“A cynic is not
merely one who reads bitter lessons from the past, he is one who is prematurely
disappointed in the future.” – Sidney J. Harris.
Pimco’s Bill
Gross calls them ‘Old Maids’. Canada’s Eric Sprott
refers to them as UFOs from Mars. However one wishes to label the risks
attendant upon structured products invariably linked to the health of the
property and mortgage markets, the underlying reality is that leverage – throughout
the financial system – continues to be aggressively unwound, that the “fair”
pricing of those products remains opaque at best, and that supposed
professionals are not necessarily any closer to understanding the dynamics of
this market than otherwise uninformed observers. Bob Parker, vice-chairman of
Credit Suisse Asset Management, told clients last week that the worst of the
sub-prime mortgage crisis would be over within weeks. Perhaps so. This opinion
would, however, have carried more weight had it not come from within Credit
Suisse, which just a week after reporting decent fourth quarter 2007 earnings,
suddenly announced that it would be writing down an additional $2.85 billion
because of unspecified “mismarkings” by a group of traders.
That so many
storied members of a former global banking élite have been carried out on
stretchers during the credit crisis perhaps suggests that we have seen a
fundamental changing of the guard during this period of acute financial
disfunction. One way of expressing this change is in the coinage used by a
number of market commentators: that the days of ‘The Great Moderation’ may be
over. The chart below, for example, shows the recent price history of Chicago’s
Vix index, a market estimate of future volatility for the S&P 500 stock
index.
Notwithstanding
a short-lived spike during the summer of 2005, the Vix’s longer term trend
pointed to “the death of volatility” – until subprime-related concerns
progressively set in last year, with a vengeance. Credit Suisse may believe
that the worst is passed. Others, including former Federal Reserve chairman
Alan Greenspan (who now seems tragically unable to keep his trap shut), believe
that the US economy has stalled and may well take longer to recover than
normal: “As of right now, US economic growth is at zero.” Bank of England
Deputy Governor Rachel Lomax warned last week that in the light of the credit
crunch, central banks internationally face their “largest ever peacetime
liquidity crisis,” as “each week seems to highlight some new dimension of the
ensuing disruption to core financial markets.” Consultancy Gavekal
Research may have been among the first to elaborate upon the theme of “The
Great Moderation”; as their chart indicates, the last forty years have seen a
marked decline in the volatility of growth. The companion chart shows that with
lower volatility to growth has come higher profitability.
But the trillion
dollar question is whether either of these trends is sustainable. Corporate
profits in the US, relative to US GDP, had never been higher than in 2007. In
the light of a softening property market and a wounded financial sector, it
seems reasonable to assume that analyst expectations for corporate profits
growth in 2008 are simply unrealistic. Similarly, the thesis that ‘permanently’
low economic volatility can justify sustainedly high price / earnings ratios
looks like being stress-tested to perfection this year. If the financial sector
over the last 12 months is any guide to the broader market, the ‘p’ can easily
get crushed, with the ‘e’ shortly to follow.
Tony Jackson,
writing in last week’s Financial Times, took a withering view of the Pension Benefit Guaranty Corporation’s
decision, as an itself indebted federal protector of pensions for nearly 44
million Americans, to ‘bet the ranch’ by switching the majority of its assets
from bonds into equities. Nobody disputes that equities are likely to perform
better over the longer run, but the longer run can be longer than you or I can
remain solvent. Mr. Jackson made specific mention of the Asia effect, which is
surely playing a significant part in the across-the-board rise in the prices of
both hard and soft commodities:
“The China
effect is crucial. In contrast to the shock increase in the world’s labour
supply, which for some years proved disinflationary [that Great Moderation
again], the acceleration in per capita incomes points the other way. It
produces a multiplier effect on consumption of raw materials, to say nothing of
strains on the environment. The result – too much money chasing too few
resources.. The result.. will be a hoovering up of investment by resource
sectors generally, including water, waste disposal and alternative energy. In
such a world, diversified portfolios may no longer make sense. In the 1970s,
resource-based portfolios were alone in producing real returns.. Meanwhile,
equities in general will suffer from the higher risk premium due to economic
instability, and bonds from higher inflation..”
We wrote last
week of the remarkable surge by soft commodities prices. The exquisite
challenge of investing across multiple asset classes today is that innumerable
investment sectors with solid longer term fundamentals are almost effortlessly
taken “there”, seemingly overnight, by more speculative capital. Contrarianism
used to be about bucking the trend by buying out of favour investments at
revulsion lows. Contrarianism in 2008 might be about, effectively, endorsing
the speculative trend - but keeping the faith for the longer term. Shorter term
price action, in other words (wheat, anybody ?) amounts just to weather;
longer term, secular, sustainable and fundamental trends amount to climate.
(In commodities markets, even more than in stock-picking, buy and hold may come
to trounce trading strategies, and the recent article by Bloomberg’s Andy
Mukherjee, “Food is a great asset – minus the fund manager” also points in that
direction.) Tony Jackson, we hope, is
wrong in suggesting that portfolio diversification could be redundant (to be
fair, he concedes as much himself). Whether he is correct or not, no rational
investor would surely choose to allocate 100% of their liquid capital to
commodities and nothing else. But he could be half right – in that investment
right now into every distinct asset class requires extreme selectivity and
care. Given the heightened volatility of the resources sector at present, and
the marked disconnect between the level of equity indices (borderline euphoric)
and the tone of credit markets (borderline suicidal), that seems like an
eminently reasonable conclusion.
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