Fragile – that is the watchword for the global financial markets right now. There is a wide disparity of views as to the future course of the financial markets. One thing everybody agrees upon is that there are many big challenges to returning to any sense of normalcy.
Unlike all other business cycles that most of us can remember, this time really is different. This time it is a Debt Supercycle. It has taken 30 years of easy credit and low interest rates to enable governments at all levels, corporation and households to become overburdened with debt. This type of cycle takes many years to reverse and causes great pain. (To learn more about this read: This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff.)
Debt, like diamonds, is forever – no free lunch, somebody has to pay. Either the debtor has to suck it up by earning more or cutting spending to pay it off. Or, the creditor has to take the loss as a result of the debtors’ defaulting or repudiating the debt. Sovereign nations who have their own currencies have a third alternative; they can devalue their currency by creating inflation. For example, if the government owes you a thousand dollars, they could allow the currency to be devalued to 50 cents. You would get your full thousand back, but it would only buy 50 cents worth of goods. Historically this has been done by gradually allowing inflation to accelerate so it is less noticeable, but still effective.
Investing is about managing risk, which is about weighing probabilities versus payoffs. Payoffs can be either positive or negative – profit or loss and probabilities are constantly changing. So the wise investor (survivor) pays attention not only to the probability of something happening, but also to the potential for catastrophic loss if it does.
Right now the global economy faces more such potential catastrophes than I have seen at any time in my 50 years in the investment business:
- Potential Recession in the U.S. – are we or are we not going into a recession? If you are a financial media maven, you say no; if you are one of the millions who can’t find work, you say yes. According to the Economic Cycle Research Center (ECRI), a private consulting firm, the Weekly Leading Index (WLI) dropped into a negative level that has historically heralded a recession.
- The Eurozone is in danger of collapse. The community of 17 counties that has adopted the euro as currency has been valiantly trying to support the over-leveraged PIIGS countries (Portugal, Ireland, Italy Greece and Spain), but is running out of patience and options. Germany is the main financial supporter, but the German people are beginning to vote no more support. A default by any of these nations or their largest banks would have global repercussions because of the interconnected loans.
- Volatility in the stock markets is at extreme levels. The Wall Street Journal reported that the average daily swing from high to low for the Dow Jones Industrial Average (DJIA) for the month of August was 1.9%, the 10th highest in history. Financial Advisor Magazine reported that High Frequency Trading (HFT) exceeded 60% during August and more than 80% on some days. HFTs are computer generated trading operations that make thousands of trades for very small profits by taking advantage of small discrepancies. This means that there is very little participation or support in the markets from traditional institutions or public investors. This allows the potential for other days like the Flash Crash of May 6th 2010 when the DJIA dropped 900 points in 20 minutes.
- Revolutions in the Middle East raise uncertainty. They may cause us to cheer the downfall of despots like Gadhafi, but we have no idea who will take over. The Muslim Brotherhood in Egypt and the Libyan Islamic Fighting Group in Libya have both been accused of sympathizing with Al-Qaeda. True or not, we simply don’t know, but it raises serious questions especially about future energy supplies.
There are plenty more areas of concerns that could have catastrophic consequences such as the potential for a giant U.S. bank failure, a sharp rise in interest rates, a run on the U.S. dollar. But my objective is not to cause panic merely to advocate caution in financial matters right now. We will have opportunities to invest with better risk-reward prospects at some point in the future. A wise course now is to maintain solid cash positions to meet personal needs and to take advantage of promising opportunities. This may be a good time to diversify your range of managers to include those with strategies to benefit from uncertainties.
Please read the next post of Investor’s Help Now – Part II. It may provide you with some additional strategies.