life Insurance of Pittsburgh...

John, the father of six, paid $10 for the stock. Then defended it for decades from lowballers and scoundrels who tried to buy it out from under him and his family.

Then in the late 1950's, American General insurance company started acquiring Knight's Life. And after a few years, the Reilly family investment was split and converted to American General shares...

John's six children eventually inherited the stock. And by the 1980s, through splits and reinvested dividends, their investment was worth hundreds of thousands of dollars...
It helped buy homes in places like Pittsburgh and Somerset, PA, and Vienna, VA. And helped pay for college degrees for John Reilly's grandchildren from schools like Wharton, Penn State, and Stanford.

And with plenty of American General shares still in place after all this, continuing to multiply and grow all the way up to 2001 when AIG acquired American General -- no member of the Reilly family ever once thought of selling. After all, AIG was a bellwether of the American economy. And the insurance business had been profitable for the Reilly family. So much so, that...

By 2007, John Reilly's ONE SHARE had grown into more than $480,000!

And it looked as if his amazing investment could one day help pay college tuition for his great-grandchildren. Yet, I'm afraid you know the rest...

Last month, over the course of a few days, AIG's share price plummeted. Destroying $180 billion in shareholder wealth (that's roughly equal to 3 Enrons)... and almost brought down our entire financial system, before the government loaned the company $85 billion.

And while the Reilly family (my in-laws) was coming to terms with the fact that their total AIG investment is now worth less than $12,000, and that the vision and hard work of their of their patriarch had been mostly obliterated -- top AIG executives took a posh spa retreat to California. Threw themselves a banquet and awarded each other handsome bonuses.

It was a slap in the face! And a wake-up call...

We've seen Wall Street play fast and loose with our investment money for too long!

In recent years, Wall Street firms basically turned themselves into massively leveraged casino operations: Lehman Brothers was leveraged 25 to 1... Goldman Sachs was leveraged 26 to 1... while Morgan Stanley was leveraged 34 to 1. Heck, even AIG, an insurance company, was leveraged 13 to 1!
'The US economy is in big trouble. Many Americans are outraged at the way our financial security has been sacrificed.'-- The Wall Street Journal, July 28, 2008

It's no wonder so many Americans are hopping mad! A lot of people woke up to the news recently that some of their "conservative" blue-chip investments had a lot less in actual assets than they thought...

Tuesday, 11 November 2008

Learning the hard way

"When things are going well, most of us spend all of our time high-fiving and celebrating, whereas when things go sour, we turn to sulking, worrying, and even panicking."

"Meanwhile, when the going gets tough for the toughest, smartest, and most successful people out there, they do something drastically different ... they learn from it. And that's what sets them apart."

"Take Benjamin Graham, for example ... He went bankrupt three separate times as an investor. But each time, he documented and studied his failures, and he was eventually able to impart this investment wisdom to countless others -- including Warren Buffett, who in turn learned from his own mistakes and failures. Early in Buffett's career, he mistakenly believed he could save a failing textile mill. After being forced to liquidate its textile operations, Buffett learned to pay up for quality and turned that company into a $170 billion legend."

"Another great example is Pixar's John Lasseter. After graduating from college, Disney hired him and gave him a shot at being an animator, and he quickly recognized the ability of new computer technologies to revolutionize animation. But Disney was so unimpressed with his first feature that they fired him on the spot. So Lasseter literally went back to the drawing board. After fine-tuning his process, he went on to found Pixar, win two Academy Awards, and churn out a string of blockbuster hits that included Toy Story, A Bug's Life, and Cars. Oh, and let's not forget, he and Steve Jobs later sold Pixar to Disney for a cool $7.4 billion."

Quoted from an article written by Austin Edwards, Motley Fool, 27 October 2008.

Thursday, 6 November 2008

Obama's Challenges

Barack Obama, the newly elected US president, faces like President Roosevelt during the Great Depression immense challenges to cure the US economy's woes. While the sorry state of the US economy was certainly a great companion to his successful presidential campaign, the moment when he takes office in January 2009 it will become his greatest enemy.
Obama will face an economy in the middle of a severe and prolonged recession where households have to bear unaffordable mortgage and other debt, declining value of homes, foreclosures, tight access to credit, erosion of retirement savings amid the bearish stock market, rising unemployment and critical foreign policy decisions.
One of the first challenges for Obama would be to cushion the impact of the recession on consumers by means of a large fiscal stimulus package. For example, infrastructure spending to create jobs, tax cuts for lower income groups and small businesses, government aid for the auto industry and tax credits for labour-intensive industries. He also would like to impose a 90-day moratorium on foreclosures, mortgage tax credits for the middle class and setting up a foreclosure-prevention fund. Obama is in favour of greater financial sector oversight. He would like to prevent taxpayer funded bailouts of banks or that CEOs of failed institutions can receive large bonuses (golden parachute) as in the recent past.
Obama will face an increasing fiscal deficit. The financial rescue package plus the downturn in the economy, problematic medical care and social security bills will only add to the challenge of containing the fiscal deficit. One of Obama's key reforms will be to give more tax cuts to low and middle-income groups, while raising taxes on high-income groups.
Further challenges await Obama in health care reform, trade policies, labour reform, and foreign policies - especially dealing with the Iraq war, Taliban forces in Afghanistan, a resurgent Russia, Iran's nuclear ambitions, and Asian economies.
Source: RGE Monitor Newsletter, 5 November 2008.

Thursday, 30 October 2008

Here Today, Gone Tomorrow

Many investors have been lured into hedge funds since it was sold to them as a "safe haven" or an investment that would not lose money in a bear market - like cash or bonds, but only at better yields.
Yet, as the ripple effect from the global credit crunch continues, it is becoming increasingly clear that many hedge funds will be forced to close due to the interplay of shrinking access to leverage, disappointing investment performance and investor demands for redemption.
George Soros, one of the most renowned hedge fund managers of all times, recently suggested that the industry could shrink by as much as two-thirds. Speaking at the Massachusetts Institute of Technology, the Soros Fund Management chief said: 'The hedge fund industry is going to move through a shakeout. In my estimation, it will be reduced in size by anywhere between half and two-thirds.'
If the hedge fund industry does suffer carnage on anything like this scale, managers will not be the only ones to suffer. New research suggests that US-based hedge funds will cut total IT spending by 40 per cent to USD882m in 2009.
Again, the weeding-out process is reaching out to all areas of the financial world and everyone connected with it.
Quoted from: Hedgeweek Comment, 30 October 2008, www.etfexpress.com

Tuesday, 28 October 2008

Words from The Wise Investor

Charlie Rose, an American TV interviewer and journalist, recently had an exclusive interview on his show with the top investor, Warren Buffett where he asked the questions that most investors are concerned about. How serious is the credit crisis? How will it affect the economy? Will America - by far the leading economy in the world - recover from a deep recession? Are equities still a good long-term investment prospect?
Buffett, in his typical easy-to-understand manner sketched the reasons for his ultimate belief that capitalism will survive the current crisis. Hence, investing in equities will bear fruit in the future and that the current distressed market conditions offer fantastic investing opportunities.
The link below covers the full interview; it is rather lenghty (55 minutes) but definitely worth watching.

Thursday, 23 October 2008

The Fallibility of Statistical Models

Who are the culprits that caused the meltdown of the global financial system which in all probability will lead to a severe global recession? A lot has been said about the sheer greediness of mortgage originators, investment banks and their cosy relationships with rating agencies. Roman Frydman, Michael Goldberg – authors of Imperfect Knowledge Economics – and Edmund Phelps – 2006 winner of the Nobel Prize in Economics – argue in an article published in the Financial Times (October 19) that another major cause is often overlooked, namely "failure to acknowledge that market participants and regulators alike have only imperfect knowledge about the forces and mechanisms driving asset values and the broader economy."
"We rely on markets because we know of no other way to take account of the myriad bundles of knowledge and intuition that individuals use in determining economic values, such as those for financial assets. Asset prices often undergo long swings away from historical benchmark levels, followed by “corrections”, because this is how markets “discover” a sensible range of values."

"Such price reversals are a source of risk that is not recognised by standard risk-management methods. Even more importantly, these methods ignore the very nature of a capitalist economy: it generates new ways of doing things. Hence, economic relationships and patterns that applied in the past are eventually replaced by new ones."

"Many of our regulations are designed to achieve transparency of information. Public companies must make available their financial statements on the theory that investors can then decide how much of an asset to hold. What the crisis has demonstrated is that more than information is required for prudent investment decisions. Financial markets need regulation to bring to light the imperfect knowledge of those who are in the business of providing assessments of financial assets."

"Finance and economics professors devoted their talents to developing abstruse, yet simplistic, models that left out the imperfection of knowledge. Universities have produced two generations of financial engineers who sold the idea that academic models could safely neglect market discovery of risk and prices."

"The ratings agencies used statistical models that projected historical default patterns to continue. These patterns showed very low loss rates, thanks to ever rising prices since 1997. With such low loss rates, triple A ratings appeared to be justified. Brave new models tempted the industry to abandon proven prudential procedures, which combined their own judgment and more formal criteria. To be sure, agencies apply stresses to their current procedures. But these stresses are hidden in ratings reports and, as recent events have painfully demonstrated, are woefully inadequate."
"Had the agencies been required to make explicit how their ratings would have changed under the alternative assumption that house prices would fall back to benchmark levels, the markets would have feared greater loss rates, lowering the demand for mortgage-backed securities. This would have reduced the volume of mortgages originated and thus ultimately the amount of bad paper that banks ended up holding. Requiring the agencies to rate securities under one or more pessimistic scenarios as well as the optimistic one would make it harder for the agencies to deliver rosy ratings in return for business from the investment banks."

The authors propose that agencies should be required to report at least two ratings: one assuming that historical patterns will continue and at least one other assuming reversals in the trends of major variables. No single individual or institution can render a definitive judgment on the riskiness of securities. Only markets have aggregate knowledge that is not given to anyone in its totality.

Tuesday, 21 October 2008

"Put your mouth where your money was"

Warren Buffett, in a recent article - Buy American. I Am - that appeared in the New York Times (October 16), tells the story of a restaurant that opened in an empty bank building and then used the following smart advert: "Put your mouth where your money was." Today, Buffett says that both his money and mouth are saying: 'Buy equities.'
This is a very significant change in Buffett's investment strategy (for his personal account). Until now and besides his stake in Berkshire Hathaway, he owed nothing but US government bonds. We all know that financial markets are in a mess as they are discounting rising unemployment, failing businesses and scary, sensational headlines.
Why is Buffett so optimistic after all? Buffett explains it as follows:

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

"Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up."
"A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend."

"Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497."
And now for probably the most important advice from the great man:
"You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy. Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."

"Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: I skate to where the puck is going to be, not to where it has been.”

Sunday, 19 October 2008

The (Much) Lighter Side of The Financial Crisis

Humor is probably the best medicine to cope with feelings of anxiety amidst the global financial crisis and despair with the material loss of wealth investors suffered due to the growing fears of a major global economic recession. Here are some of the gems I have come across recently:
The definition of optimism? A banker who irons five shirts on a Sunday.
What's the difference between an investment banker and a large pizza? The pizza can still feed a family of four.
What's the difference between an investment banker and a pigeon? The pigeon is still capable of leaving a deposit on a new Ferrari.
What do you say to a hedge fund manager who can't sell anything? A quarter-pounder with fries, please.
"The credit crunch has helped me get back on my feet. The car's been repossessed."
"This credit crunch is worse than a divorce. I've lost half my net worth and I still have a wife."
"The bank returned a cheque to me this morning, stamped: 'Insufficient funds'. Is it them or me?"
"A man asked his bank manager how to start a small business. The manager replied: 'Buy a big one and wait.'
Money talks. Mine knows only one word: ''Goodbye".
What have an Icelandic banker an an Icelandic streaker got in common? They both have frozen assets.
The company director decided to award a prize of $50 for the best idea of saving the company money during the credit crunch. It was won by a bright young man who suggested reducing the price money to $10!
Quoted from Weekend Argus, October 18, 2008

Tuesday, 14 October 2008

A New Geopolitical Order?

The past week will be heralded as one of the worst weeks ever for stock markets around the world. In total, about $6,200bn (R56,000,000,000,000 – about 30 times SA’s GDP!) was wiped off the value of the world’s stock markets as panic and distressed selling were the order of the day.

The credit crisis began in earnest in March with the collapse of Bear Stearns, but until middle September equity markets stood up relatively well. Since then the major markets collapsed fiercely and from its highs last year markets have retracted already more than 40%.

The severity of the 2008 credit crisis is compared with the financial crisis and economic collapse of the 1930s (Great Depression). Back then the S&P 500 lost about 85% of its value within 15 months. Will we experience similar equity losses in today’s crisis? Unlikely, because governments all over the world have reacted quickly to avoid an economic disaster and are standing united to ensure the normal functionality of the financial system, but obviously at a great cost to tax payers.

Philip Stephens, columnist for Financial Times, however reckons that this crisis is unique in two aspects, and thus making it difficult for governments to deal with the crisis: First, the ferocity of the crisis and second, the geography. In the recent past financial crises used to start in Latin America, Asia or Russia – typically developing or emerging economies, and not developed economies. Back then the developed economies used to prescribe to such countries/regions how to transform their economies – market liberalisation, better fiscal control, etc. – as a precondition for financial support from the IMF. This time around the crisis started on Wall Street preceded by the slump in the US housing market. Emerging economies have been the victim, rather than the culprits.

After the Asian currency and credit crisis of 1997-98, Asian countries accumulated foreign currency reserves to defend themselves against future crisis. Today those reserves are worth $4,000bn which basically financed the reckless credit explosion in the USA and Europe. One commentator made the following remark: “America drowned itself in Asian liquidity.”

Today the West’s moral authority has been largely eroded and they cannot expect emerging economies to listen to their lectures about how to run their economies anymore. Yet, the west still assumes political and economical leadership in talks how to redesign the global financial system. To quote Stephens in his recent article – “Crisis marks out new geopolitical order”, FT.com, October, 9 – “... the west can no longer assume the global order will be remade in its own image. For more than two centuries, the US and Europe have exercised an effortless economic, political and cultural hegemony. That era is ending.”

Wednesday, 8 October 2008

The Boom-Bust Cycle of an Ideology

Gideon Rachman writes in his latest column for FT.com that ideas, similar to the stock market become fashionable and get pushed to their logical conclusion and beyond, leading to “irrational exuberance” and then a crash. The 2008 Credit Crisis is a direct consequence of a 30-year bull run in an ideology that began with the Thatcher-Reagan regimes of the 1980s.
Three central ideas can be identified out of the Reagan-Thatcher era: the promotion of home ownership, financial deregulation and faith in the market mechanism. These ideas worked fantastically for three decades, leading to increased prosperity and freedom. Yet, when the ideas combined were pushed too far it created an enormous disaster.

For example, the subprime mortgages - at the heart of the current financial crisis - personified the dream of home ownership for everyone, even if they could not afford it. In April 2005 Mr Greenspan praised subprime mortgages for helping to widen home ownership. Investment bankers, were allowed to bet their banks on these market segments because regulators and politicians believed firmly in the self-regulating qualities of the market.

Today the intellectual cycle has swung decisively against the right-wing ideas of the Reagan-Thatcher era. Rachman believes regulation and government intervention is bound to overshoot in the other direction. But eventually the joys of government regulation will fade and nostalgia will set in once again for the go-go years on Wall Street and the bracing qualities of neoconservatism.

Thursday, 25 September 2008

The Man Who Saved The World...or did he?

Alan Greenspan, former chairman of the Federal Reserve, was during the peak of his tenure widely known as the "saviour of financial markets" for his market friendly monetary policies. But today at the height of the greatest financial crisis since the Depression, many market commentators are less certain whether Mr Greenspan still deserves the same accolades.

Many commentators will argue that the Fed under Greenspan was "asleep at the wheel" while players in the financial industry relentlessly leveraged their businesses and blatantly ignored sound credit practices, all in the name of higher profit growth and "optimal" balance sheets, i.e. creating off-balance sheet structures or otherwise known as Special Investment Vehicles (SIVs).

David Blake, an executive of an asset management firm, argued recently in a FT column that low interest rates, as seen in the aftermath of the dotcom bubble and 9/11, and often cited as the root cause of the ensuing credit bubble are not too blame, but rather the lack of sufficient action taken when it became clear some asset price bubbles were forming. First, in 1996 Mr Greenspan already conceded about an equity bubble in his "irrational exuberance" speech. He suggested that a tightening of the margin requirement - which investors hold against financial derivative positions - would be effective in stopping the creation of an equity bubble. Second, in 1998 a commission expressed concern about the massive increase in over-the-counter (OTC) derivatives, which of course today is at the heart of the credit crisis.

In both instances the Fed did nothing about it and we have seen two major bubbles, directly related. The equity bubble at the end of the millennium was fuelled by the ease of lending by brokers to buy more shares. When the bubble finally burst another wave of investors interest started in the housing market. We have had a tremendous rally in housing prices and mortgage lenders securitized and packaged mortgages; thereby "spreading their credit risk". Greenspan himself said housing was a safe investment, while the mortgage-backed securitisation market was seen as very effective in spreading credit risk amongst market players.

Even subprime lending - the root cause of the current financial crisis - was regarded as innovative since many marginal applicants could now have qualified to buy their own homes. Apparently, mortgage lenders could afford such high-risk lending because innovative credit models ensured the spreading of risk.

Well, today it seems that nothing can survive the longevity of good old-fashioned credit practices. The innovative, mortgage-backed securitisation market and derivatives did not stood the test of time; it was a miraculous failure to say the least and the stability of the whole financial system is at great risk.

Wednesday, 17 September 2008

The Crisis Intensifies

Wow! What a week on financial markets as it seems that the once "too-smart-to-fail" US financial sector is after all fallible. We are witnessing a "one-in-a-hundred-year" type of event as wave upon wave of solvency and liquidity crises are hitting the beleaguered US investment banks and lately the insurance giant, AIG.
The US government stood firm in the case of Lehman Brothers; no bailout or aid this time, as they did with Bear Stearns, Freddie Mac and Fannie Mae, but rather let the market forces run its natural course. So it did and Lehman Brothers, once the 4th largest investment bank, has filed for bankruptcy. At the same time it was announced that the mighty Merrill Lynch agreed to be taken over by Bank of America in a deal worth $50bn - maybe that announcement was even a bigger shock to the market than Lehman's demise. By then all the market participants realised that nobody was safe anymore.
Then merely two days later it became clear that AIG was on the brink of failure with no obvious aid to their liquidity crisis. At the end the US government had to come to the rescue - the systemic risk was just too big with AIG, besides being a counterparty to many credit default swaps, it has widespread links to the real economy, business interests in 130 countries and over 100,000 employees.
With government's interventions in the bailout of US financials, at a considerable cost to taxpayers, it is no wonder that Nouriel Roubini recently stated that America from now on should be known as the "USSRA - "United Socialist State Republic of America"!
Roubini, among a few other level-headed commentators have been warning for some time that a financial tsunami is bound to happen in view of the unregulated credit practices, "unlimited" leveraging and pure greediness, i.e. to grow bigger and faster at all costs. Sad to say, but not surprisingly, these "doomsayers" have been right all along. Common sense prevails in the market place at the end, not so-called "high IQ products".
Is this the end of this crisis? No, I don't think so - still a lot of money will be written off. Some commentators think at least another $500bn, others even more. Beware: hedge fund investors. "Normality" will return after we have seen a dramatic shakeup in the industry. New players - maybe those that in the past have been considered "too boring and conservative" - will emerge as the new industry leaders.
Then, do not be surprised to see a lot of "financial" engineers returning to professions where they should have been in the first place - namely the engineering and construction industry where the occurrence of extreme events (black swans) are not as likely as it do occur in financial markets which most often render mathematical and risk models null and void.

Sunday, 14 September 2008

Beware: The Black Swans

The imploding of the US housing market bubble has resulted in one of the worst credit crunch crises yet with well over $500bn already written off by financial institutions thus far. How much more will the crisis cost investors? Well, analysts predict at least another $500bn, but more likely double that, are to be written off in the near future. We have already seen the demise and bailout of financial giants such as Bear Stearns, Freddie Mac and Fannie Mae and lately the bankruptcy filing of one of the largest investment banks, Lehman Brothers while Merrill Lynch has agreed to be taken over by Bank of America.

Surprisingly, the economies of the US and the Euro zone have shown some resilience thus far. Although most commentators are expecting recessionary economic conditions in these regions, unemployment figures have not risen dramatically, nor have economic output dramatically declined.

However, which events could cause a deep economic recession, especially among the major economic forces of the world? First, it is of course a global financial meltdown, which the US Federal Reserve is trying to prevent at all costs. Wolfgang Munchau, columnist of the Financial Times, reckons that the $6,000 bn credit default swap market, for example, poses huge risks as non-payments by counterparties would lead to enormous uncovered exposures by supposedly insured parties.

The second possibility is a dollar crisis. At the moment interest rates are kept low by the Fed to stimulate economic growth in the midst of the credit crisis and will probably be maintained at those levels for some time. What will happen if US inflationary expectations will rise significantly above the prevailing interest rates? Despite the prominent role of the US dollar in global financial affairs or its dominant position in countries’ foreign reserves, it is not unlikely that a flight of global investors from the US will result in vicious circle of a falling US dollar, rising US inflation and interest rates, bank failures and a deep recession (depression?).

The materialising of either scenarios seems rather unlikely at the moment. In fact, the dollar has strengthened considerably against the euro in recent months as investors globally have increased their allocations to ‘flight-to-quality’ investments, like US treasury bonds. But then, not even a year ago, very few commentators, if any, would have predicted that stalwarts such as Bear Stearns and Lehman Brothers (and Merrill Lynch) would have ceased to exist by today.

Tuesday, 9 September 2008

The Rescue of The Twins

On Sunday, September 7, the US government finally announced that the two beleaguered and insolvent GSEs, Fannie Mae and Freddie Mac with a total debt of $5.3 trillion, will be placed into ‘conservatorship’ (read nationalised). The US government will immediately acquire a $1bn stake in each in the form of preferred equity with the option to expand its stake to $100bn in each company. The new preferred equity is senior to existing preferred and common shareholders, but junior to existing senior and subordinate debt holders. Creditors’ interest and principal payments are furthermore secured by a lending facility.

From the action plan announced it seems that the winners are debt holders, but preferred and common shareholders are big losers because they won’t receive any dividends, at least in the foreseeable future. Hence, sharp losses and further writedowns are expected to continue for such shareholders.

The reaction to the announcement is mixed. Some commentators argue that the plan will have a positive impact on credit markets. Others are more critical; nothing can prevent the US housing market to continue its slump and subsequent further losses in the securitisation markets.

Another concern is that the increase in government debt would start affecting the US sovereign credit rating (currently AAA). The expected rise in Treasury supply could depress bond prices if demand does not rise in line with supply.

Click on the video link below for some comments on the rescue plan.

Assessing The Plan
Assessing The Plan

Thursday, 4 September 2008

The Health of the US Banking Sector

The FDIC (Federal Deposit Insurance Corporation) which provides protection to checking and savings deposits up to $100,000 per depositor, recently released their latest “Quarterly Banking Profile”. The results look ‘pretty dismal’ as Q2 earnings were 87% below the Q2 2007 level ($5bn versus $37bn) as loss provisions rocketed to $50bn. The number of troubled banks on the FDIC’s watch list increased to 117, up from 90 in Q1.

While the banking industry’s ‘coverage ratio’ (ratio of loss reserves to noncurrent loans) dropped to a 15-year low, banks would have little choice to shore up their reserves in forthcoming quarters. Importantly, this will come at the cost of future earnings growth.

Globally, the total writedown of losses in the recent housing market and credit crunch crisis exceed $500 bn. Thus far primary dealers were at the forefront of the writedowns. Institutions like the IMF estimated earlier that the total losses would eventually amount to $1 trillion ($1,000 bn), while Nouriel Roubini, a widely respected economist, estimated a global $2 trillion loss. Interestingly, foreigners hold about 40% of asset-backed US securities. With a 20% markdown of these assets about $475bn will be lost abroad.

An additional worry is the fate of Fannie Mae and Freddie Mac, where banks and insurance companies are major holders of their $36bn preferred shares, but which have been downgraded heavily thus year. Government intervention is imminent, but it is unlikely that existing shareholders will not have to write off some losses.

Tuesday, 2 September 2008

A Flood of Liquidity

Many economists and market commentators in recent months have expressed their concern that the US Federal Reserve's policies of managing the credit crunch crisis will lead eventually to more inflation and perhaps even bigger problems to solve in the future. The Fed has intervened in the credit crisis by taking unusual steps such as making credit facilities available to investment banks and facilitating the takeover of Bear Stearns.
George Magnus, senior economic advisor at UBS, however recently argued in a Financial Times article that inflation should really be of lesser concern, but what is important now is for the Fed to provide sufficient liquidity in the market to prevent a systemic meltdown such as was seen during the depression of the 1930s.
Magnus is of the opinion that unusual events merit unusual solutions, especially where systemic risk is prevailing. Furthermore, he lists a number of reasons why the criticism against the Fed's actions is largely unfounded: First, US long-term bond rates do not discount an expectation that inflation will spiral out of control. Second, the credit crisis remains largely a US problem with up to 117 of their banks in trouble as it becomes more difficult to raise capital. The consequential sell off of assets to shore up the balance sheets of banks highlights the severity of the downturn and justifies the Fed's actions. Third, consumers will find it increasingly difficult to access credit. With a slowdown in consumer spending expected the worries about inflationary pressures will become unfounded.
Thus, while the Fed's actions may be seen by some as inappropriate one must bear in mind the severity and extent of the credit crisis and its possible ramifications. In this context one former central banker is quoted: "it is after depression and unemployment have subsided that inflation become dangerous".

Wednesday, 27 August 2008

Inflation expectations lead to more inflation, right?

Generally it is argued that rising inflation expectations will lead eventually to higher inflation. Hence, it is no surprise central banks are monitoring such expectations closely and typically will raise interest rates if such events occur. Globally, inflation expectations have shot up - primarily driven by rising energy and food prices.
Thus, should central banks repeat the standard response by tightening their monetary policies? Larry Hatheway, chief economist at UBS, does not think such a policy would necessarily be such a good idea:
"Ever since Milton Friedman's address to the American Economic Association in 1968 and the ensuing theoretical work by Robert Lucas and others in the 1970s, the mantra - at least among central bankers - has been that rising long-term inflation expectations inexorably lead to higher inflation.
The central question is not about inflation expectations, per se. Nor is it about commodity prices, however quickly they may be rising. Rather, inflation is determined by the interplay between monetary conditions and capacity in the economy to grow without pushing most prices higher. That is where the story gets more complicated. Are monetary conditions easy? Is there spare capacity?
In the US, slack is appearing in the economy, as seen in rising unemployment, now up to 5.7 per cent. Negative real interest rates suggest monetary conditions are easy. But the Fed's own surveys suggest that bankers are less willing to lend; consumers less willing to borrow. Low real interest rates are a manifestation of economic and financial malaise, not excessive monetary accommodation. Altogether, the case for accelerating US inflation looks weak in the face of below-trend growth and stuttering credit conditions.

In the UK, consumer borrowing is falling sharply, the housing market is following its US counterpart into deflation, and consumers are retrenching. Here too, underlying inflation pressures ought to moderate.

In the eurozone, the picture is less clear. Money and credit growth have remained in double-digit territory and economic activity has been robust in recent years. Some signs of higher wage settlements are evident. But the most recent data also point to a sharp slowdown in the eurozone economy.

So, what are we to make of higher inflation expectations in the US and western Europe? Investors and households seem to believe energy and food prices will continue to rise. But will other prices and wages automatically follow suit? Stagnating growth and tighter credit conditions suggest the opposite.

Perhaps that is why consumer confidence has plummeted on both sides of the Atlantic. Eating and driving are more expensive, but weak growth, rising unemployment, and fear of outsourcing are keeping most wages in check.

In short, households may say they expect higher inflation, but there is little they can do about it. The reality is they are experiencing falling real incomes and pinched balance sheets. That is hardly the stuff of overheating.
The Friedman-Lucas emphasis on inflation expectations was a model suited to different times. Central bankers no longer try to ramp growth by springing inflation surprises on unwitting workers. Unionisation has declined, automatic cost-of-living adjustments are rare, globalisation has reduced pricing power for most companies and bargaining power for most workers.
Today, advanced economies are confronted with stagnating growth, collapsing housing markets, slowing world trade, stressed financial systems, and weak household balance sheets. This is not the 1970s. Broad-based price and wage inflation is unlikely today. We should therefore be sceptical of the case for tighter monetary policies based on models developed in, and better suited for, a bygone era."
Quoted from: Hatheway, L., 2008. "An Inflation model from a bygone era" Published: FT.com, August 24

Saturday, 23 August 2008

Managing a financial crisis

Today's subprime crisis and resulting credit crunch is perceived by some analysts as the worst financial crisis since the 1930s. Typically, market analysts are drawing parallels with previous periods of economic distress where authorities made some gross monetary policy errors.
Back in the 1930s an excessively tight monetary policy led to a prolonged period of deflation, while in the 1970s a loose monetary policy caused inflation expectations to become unanchored, leading to a stagflationary economic environment. Thus, in order to avoid the same mistakes as in the past, analysts are calling for a level-headed approach.
"Now, with inflation rising, the popular parallel is not the deflationary 1930s but the stagflationary 1970s. In fact both analogies are misleading, precisely because market participants and policymakers are aware of this history. Their awareness means that financial history never repeats itself in the same way. Biochemists can replicate their experiments because molecules do not learn. Central bankers lack this luxury.

In the 1930s the critical mistake was the Federal Reserve’s failure to recognise its lender-of-last-resort responsibilities. The result was not just financial distress but the collapse of the US price level, which fell by 21 per cent between 1929 and 1932. Since demand for commodities, including food and oil, was inelastic, their prices fell even faster than the overall price level, causing distress among primary producers. And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation.
As US demand weakened, other countries saw their currencies become overvalued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.

The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.

The Fed's response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.

What is the solution? Emerging markets need to tighten their monetary policy further to damp down inflation. They need to revalue against the dollar to fend off inflationary pressures coming from the US, just as they needed to devalue in the 1930s to protect themselves against US deflation. We have seen small steps in the right direction, such as the interest rate rises recently agreed by the Bank of Korea and Bank Indonesia, but more needs to be done.

The Fed’s position is harder. If it now tightens, it risks compounding the recession. If it fails to do so, it risks undermining confidence and precipitating a dollar crash – which could still happen, in spite of the recent relief rally. Here the historical analogy is direct. In the 1930s the US needed expansionary policies to counter the depression but worried that moving too aggressively would demoralise markets and destabilise the dollar. Franklin Delano Roosevelt personally oversaw the process, setting the new dollar exchange rate each morning while taking breakfast in bed. In hindsight, his judgment looks sound.

One hopes that history will judge the Fed as favourably. James Bryce, the historian, had it right when he wrote that the chief practical use of history is to deliver us from plausible but superficial historical analogies. Or as Mark Twain more prosaically put it, the past may not repeat itself, but it rhymes."
Quoted from: Eichengreen, B., 2008. " The Fed can learn from history's blunders" Published by FT.com, August 18

Tuesday, 19 August 2008

Michael Phelps' Gold Triumph, But Not In Value

Michael Phelps should be considered as one of the best athletes of all times after his winning streak of eight gold medals at this year's Olympic Games. But while on the topic of gold, another major event transpired during the past couple of weeks, namely some significant price reversions in precious and base metal prices.
"In the past month, as the Olympic games featuring the famously ambitious US swimmer got under way, the value of the metal awarded to winners has slumped by a fifth. Runners-up, as usual, fare worse, with silver down almost a third.

The proximate cause is the US dollar’s rebound. In the past year, gold and its silver sidekick have moved inversely with the greenback. The violence of the shift suggests other factors are also at work. Crude oil is one, with the commodity-in-chief’s own rapid decline possibly forcing some to liquidate metals positions.

The wider issue is that, when even war in Georgia fails to lift prices, commodities markets as a whole appear angst-ridden.
Indian brides are shunning gold jewellery, with demand falling 41 per cent year on year in the second quarter, according to Lehman Brothers. Even China’s supposedly inexorable march to mass middle-class prosperity is not immune: growth in sales of SUVs and light trucks there slowed last month to its lowest pace in two years. Meanwhile, Congressional ire against “speculators” continues to mount.
Metals are not doomed to fall in unison from here, with geopolitics, currency moves and the relative performance of financial markets all having a say. But the drumbeat of demand destruction is becoming deafening. Simply going long and holding on is looking ever less tenable."
Quoted from: Lex, 2008. "Metals and the dollar", FT.com, Published August 17.

Friday, 15 August 2008

Market Volatility

The past month (July 2008) must have been one of the most volatile ever seen by investors; not so much because the stock market overall retracted sharply, but rather the divergence in the performances of the different sectors of the market. For example, the resources sector plunged 19% in July, while the property and financial sectors gained 18% and 13% respectively!

It may well be that commodity prices, at least for now, will be under pressure with the prospects of a slowdown in global economic growth and strengthening US$. But then the rand may also become weaker and thus making those mining and resources shares attractive from a rand hedge perspective. Thus, do not necessarily expect the sharp downturn in resources stock prices to continue!