When overconfidence and leverage meet other people’s money

“Trust is a tough thing to come by these days.” – RJ MacReady (Kurt Russell) in John Carpenter’s ‘The Thing’.

 

Those of us who grew up in the 1980s have a special affection for ‘The Thing’. The last great gasp of special effects before CGI and a spirited remake of Howard Hawks’ cold war sci-fi classic, the film is set in an isolated Antarctic research station. A dozen Americans are assailed by an extraterrestrial with the ability to change shape at will. Because the alien can easily imitate human beings, pretty soon the atmosphere of tension, mutual distrust and paranoia becomes almost unbearable. As the small band gets whittled down further and further, self-preservation wins out over camaraderie. As helicopter pilot MacReady comments in a diarised recording to tape,

 

“Nobody.. nobody trusts anybody now, and we’re all very tired.. there’s nothing more I can do, just wait..”

 

‘The Thing’ bears further comparison to current markets in that the carnage is unbelievable.

 

Financial markets are reliant on trust to function normally. The days of gentlemanly capitalism and dictum meum pactum are of course long gone, but a vestigial sense of surety in the financial system is still required for its smooth functioning. Unfortunately, having failed to entirely crush all faith in propriety during the dotcom boom, a motley combination of investment banks and leveraged speculators has had another go at mutually assured destruction. This time round they seem to have come closer to succeeding. What is more than a little shocking is how few lessons appear to have been learnt by ‘hedge’ fund managers from the LTCM crisis. Too much reliance on financial modelling; optimistic assessments of market liquidity; crowded trades; grotesque overleverage.. History may not repeat itself, but it sure does rhyme.

 

Reading one book will have made a substantive difference to investors this year. Yale endowment manager David Swensen’s ‘Pioneering Portfolio Management’ has much to recommend it, but two observations are invaluable: bondholders are typically fighting a losing battle; and boutique fund managers have demonstrably fewer conflicts of interest than full service investment banks. Suffice to say, the initial spark to this year’s market tinderbox was structured debt distributed by investment banks. Fingerpointing is never that productive at the best of times, but it is perhaps worth noting the reputational and material damage inflicted upon full service houses after forays into largely non-core investment businesses. Any lessons learned from the subprime debacle will of course be long forgotten by the time the next broad market dislocation grinds into being.

 

What now ? Amid such extraordinary volatility, it only makes sense to be positioned for the longer term, both at an asset allocation and an underlying level. Specific pockets within the equity market (notably diversified miners and resources groups) have at least optical cheapness, but the price swings are still so wild that averaging into them makes more sense than calling a definitive bottom to either market or sector, emergency Fed action notwithstanding. And the future behaviour of the US consumer is uncertain. Equity markets are not just reflecting being caught in the drive-by shooting of a credit market panic but are starting to price in genuine economic weakness. Last week’s deteriorating newsflow from the likes of Wal-Mart and Home Depot points to the real world impact of what would otherwise be a problem limited to the residential property and mortgage market. There are worsening property-related economic impacts to follow – most likely in the UK, but Eastern Europe and Asia will not be immune. Tellingly, Asian stock markets were shocking performers at the end of last week. (Though again, over the long run, Asia’s anticipated outperformance versus US and Europe looks as inevitable as a force of nature.)

 

It’s difficult to see how easier monetary policy substantially brightens the mood. Nevertheless, on a ‘least worst’ basis, government debt, though technically overbought, is proving a safer haven than many of the usual suspects, including gold – which now looks like a good candidate for longer term portfolio diversification and a hedge against a dollar crisis that may yet come in the aftermath of easier money – again – in the US. Many commentators are lambasting commodities and precious metals for failing to hedge conventional investments. This criticism is premature, as the recent correlation between any number of disparate assets has been extraordinary, and the markets have been notably indiscriminate as investors dash for liquidity. The good, the bad and the ugly have all been sold, but the good will obviously recover in time. Given the dependency of much of the private equity and much of the ‘hedge’ fund market upon cheap credit, it feels like we have seen the high water mark in the fortunes of these sectors for quite some time. (If this proves to be the case, it will not necessarily make sense to buy financials when the low is apparently in – the knock-on effects upon underwriting, lending and prime brokerage, and most importantly confidence, will be severe.) The traditional defensives in equity markets include tobacco, utilities, pharmaceuticals, consumer personal care products, food and brewers. Foodstuff inflation will probably dampen the outperformance of the latter two sectors, but the composition of the list should still make sense. Notwithstanding Warren Buffett’s advice to get greedy when others are fearful, the same investor also counselled: Rule No. 1: Don’t Lose Money. Rule No. 2: See Rule No. 1. While markets are evidently part-way through the cycle of fear, it is by no means clear that the final revulsion stage has successfully been passed.

 

(Caution: spoiler warning.) In a desperate attempt to destroy the alien in ‘The Thing’ and prevent it from infecting the rest of the world, the survivors – Childs and MacReady - set fire to their Antarctic base..

 

Childs: “The explosions set the temperatures up all over the camp. But it won’t last long though.”

 

MacReady: “When these fires go out, neither will we.”

 

Childs: “How will we make it ?”

 

MacReady: “Maybe we shouldn’t.”

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