Rational Advisor

Just came back from our National conference in Niagara - there’ll be more updates on my views on that.

But, one advisor cornered me, and asked a really good question

“Alan Greenspan, says we are in a similar environment to the crashes in 1998 and 1987 should I be worried?”

I never had time to give a full answer, so here it is

Former U.S. Federal Reserve chairman Alan Greenspan added to the misery in the markets when he compared the current turmoil in the financial markets to previous crises that shook the U.S. economy and reverberated around the world. Mr Greenspan’s comments come about a month ahead of the 20th anniversary of the stock market’s crash on October 19, 1987.

“The behaviour in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, I suspect what we saw in the land boom collapse of 1837 and certainly [the bank panic of] 1907,” Greenspan said at a Washington event, according to the Wall Street Journal.

The 1998 reference was to the collapse of a huge hedge fund, Long Term Capital Management.

In both 1987 and 1998, stocks fell sharply starting in July or August and, although markets seemed to stabilize by September, they abruptly plunged again, and didn’t come out of their tailspins fully until October. Whether stocks will suffer a similar fate now, or escape it due at least in part to timely Central Bank action is the big question on investors’ minds. In the previous two cases and again this time around, market downturns turned into routs as computer-based stock-trading models blew up in the faces of the investors who used them.

The crash of 1987 took place during the original buyout boom, which bullish investors said would keep stock prices high for years. And 1998 was the year Long-Term Capital Management almost imploded, forcing the US Fed to step in to calm credit markets. Big corporate buyouts, such as TXU’s $32 billion buyout and student lender SLM’s $25 billion deal, have formed part of the backdrop to this year’s trading. So have battered hedge funds: Two funds at Bear Stearns lost almost all their value after investing in securities linked to low-quality mortgages.

ln 1998, the Fed wound up intervening three times, because its first attempt proved insufficient. In 1987, the Fed didn’t intervene until after the crash, although when it did step in, it succeeded in stopping the bleeding. This time, as in 1998, the Fed has tried to intervene before things get worse. But unlike Greenspan in 1998, Bernanke has taken a gradualist approach. He has cut the rate the Fed charges to provide cash to the banking system. But he has avoided cutting the more broadly influential federal-funds rate, which governs banks’ prime lending rates. A cut in the federal-funds rate would more directly help small borrowers, but the Fed fears it also could rekindle inflation.

As in 1987 and 1998, one of the most unsettling aspects of the recent sell off is that stocks are falling and people don’t fully understand why. A big reason in each case was the role of computers programmed by people who were supposed to be market geniuses. This time it was hedge funds using mathematical models, whose forced selling contributed to huge market swings and massive trading volumes over the past few days. The hedge funds, many of whose models were strikingly similar, had to unwind unsuccessful trades involving millions of shares after troubles in the mortgage markets bled into the stock market. The sight of unknown sellers using computers to sell millions of shares of many different stocks, while buying millions of shares of other stocks, led to panic among other investors.

It caused so much mass buying and selling that the market couldn’t easily handle it. It was almost like trying to get a stampede of elephants through a small door. There was a similar break down in computer models in 1987 and 1998.

The models on which investors relied in 1987 were known as portfolio insurance. The portfolio-insurance models called for investors to protect themselves from losses by making sales in stock-futures markets if their actual stock holdings fell a predetermined amount. The models, which were based on detailed analyses of market history, didn’t take into account what would happen if everyone using these models all tried to do it at the same time. Markets couldn’t absorb all the sales demands, and the selling pressure helped cause the 1987 crash.

The models du jour failed in both 1987 and 1998. I remember being amazed at the stock gains earlier in 1987, despite rising interest rates and inflation. Only later did I realize that people had felt free to behave recklessly because they had “portfolio insurance.”

Indeed, in all three years, market turmoil was made worse by overconfident investors using borrowed money to purchase risky and “hot” investments. The unwinding of all of that leverage, or borrowing, can be brutal because as these “hot” investments fall, investors are forced to sell stocks to pay back their loans, creating a downward spiral.

In 1998, the blowup that forced the Fed to act came at a multibillion-dollar hedge fund called Long-Term Capital Management, which had become the dominant player in the Treasury-bond market. In the summer of 1998, LTCM was making highly leveraged bets against Treasury bonds and in favor of other bonds, including those of Russia. Its models showed the risk of losing money that way to be minuscule. When Russia nonetheless defaulted on its debt payments, LTCM faced bankruptcy until the Fed helped persuade a group of banks and brokerage firms to rescue it.LTCM’s models were created by Nobel laureates.

For a while, the incident soured many investors on computer models and borrowed money, but with time and people’s short-term memories, new models emerged and began showing large gains. In response, investors pulled billions in investments away from traditional diversified portfolios, who simply tried to select quality investments. The latest vogue was for quantitative, market-neutral hedge funds, which were supposed to avoid market gyrations by betting on gains in one large group of stocks, bonds or currencies, while simultaneously hedging their risks by betting on declines in other large groups.

At dinners with other investment firms, I would hear people talk about how they have ‘quant’ models, or that they were long-short managers or market-neutral managers. They would look at me, because of my views like I was a dinosaur. Now I realize that what sounded impressive was not much more than a thing we saw played out in 1987 and 1998.

Another big lesson of all three years is that it is the debt markets that often pose the biggest threats to stability in the stock market. In 1987, it was rising interest rates that eventually sent stocks plunging. In 1998, it was the risk that the collapse of LTCM could roil the bond markets. Lately, it has been securities backed by high-risk home mortgages that had found their way into a wide variety of investment portfolios. The mortgage securities were so widely held that, when they went bad, they caused credit markets to freeze up, hurting other, higher-grade bonds.

As in 1987, huge investment funds (now called “private Equity”) used junk bonds in recent years to take over companies once thought too big to be acquired. In 1987 and again this year, the market suffered once buyouts started to face trouble. My view of booms is that they generate looseness in standards for loans because there is a general sense of optimism. That is what we saw in the late 80s.

Also supporting stocks in 1987, as well as in recent months, were a strong world economy and healthy corporate profits, which investors expected to last for years. Both times, the sudden stock declines shook those hopes. In all three cases, markets turned increasingly volatile. Sharp drops earlier on proved to be temporary affairs, helping create a false sense of optimism.

To be sure, there are also some big differences. One is valuation — stock prices compared to companies’ underlying value. Valuation looked excessive in 1987, with stocks trading at more than 20 times corporate profits. Price/earnings ratios were similarly high in 1998. This time around, the ratios remain in the teens, close to the post-1945 average of about 16.

The real excess this time has been in lending markets, where investors bid up mortgage-related securities and junk bonds to unheard-of levels, and where investment banks invented novel bond-like securities. One reassuring difference is that, in the previous crises, problems developed in the bedrock Treasury-bond market. This time, Treasury bonds remain an island of relative tranquility.

Another hopeful sign: In both 1987 and 1998, the market’s woes were severe but brief. Despite the sharp market drops (more than 36% in 1987, and nearly 20% at one point in 1998), the Dow Jones Industrial Average finished both years with gains. It was up 2.26% in 1987 and 16.1% in 1998, and the S&P500 index, and S&P/TSX were up both years as well.

Although memories of the 1987 crash still make some investors shiver, that day — Oct. 19 — actually marked the bottom of the bear market. The next day, stocks began to recover, beginning a new bull market. One reason for the quick rebounds was prompt action by the Fed, and another was that the economy avoided recession in both 1987 and 1998.

But the fast rebounds led to more excess, and more abuse of borrowed money. The buyout boom resumed in 1988 but went bust in 1989, when a proposed buyout of United Airlines fell through and the junk-bond market plunged. The Dow industrials fell into a bear market in 1990, as recession arrived. The consequences of the post-1998 tech-stock excess were worse: the 2000-2002 bear market.

Besides valuation, Fed intervention and the economy, investors need to watch for other corporate and hedge-fund blowups to get an idea what might lie ahead. The longer it takes to work these problems out, the more likely credit and stock-market problems will be to spill over into overall economy, causing a slowdown, or worse, a recession.

“When the market does recover, it should recover quickly, more like 1987 and 1998 than 2000,. I don’t think the hedge-fund blowups are over yet. It is undoubtedly the case that we will be reading about more now. It is not just the Bear Stearns one and the Goldman Sachs one. Undoubtedly, a lot of those funds were more highly leveraged in some of those investments that now are no longer profitable. A number probably bought mortgage-backed securities that they didn’t completely understand.

The current panic is, by my count, the fourth of the past 10 years.

Here’s my list of the major financial panics of the past decade:

The Asian currency crisis of 1997.

The Long Term Capital crisis of 1998.

The Nasdaq bubble of 2000.

And the current contender, the subprime crisis of 2007.

On the surface, these panics seem significantly different because they all have involved different players and different market vehicles. The Asian currency crisis saw a huge devaluation of the Thai baht, the Indonesian rupiah, the Korean won and other East Asian currencies. It also saw a devastating stock market crash and stalled economies throughout the region.

The Long Term Capital crisis the next year was exacerbated by Russia’s default on its debt and was the result of an over-leveraged hedge fund, Long Term Capital Management, getting swamped when currency prices moved against it. At one point, the fund had borrowed $129 billion on assets of just $4.7 billion.

The 2000 Nasdaq crash was a classic stock market bubble built on ever more feverish expectations for huge growth in revenue and profits.

And the current panic is rooted in a boom in home prices that produced a boom in mortgage lending to ever less and less qualified borrowers, who are now defaulting at levels above those projected by the banks that originated the mortgages and the investment banks that packaged them for resale.

But here are the similarities below those surface differences:

Each was rooted in a surplus of global cheap money. Inflows of overseas capital inflated economic-growth rates in East Asian countries, sending stock prices in those countries higher and attracting more capital, because investors were more than willing to finance the large current-account
deficits being run up by these countries. Long Term Capital’s investment strategy required massive leverage because the profit from each transaction was relatively slight. The Nasdaq bubble required rivers of cash to chase stocks as they climbed ever higher. And the current crisis saw mortgage
lenders recklessly chase marginally qualified borrowers so they could generate more mortgages to sell to insurance companies, pension funds, hedge funds and foreign banks hungry to put mountains of cash to work at slightly higher rates of return.

Each required a massive mispricing of risk. Investors put so much money to work at relatively low rates of return because they underestimated the risk involved in those investments. East Asian economies were growing at 8% to 9% a year, it was believed, so their stock markets were low-risk investments. A similar thing is being seen today with China and India.
Long Term Capital took on only tiny risks in each of its bets, so the aggregate risk appeared low. Nasdaq stock prices were high, but not riskily so in comparison to projected growth. Individual mortgages to less creditworthy borrowers might be risky, but when bundled together the resulting securities, they were low-risk.

And each cycle led the world’s central banks, often led by the U.S. Federal Reserve, to limit the fallout from the panic by flooding the market with cash, thus setting up conditions for the next turn in the cycle. The International Monetary Fund led bailouts for the stricken East Asian economies. Thailand, for example, was at the receiving end of a $20 billion bailout effort. The Federal Reserve put together a $3.6 billion bailout of Long Term Capital to stabilize the financial markets. The Fed cut interest rates and cut them again — finally to just 1% — after the Nasdaq crashed in order to stabilize the economy. The move created a boom in housing prices that would keep consumers spending even if they’d lost money in the stock market. In the current panic, the Fed has cut rates for loans of member banks to inject cash into the markets.

Go further and I think you’ll find the global trends that produce and reproduce these similar panics.

First, the financial markets are being asked to redistribute massive amounts of cash. Higher oil prices have produced a gusher of cash flowing from the developed economies to the oil-producing economies like Canada. All that cash has to be reinvested somehow, often in the financial assets of the developed economies, thus completing the cash cycle.

But that’s only a part of the global gusher. The massive trade surplus reaped each year by China — and to a lesser extent by other developing economies — has to be recycled, too. And again, much of this money goes back into the developed economies because even a developing economy such as
China can’t — or won’t, by government policy — absorb all this cash.

Reinvesting this much cash without inflating asset values in some part of the market is probably impossible given investors’ propensity to chase returns.

Second, the globe is at a demographic turning point. Like an individual in middle age, the globe as a whole is in its prime earnings period. Taken as a whole — largely thanks to China and the developing world — the world is a net saver. That saving adds to the global cash flow. But everyone from the
savers (China) to the relatively older spenders (Europe, Japan and the U.S.) feels the need to get the most return on each of those investments. That has produced a global search of any potential extra penny of return and an understandable willingness to underestimate the risk of reaching for that extra return.

And third, with the aging of their populations, the economies of the developed world are slowing, both absolutely and relative to the younger and faster-growing economies of China, India and the rest of the developing world. That may be completely natural in the life of an economy, but that doesn’t mean it sits well with the governments of those aging, slower-growing developed nations. Engineering economic growth and preventing recessions has moved up on the agenda of every central bank in the developed world, whether they admit it or even recognize it themselves.

That means more active efforts to help the economy after a bubble bursts and more willingness to turn on the cash spigot to head off any slowdown.

These underlying trends mean that the boom-panic-boom-panic cycle isn’t going away anytime soon. The world is likely to see another decade or two of positive global cash flows that have to be recycled before aging catches up with the globe as a whole. The search for that extra 10th of a percentage point of return will go on with current or heightened fervor. And any slowing of growth in the developed world will be met with a wave of cash, and, if growth starts to flag in the more developed parts of the developing world, we can expect central banks there to turn on the cash spigot as well.

That cycle, including the panics that scare us so much, is likely to be normal for quite some time.

So how do you live with this kind of financial market?

Three general rules will help:

Watch risk like a hawk. Think about it all the time, don’t ignore it. I think you’ll get the biggest return from studying risk.

Make sure you have the appropriate asset allocation for your risk tolerance. In a market subject to booms and panics, asset classes that don’t move with the market averages will be sources of extra return. Don’t be upset when you get a negative performance from an asset class, sometimes, that the best thing, it’s reducing the risk from an appreciating asset class.

Good and independent management — real honest-to-goodness independent investment management that comes from doing their homework, and have demonstrated this in the past booms and bust is critical.

Lastly, have an sound investment advisor that has a sound intellectual framework. Ignore advisors that have the latest greatest thing!

So, I hope it is like 1987 and 1998! It will get the speculators out, and leave the real investors in.

Rational

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