Friday, October 10, 2008

The Crisis Upon Us Requires Some Planning

Thoughts on the Financial Crisis

Andre Sharon, Consulting Research Analyst Euro Pacific Capital

What happened:
While every cycle is different, they all share pretty much the same characteristics: the system starts looking like a pyramid, with the overwhelming bulk consisting of real capital resting on a solid base. Over time, responding to a variety of forces (discussed below) the pyramid becomes inverted, i.e. involving an-ever higher level of debt holding up an ever-smaller foundation, incorporating far less equity at the big fat top. This is an inherently unstable situation, which can cause the whole edifice to come crashing down for any number of reasons, since increased use of leverage and interdependence between many of the component parts makes it increasingly difficult to isolate and absorb individual shocks. Result: An accident waiting to happen.
What happened this time?
During the past 10-15 years we've experienced decent growth and low inflation. Most people took the good times for granted, coming to believe they were a new norm, and would go on forever. In my opinion they were no such thing ---- they represented an exceptional period, brought about by the very unusual combination of four forces fortuitously coming together:
1. The full fruits of the Volcker-Reagan revolutions in monetary and fiscal policies, which took many years to work their way through the system as they altered the culture of saving, spending, corporate behavior, etc...
2. The end of the Cold War, which released tremendous resources from the public to the private sector
3. The technology revolution, which brought about a dramatic improvement in productivity
4. Globalization, which dramatically lowered prices
As we settled down comfortably into this unique sweet spot in history, human nature took over. People became increasingly complacent, greedy, reckless. Overspending, undersaving, and all the rest, on all levels: personal, corporate, national, international. The pyramid became increasingly inverted and inherently unstable, though only a few realized it.
Architects of Disaster
Even if one accepts the various premises I've outlined above, it doesn't have to follow that the entire edifice necessarily will come crashing down. Nothing can repeal human nature ---- what Keynes correctly called "animal spirits", i.e. greed, selfishness, ambition, the urge to succeed, and all the rest --- but it can be held in check with regulation and sensible monetary policy. In other words, it becomes essential that the monetary authorities not become enablers and facilitators of irrational, stupid, and downright dishonest behavior. The capitalist system works best if risk-takers are allowed to reap the rewards of their activities, but also if they know up-front that they, and they alone, will pay the full price for their failures. We dismantled too many sensible regulations, the Greenspan Fed opened the floodgates of liquidity, and both Congress and Wall Street became increasingly, and symbiotically, corrupt. Those are the architects of the perfect storm. Alan Greenspan has always had a special place of honor in my pantheon of those responsible: by lowering real interest rates to close to zero he practically guaranteed that the scramble to generate return in a context of super-cheap money plus low risk would lead to the creation of insane new financial models. Now Main Street --- the American taxpayer --- is being asked to bail out Wall Street. No wonder the caviar socialists are lapping it up.
And above it all, explaining all, is Freud. I've begun to hear and read a lot about the Svengalis behind the debacle. My thoughtful, considered, response is: undiluted nonsense. Greed and stupidity are universal and eternal, always there and ready to reassert themselves. With no due respect to the anti-American European media, trendy left-wing capitalist bashers, and disingenuous populist conservatives, this is not an American phenomenon. Interesting historical tidbit to help put the present crisis in perspective: Isaac Newton, hardly an icon of emotion and irrationality, lost his shirt in the South Sea Bubble in Britain in the eighteenth century, a phenomenon not unlike the tulipmania that gripped those solid Dutch burghers in the seventeenth. Fearless prediction: we'll re-reregulate, we'll scapegoat, the deals will flow to places where regulations and compliance are a joke, and new models will launch new cycles starting elsewhere but landing here anyway.
What Now?
Only three possible outcomes:
1. We inflate to the level of the debt, i.e. we "fulfill" debt obligations, but in mini-dollars
2. We take the hit, cleanse the system of excesses and move on. Result: deflation, bankruptcies, high unemployment, etc...
3. We disinflate veeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeery slowly, like Japan. Won't happen: the American psyche won't take 16-odd years of no growth. Different cultural mindset: you can't prick a balloon slowly here.
My guess: combination of 1 and 2. I would hope for a bias towards 2. Terrible for many, but healthier for the system long-term. Schumpeter's concept of creative destruction trumps Keynes, in my book. That's life, and progress, with all its faults and flaws.
Investment Implications
Here's my personal list:
1. By all means live boringly in turbulent times. Spend, save, and if you must borrow do it prudently and within your means
2. Inform yourself: listen, read, and observe widely, then use your common sense. There are no experts, only different points of view
3. Distrust most politicians, theoreticians, simplistic slogans, and paper currencies, at least some of the time
4. Diversify your holdings --- geographically, by asset class (ladder fixed income), by sector, by currency, by individual company holdings
5. Right now and until the dust settles, I'm happy to sit on the sidelines (cash) with a significant percentage of my portfolio until I can better measure the expected depth and duration of a global slowdown/recession, contraction of corporate profits, and equity market contraction, which I fully expect to unfold over the next year or so
6. Beyond that period, I expect that the gargantuan world-wide infusion of liquidity will lead to a new wave of global inflation, and a weaker dollar. For that reason I expect gold to appreciate against all currencies during the coming years. For the share portion of gold exposure investments should be concentrated in as safe geographical locations as possible
7. Among sector preferences agriculture stands out. I would take advantage of recent price corrections in this area
And wherever and whenever possible, choose high dividend payers, denominated in attractive currencies
Final Thought
Twenty-five or so years ago Mike Milken, the first major financier to harness junk bonds for investment banking purposes, paid a fine and went to jail. Today executives of some of the world's leading investment banking and brokerage firms were reported to be working on improving their golf games and playing poker with their cell phones turned off as their companies were hemmorageing billions. They ran proud century-old firms into the ground, and below, while walking away with hundreds of millions of dollars in compensation.
I asked several people about the logic of this, and the answer is always the same: they did nothing illegal. Neither did their Boards. Stupidity and incompetence are not indictable offenses. You can't legislate morality, and so on.
They're right, of course. Still, one is entitled to ask, "but what about justice? It's outrageous!"
It requires a conscious effort to calm down and reflect on this: the Founding Father writers of the Constitution had it right. With no illusions, they assumed up-front that people are deeply flawed, greedy, corrupt, and corruptible. You can't legislate morality, but you can try to regulate patterns of behavior, while seeking to avoid doing harm. You will never get it exactly right, because it's a process, eternal and never-ending because embedded in the human condition. To expect that one can devise a magic wand to make everything right all the time and in all conditions is a conceit best left to charlatans and intellectuals.
So the party's not over. This particular party is over. But like the final words in Camus's The Plague, new schemes and new models are inevitably being devised consciously or unconsciously in people's heads in response to this crisis, ready for launch at the next round. Be prepared!

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