Rational Advisor

Boy, am I glad that August is over. What a Rocky and exciting month.

Why was it so volatile – because of liquidity! The liquidity crisis is there because a lot of these investors have been using short term funding for long-term assets. And this is a recipe that just invites a crisis of funding.

What we have is a system that is addicted to short term profits, and much of this has been increased since the increases in the number of Hedge Funds. These investors have to take extreme risks to try to obtain short term results, and much of that risk is in taking on greater leverage on a particular investment decision. The Hedge Funds are in the business of taking risk and right now the set of circumstances that have come to bear means the risk has been realized. And they are squealing because they are losing money. Unfortunately it is also impacting other investors in the amount of volatility.

The markets are subject to a variety of different shocks. This particular shock may be slightly different than what has occurred in the past, but the nature of the markets is such that you can certainly expect these types of disruptions. They are common.

This is not the first time the markets have gone through a liquidity crunch. For example, the commercial paper market in Canada dried up for a while after Olympia & York Developments Ltd, defaulted on its commercial paper in 1992. And history is littered with more significant examples, which gripped the markets, causing major disruptions: the Asian financial crisis in 1997, Long Term Capital Management’s collapse shortly after that, the bursting of the tech bubble in 2000. The oil shocks of the mid 70s pinched the market, and the recession in the early 1980s did not help liquidity either. Black Monday, Black Tuesday and Black Thursday in October 1929; Black Monday in October 1987, September 11th – all precedents, which highlights how risk can manifest itself at anytime and should be expected. However one truth has remained through all of these crisis, and that is that the investment markets have risen and successfully gone past these and prospered. And investors who stayed true to their financial plans did well; investors who added to their plans did even better.

What we are now seeing is just the markets re-asserting itself to better fundamentals.

Essentially, the markets have rediscovered its roots, returning to fundamental investing after its fixation with the complicated hedge strategies that have proliferated over the past few years.

You can expect the volatility to continue in September, as the institutional investors need to do a lot of window dressing for their 3Q reporting. You will see them shift to quality investments that have less speculative appeal. They want to show that they do not hold the companies that have suffered over the last month. So expect the companies that were hit the most to fall further. And expect companies tha can produce good balance sheets, strong dividends to have an advantage.

Investors have been frantically hoping for a cut in the Fed’s fund rate to restore confidence and help the crisis, which has its roots in the subprime mortgage meltdown.

The recent volatility is likely to continue until the Fed’s Sept. 18 meeting — unless the central bank decides to make a rare inter-meeting move before then. But we don’t think that’s likely to happen unless the market’s volatility gets much more severe.

My guess is the Fed will not ease at the meeting. If I am the Fed, I wouldn’t waste a cut on a regular scheduled meeting, I’d save it for when it was needed to boost panicky confidence and otherwise, unless real economic growth fades, I wouldn’t use it.

Bernanke cautioned investors that “it is not the responsibility of the Fed to protect lenders and investors from the consequences of their financial decisions.”

If the markets expect the Fed to ease and Mr. Bernanke fails to oblige, he runs the risk of triggering another round of problems in the markets – hence be prepared for continued volatility.

By the way, the Fed typically keeps the pump primed heading into Presidential Elections, since the Fed does not want the U.S. economy to be the subject of debate. So during thee next year, you can expect to see rates fall or be a non-factor.

As markets re-acquaint investors with the concept of risk, what is the next lesson they have in store? Better safe than sorry, trees don’t grow to the sky. You can’t judge a book, or an investment by its cover (or media hype). It seems like many investors have yet to absorb even these old chestnuts.

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