The price of everything

Stocks in turmoil as Neasden bank reports shock profit

“You couldn’t get a clue during the clue mating season in a field full of horny clues if you smeared your body with clue musk and did the clue mating dance.” – Edward Flaherty.

 

January 29 (London) – European stock markets were thrown into fresh turmoil today as Société Bancaire de Neasden shocked investors by disclosing that it had inadvertently drifted into profit during its fourth quarter. At a press conference, SBN Chief Executive Officer Boris Nurdbongleur expressed his remorse.

 

“This is a dark day in the history of Société Bancaire de Neasden, the premier investment banking powerhouse of the Willesden Green and Dollis Hill area. I know our customers, investors, shareholders and taxpayers count on us to lose money, and I feel like I have let them all down.”

 

He admitted that he had tendered his resignation to the bank’s chairman, Mr. Boris Nurdbongleur, but that his offer had been rejected. The bank’s CEO also pledged to launch a full scale investigation into the rogue profit, jointly headed by the bank’s crack Forensic Trade Oversight, Manipulation and Reconciliation Committee, Boris Nurdbongleur, and head of Settlements, Compliance and Executive Compensation, B. Nurdbongleur.

 

The errant profit is thought to have been triggered when a sandwich delivery man managed to bypass the bank’s state of the art security system, Mavis on reception, and accidentally sat on a keyboard in the bank’s dealing room. Announcement of the profit was delayed pending the purchase of a replacement keyboard, thought to be a Keysonic Wireless Mini, available from Argos Neasden at  £34.95. Commentators suggested that this might not be the last occurrence of an incompetent arse in a dealing room this year.

 

Speaking on condition of anonymity, Marti Peeps, a spokesman for the bank, admitted that he was gloomy on prospects for the sector, notwithstanding Société Bancaire de Neasden’s surprise results.

 

“This has come in the wake of other débacles within the group, and indeed from all other banks, in real estate lending, securitised lending, high yield, subprime investment and hedge fund sponsorship. I foresee a flight to liquidity followed by possibly severe depression – but enough of my plans for the evening.”

 

SBN was recently forced to close its flagship hedge fund, Long Term Riskless Ultra-Cautious Diversified Capital Preservation III Master Fund, which catastrophically failed three minutes after launch. Regulators believe Boris Nurdbongleur may also have played a part in proceedings, as Head of SBN’s Triple Alpha Pro-Plus Delta One Specutrage desk. The firm tried to head off creditors to the fund by claiming, unsuccessfully, that it was incorporated on Io, one of Jupiter’s larger moons, and therefore beyond any terrestrial claims for compensation.

This is not the first time the Neasden-based bank has been involved in an awkward trading mishap. Traders at the bank last year managed to lose $4.3 quadrillion during the morning coffee run. CEO Nurdbongleur promised to winkle out the miscreants responsible for the latest blow to the prestige of the Prout Grove-based banking leviathan.

 

“And I will strike down upon thee with great vengeance and furious anger,” commented Mr. Nurdbongleur in a newly revealed “hardline” stance against banking fraud, which was later revealed to be part of the dialogue from ‘Pulp Fiction’.

 

Fears were first raised about the extent of Société Bancaire de Neasden’s previous trading losses when the Eurex derivatives exchange started receiving the bank’s margin payments via the Emma Maersk, a 400 metre long 170,000 ton container ship.

 

As news emerged of the latest shock profit, the Federal Reserve Open Market Committee was said to be in secret session.

 

UK Prime Minister Gordon Brown and Chancellor Alastair Badger were said to be following proceedings closely. French President Nicolas Sarkozy was otherwise engaged, to fruity Italian Ms. Carla Bruni. The FTSEurofirst 300 Bank Index closed down 1, at 0.

Download Stocks_in_turmoil.pdf with enhanced, banktastic graphics.

Time, gentlemen, please

“Even in such a time of madness as the late twenties, a great many men in Wall Street remained quite sane. But they also remained very quiet. The sense of responsibility in the financial community for the community as a whole is not small. It is nearly nil. Perhaps this is inherent. In a community where the primary concern is making money, one of the necessary rules is to live and let live. To speak out against madness may be to ruin those who have succumbed to it. So the wise in Wall Street are nearly always silent. The foolish thus have the field to themselves. None rebukes them.”

 

- from ‘The Great Crash: 1929’, John Kenneth Galbraith.

 

So there we have it. The US Federal Reserve has precipitately shown that, along with other central banks, it has no real clue – other than to offer the desperate drunk one last, colossal drop. (The phrase colossal drop here used with full acknowledgment of the sick irony involved.)

 

There was a time when central bankers were capable of tough decisions. As their reputation has grown, their practical value has shrunk markedly. Paul Volcker at the Fed created plenty of enemies in the course of crushing inflation, even as his policies laid the ground for the strongest bull market in history. But our current situation, while it screams out for firm policy leadership, offers us the likes of Bernanke, Trichet and King. If any aspirant media tycoon wanted to reinstate The Muppet Show, he could do worse than starting there. To get the measure of our times, note how the previous Fed chairman has joined the staff of the hedge fund that probably made more money from the property crisis that he himself largely caused than any other institution. As the wags at Long or Short Capital suggest, there are just five simple steps to becoming a billionaire using ‘The Greenspan Method’:

 

1. Become Fed Chairman.
2. Lower interest rates until you create an asset bubble. Hold them low until stagflation is in the air and a real estate bubble is floating.
3. Stop being Fed Chairman and release a book on how you didn’t do anything wrong and have no regrets. If possible, time it perfectly with the worst real estate market in generations.
4. Join the hedge fund which has profited more in percentage and dollar terms than anyone else has from your mess (which you didn’t create).
5. Build a platinum statue of your muse, Ayn Rand, and sleep with it every night.

 

Perhaps the danger was always in even presuming that strong fiscal leadership might see us and the economy through. No matter. If we are to protect our capital and well-being, let alone enhance it, it is going to be every man for himself.

 

The amount of correspondence we have recently received that touches explicitly on the moral failings that have arguably taken the markets to this cliff edge is striking. The founder of a community currency consultancy wrote the following:

 

“I know next to nothing about the Casino Economy you describe but I am deeply interested in the real value of the planet we live on and the future of everything humans hold dear such as community and care for each other.. We have learned a lot as we prepare to build liferafts for the millions of people who have no stake in the Casino but who are affected by the fallout from its addictions..”

 

Notwithstanding the shocking recent losses incurred in an indiscriminate orgy of selling, the real danger may be to fail to appreciate the gravity of where we are and what could still be to come. Investor Jonathan Spring suggests that the current market turmoil is

 

“..just the beginning of what could be a long, painful period for markets worldwide. The repercussions of too much easy credit for too long, and the haphazard financial vehicles and structures that such conditions have allowed, may finally be coming home to roost. Specifically, there are potentially a lot of problems with credit and credit structures in the world today, and it could take a long time for them to get fixed. Some of the complex structures (and their dependencies upon one another) that are being revealed are poorly understood by the financial community, and much less by the average investor. I don’t think there are many upside surprises that can come from this complex web being brought under scrutiny, something which now seems may occur sooner rather than later.”

 

This is not scaremongering – or at least it’s not intended to be – but rather a sober assessment of the mess we’re facing. Cleaning out the Augean stables of Wall Street and structured finance is going to be a thankless task – one reason why we continue to see little point in wading into financials, even at these levels. The preferred asset class choices remain: government debt (increasingly including inflation-protected debt); very selective defensive or unequivocally “global growth” equities; absolute return funds with limited use of leverage; precious metals; soft commodities; cash. George Soros, writing in Wednesday’s Financial Times, is probably right to call this “The worst market crisis in 60 years”. He is probably also right to suggest that the Fed (and for that matter any other central bank) may not be in any position to do anything about it. In extremis, investors should only commit capital right now to those things that they can attach supreme confidence to. When there is technical evidence that equity markets have capitulated – and that will also be when they can’t sink any lower on the back of new bad news – investors can then reassess their commitment to stocks. But in the meantime, nobody wins in a bear market; the triumph will be in keeping one’s losses to a minimum.

Keeping your balance on Dover Beach

 

“I sit in one of the dives

 On Fifty-second Street

 Uncertain and afraid

 As the clever hopes expire

 Of a low dishonest decade:

 Waves of anger and fear

 Circulate over the bright and darkened lands of the earth..”

 

- WH Auden, ‘September 1, 1939’.

 

There may be a few stubborn holdouts who believe in the primacy of economic analysis, but the investment community is otherwise coming round to the reasonable conclusion that successful investing particularly during turning points in the evolution of markets is as much psychological as fundamental. This would reinforce the essential truth behind Keynes’ infamous comparison of investment to judging a beauty contest:

 

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (‘General Theory of Employment, Interest and Money,’ 1936.)

 

There is, of course, another way of gaming the markets, and one with a better likelihood of ultimate success. And that is to make proprietary investments which, whether they work out or not, can be sold at a profit by leveraging one’s brand - to investors in thrall to that brand. Investment products, after all, tend to be aggressively sold rather than passionately bought. Such is the logic behind the full service investment bank. In its senior incarnation, FullServiceInvestmentBank nurtures a relationship with a promising startup. FullServiceInvestmentBank then takes PromisingStartup public (earning mysteriously sticky IPO fees of roughly 6.5%), and simultaneously creates cannon fodder for its private client division. FullServiceInvestmentBank then issues research on PromisingPublicCompany in return for brokerage commissions. After a suitable period it then romances  PromisingPublicCompany with proposals for potential corporate acquisitions that primarily appeal to executive vanity. Assuming its client rises to the bait, FullServiceInvestment Bank earns more fees for consultancy advice. At some point PromisingPublicCompany becomes AilingPublicCompany, and FullServiceInvestmentBank charges more fees for further strategic advice that may or may not be self-serving or conflicted – this is about revenues and expressly not client service. In the most perfect incarnation, which is admittedly rare and presumably illegal, FullServiceInvestmentBank mysteriously manages to play both sides of this game against its supposed client, PublicCompany, by acting as both bodyguard and matchmaker. In any event, a merger or breakup is on the cards, dangling the prospect of yet more fees. Lather, rinse, repeat.

 

The ways of Wall Street invariably seem impenetrable to outsiders. This may indeed be because they defy conventional commercial logic. Most listed businesses are presumed to be run for the benefit of shareholders, employees and “stakeholders” (whatever that means), in that order. But as Bloomberg’s Michael Lewis writes (“What does Goldman know that we don’t ?”), conventional commercial logic and Wall Street make uneasy bedfellows. How else to explain, for example, the payment for failure pocketed by outgoing Merrill Lynch CEO and amateur golfer Stan O’Neal ($161.5 million) versus Merrill’s latest $16.7 billion writedown ? Commercial language can’t really cope with this mismatch between reality and the money-porn fantasy that passes as executive compensation. Fiction can at least attempt to – we can legitimately say that this is ‘Alice through the Looking Glass’ stuff. As Michael Lewis and the Wall Street Journal’s Kate Kelly point out, just one Wall Street firm – Goldman Sachs – has managed to neatly sidestep the subprime car crash that piled into all of its rivals. But as Ms. Kelly’s recent article suggests, only because senior management at Goldman overruled its own traders on the sly and took short positions in subprime junk even as trading employees were busy loading up the truck like everybody else. Because management’s short positions were larger than the loss-making long-biased holdings of subordinate staff, the firm managed to survive the carnage. But does this not sound like a chaotic modus vivendi for a trading firm – the white-collar version of an arm-wrestling match ? And as Michael Lewis asks, “why do you need the traders ? And what happens when the guys at the top of the firm are wrong ?”

 

Brokerage stock investors would respond by reference to the cyclicality discount imposed on investment bank valuations. Trading earnings are not consistent. But even at today’s battered down valuations, it is debateable whether investors have truly priced in the disappearance of so many different revenue streams for what may be some time to come, and the likely permanent closure of some of the more exotic or opaque structuring areas. Those investors who bought what they presumed to be AAA rated debt offering a riskless premium to Treasuries and saw it default in a matter of months will surely take a more sceptical view of Wall Street’s plat du jour in future – if they have the luxury of retaining their jobs at all.

 

It seems astonishing that only a few years after Worldcom, Enron, Blodget et al., through the mechanism of fundamentally flawed repackaged debt Wall Street has managed not only to poison its own wells, but those across the global investment community. Raghuram Rajan’s recent commentary in the Financial Times on Wall Street’s equally flawed executive pay model has rightly triggered much debate among investors. After the dotcom research fiasco (where $10bn was paid in settlement, mysteriously without any acknowledgment of blame) and now subprime, with the apparent connivance of the ratings agencies, expecting Wall Street and the City to show moral leadership is like expecting brothel-keepers to advocate chastity. But for the individual, the lure of investment banking remuneration is hard to resist, as Tony Blair has shown.

 

The recent well-funded departures of key Wall Street executives after overseeing billions of dollars of losses plainly reveal the lack of correlation between executive compensation and the delivery of shareholder value. Executives in “real world” businesses – manufacturing (what’s left of it), retailing, real industries - despite more mundane compensation levels, are plainly held more accountable for their actions. There is a tone of hopelessness about this debate, but there need not be. Just as investors need not throng to buy the products or advice of invariably self-interested banks, so shareholders can vote with their wallets and elect to sell their stock in those same banks. On recent evidence, a growing constituency (admittedly not including sovereign wealth funds) appears to have worked this one out for themselves.

 

On the basis that January does turn out to be a leading indicator for the balance of the year, there is currently just one sub-index (pharmaceuticals and biotechnology) from the FTSE All-Share showing a positive return of any kind, which obviously does not bode well for the future. Interestingly, retailers are currently underperforming the banks. But in ‘reversal of fortune’ terms, the retailers are playing catch-up. So much bad news is now priced in for the financial sector that it feels exquisitely difficult not to start to nibble at current valuations, in the full knowledge that the sector isn’t out of the woods yet (rather, investors into the bank sector are having to pick their way across a minefield through a dense fog). Citi has shown us that bank dividends can get chopped, but if dividends are maintained, the likes of 8.2% (RBS) and 6.8% (Barclays) certainly stack up well against Gilt yields. With price / earnings ratios hovering around 5 or 6 times, according to Bloomberg analytics, a fair degree of apocalypse is already priced in. This is not the case for US investment banks: the S&P 500 Investment Banking and Brokerage Index, by contrast, trades on a price/earnings ratio of 10 (so not cheap enough yet by a long chalk) and a dividend yield of a puny 1.9%.

 

But to return to the macro picture. No amount of graphs, tables or share price charts can capture the essence of the current investment environment as well as some apposite ‘verbal pictures’ can. Matthew Arnold’s ‘Dover Beach’ (admittedly ripped at least one cultural milieu and two centuries out of context) does a surprisingly good job at painting the Zeitgeist of investment markets afflicted by a dysfunctional banking, currency and credit system in January 2008. Earlier in pre-subprime 2007 all is well:

 

“The sea is calm tonight.

 The tide is full, the moon lies fair

 Upon the straits..”

 

And then Wall Street exerts its inexorable malign gravitational pull:

 

“for the world..

 Hath really neither joy, nor love, nor light,

 Nor certitude, nor peace, nor help for pain;

 And we are here as on a darkling plain

 Swept with confused alarms of struggle and flight,

 Where ignorant armies clash by night.”

 

Readers are welcome to propose alternative language that better addresses a climate of loss of faith in establishment hierarchies, general mistrust, and the fear of an ever-darkening future. If nothing else, it would seem to make a lot of sense to view the equity market through an aspirational prism of maintaining capital values, rather through one of inevitable capital gain, because bear markets wear numerous disguises. Not least, favour “return of capital” over “return on capital”. Or to voice it in a way that even Wall Street might find uncomfortable: please give me my money back. For a sign of things that might be to come in financial sector remuneration, see last Thursday’s Wall Street Journal lead article: “(US) financiers’ pay spurs financial crisis”. As feared, but perhaps inevitably, the politicians are now rooting for dead bodies. Stan O’Neal, ‘Chuck’ Prince of Citigroup (just $29.5 million in departing compensation), and Angelo Mozilo of Countrywide Financial have all been asked to testify before the House Committee on Oversight and Government Reform. Each has been asked by Committee chairman Henry Waxman,

 

“You should plan to address how (your pay package) aligns with the interests of.. shareholders and whether this level of compensation is justified in light of your company’s recent performance and its role in the national mortgage crisis.”

 

A financial system wherein workers can only get paid upon completing transactions is inevitably geared to self-interest. Up-front commissions may be well-established, but the political winds are starting to blow – The Wall Street Journal, which reports the inquisitorial momentum with some sympathy, is hardly a bastion of socialist tendencies. Life in financial services is about to get a lot more interesting, irrespective of the direction of the markets.

Apple Days Are Here Again

“The Wall Street of 1932 was a dismal ghost town. Securities firms declared “apple days” – unpaid vacation days each month that enabled destitute brokers to go out and supplement their income by selling apples on the sidewalk. Apple vendors appeared at the Corner. Downtown real estate was so depressed that building companies defaulted; astute investors who bought their bonds became the future owners of Wall Street. The misery extended everywhere. Riverside Park was lined with Hoovervilles, and sylvan retreats in Central Park looked like ragged hillbilly hollows. On Park Avenue, ten-room apartments that had been occupied by financiers of the twenties now lacked tenants. The new, half-occupied Empire State Building was mocked as the “Empty State Building”.”

-      Ron Chernow, ‘The House of Morgan’  (with thanks to Stratton Street’s Andrew Clark).

This writer can state from personal experience that the perception of time spooling out in slow motion, with all the details of one’s surroundings given a sharper focus, really does occur just before the impact of a car crash. According to scientists, as the brain area called the amygdala becomes more active, it lays down a dense second set of memories; because these memories are more intense and extensive than normal, they make it appear after the fact that the incident lasted much longer than it actually did.

So time seems to slow down in a crisis, even as we speed to that impending collision. Such has been the case in debt markets for some six months now. The inevitable bust in credit markets (call it subprime if you will, though the problem is altogether more systemic) first started revealing its cracks in late 2006 – with a sharp rise in US home foreclosures – but it took another half year before investors woke up to the brave new reality, or managed to join the dots. Some commentators have resolutely clung to their half-full glasses by suggesting that the US will avoid the recession it’s probably already in because economic expansion is always killed by the Fed – which is now busily lowering short rates. But the debate is more than usually academic: it was higher rates that put the sword to the credit bubble – so traditional boom and bust dynamics still apply – but those rates were hiked by the Fed back in early 2006 (when the Fed Funds target rate was raised from 4% in November 2005 to 5.25% in June 2006). Not, perhaps, a dramatic tightening – but enough to kill off a sufficient number of overborrowed home owners barely able to finance their original teaser rates let alone the refixes, and to trigger in turn the defaults that started, effectively, a run on CDOs and MBS, and then on interbank liquidity, Northern Rock et al.

So far, so history. The fact that the ‘originate and distribute’ model has perversely left banks still holding a largely unpriceable nursery of toxic babies – and that, more than a little awkwardly, the Anglo-Saxon housing markets are simultaneously in retreat – now means that a forced deleveraging by the financial community will lead to ongoing risk aversion by the banking sector and punitive borrowing rates for those entities and individuals able to secure credit of any kind. This is what the start of a recession looks like – whether in slow motion, or not. Unfortunately, the UK boomsters now occupying investment banking dealing rooms have been reared on 60+ consecutive quarters of growth. Most of them have never seen an economic contraction, much less a severe one. That may partially account for the air of unreality and denial pervading stock markets, even as banks, homebuilders and now retailers get selectively taken out and shot.

While equity markets are experiencing a slow motion crash as the dead hand of reverse leverage slowly but inexorably does its work on the consumer economy, it is a marvel to see history repeating itself so precisely from previous debacles. In his account of ‘The Great Crash’, J.K. Galbraith wrote that

“As reverse leverage did its work, investment trust managements were much more concerned over the collapse in the value of their own stock than over the adverse movements in the stock list as a whole. The investment trusts had invested heavily in each other. As a result the fall in Blue Ridge hit Shenandoah, and the resulting collapse in Shenandoah was even more horrible for the Goldman Sachs Trading Corporation..”

Other than the crisis of 2007/8 being a debt rather than an equity debacle, there are few real distinctions. Same circus, different clowns. This time round, as apparent self-preservation wins out over maintaining orderly markets (the interests of clients having long been discarded), the complexity of the products and the inherent interdependency of Wall Street means that supposedly self-interested firms have been shooting their own feet off as they struggle to stay upright. As Bloomberg’s Yalman Onaran reports, Merrill Lynch (for example) sold hundreds of millions of dollars of CDOs to Bear Stearns hedge funds. Merrill Lynch also loaned some 90% of the face value of the CDOs to Bear Stearns. (This sort of vendor financing was also well deployed during the TMT boom and it didn’t end much better then.) When the prices of those CDOs started to fall, Merrill Lynch demanded more collateral in the form of margin calls (payback, some suggest, for Bear Stearns’ non-participation in the bailout syndicate for LTCM in 1998 that included Merrill Lynch). Bear Stearns responded that a fire sale of their CDOs would push down the prices of everybody else’s. Intransigence reigned. The resultant fire sale subsequently detonated beneath the $23 billion of CDOs that Merrill Lynch itself owned. In the financial markets equivalent of Mutually Assured Destruction, Bear Stearns’ hedge funds run by Ralph Cioffi, goaded there partly by Merrill Lynch, declared bankruptcy, but at the price of triggering a $7.9 billion writedown (so far) and a CEO departure for Merrill. At the risk of stretching a metaphor, one assumes that unlike investment banks, international arms dealers at least try and sell down their inventory before seeking new victims. In this playground of the Wild West, Sovereign Wealth Funds have ridden to the rescue – according to conventional wisdom – but are in no position to magic functional markets back into being. Few tears should be shed for Wall Streeters facing the 2008 equivalent of “Apple Days” – this is a market for grown-ups who have tended to be well paid even as their employers haemorrhage capital – but whether politicians will be charitable to investment bankers facing accusations of ‘breaking’ the real economy, not least due to a wholesale abandonment of ethical principles, is another question. Two questions for those investors scooping up “cheap” banking stocks: assuming that current dividends are maintained, when do you expect future revenues from debt structuring and mortgage-related issuance, say, to return to 2007 (or 2006) levels ? In your lifetime ? Does your assessment of current valuations take any account of a conceivable wider deterioration in related credit businesses ? And does the reputational damage to investment banking brands inflicted by the various facets of the credit boom and bust make the swift return of 2007 (or 2006) revenues more or less likely ? If you answer anything other than “less likely”, do you think you deserve to have any customers ? (This is a game staff at credit ratings agencies can also play.)

We now know that retailers are falling off the ugly tree and, as a whole, hitting every branch on the way down. Patrick Perret-Green of Citigroup separately points to the growing risk of non-residential property to the broader economy: “With credit no longer easily available and a large construction pipeline set to hit an increasingly vulnerable market, activity is set to cool rapidly.” Leverage in reverse still has a few more victims to strike down. All of this is in plain sight, as it were, but the outcome will likely take months if not longer to play out.

Other potential outcomes ? In a severe Anglo-Saxon economic contraction (which bond markets have been pricing in for a while but which would still come as new news to equities), western government bond yields could yet decline close to Japanese levels. (10 year JGBs currently yield less than 1.5%. Now that’s deflation.) But as central banks finally and belatedly realise that the financial sector is undergoing a crisis of solvency rather than just liquidity, all bets are off when the pumps finally get primed – and the deflation / inflation cycle finally swings round, explosively, to the latter. A Japan-style “lost decade” is a remote likelihood, as western finance lacks the baroque cross-shareholdings of the zaibatsu; but banking shareholders (SRM and RAB take note) will likely have to learn to take their lumps along with everybody else. And given the 1930s experience, one shouldn’t ignore the potential in a severe crisis for politicians to do extraordinary things (renationalisation ? state appropriation ?) to save their hides. It would be ironic if, just when capitalism seemed to have won the global battle for consumer hearts and minds, its venal banking sector had sown the seeds for its own destruction and replacement by a newly resurgent spirit of socialism and protectionism. Financial assets – in a world of fractional reserve banking and fiat currencies – are ultimately only as strong as the confidence of the environment that nurtures and tolerates them. Having long behaved as if untethered by any moral or social accountability, Wall Street and City interests can be forgiven for looking wistfully on as investors vote – as they have already started to – in favour of the supreme fiscal independence of gold and of hard assets more generally.

The song “Happy Days Are Here Again” was played during Franklin D. Roosevelt’s successful presidential campaign as a Democrat in 1932, in the aftermath of a stock market collapse - exacerbated by too much leverage - and in the midst of an economic depression. To what extent could history repeat itself in the months ahead ? It would be nice to think that we avoid the worst case scenario hinted at above. But capital preservation and absolute return investing is primarily about preparing for the worst case even as one anticipates ultimately more favourable outcomes. In any event, investors will not be well served by portfolio managers blithely pursuing the same old equity / bonds / cash paradigm or committing to a long-only investment style contingent on continued economic expansion. The game has profoundly changed. Portfolio managers would do well to recognize that fact.

In flagrante delicto

“A financier is a pawnbroker with imagination.” – Arthur Wing Pinero.

Warren Buffett once admitted that if a graduating MBA were to ask him how to get rich in a hurry,

“I would not respond with quotations from Ben Franklin or Horatio Alger but would, instead, hold my nose with one hand and point with the other toward Wall Street.”

That career advice comes from a more innocent, pre-subprime age. ‘Wall Street’ is, of course, no longer geographically distinct, but a global phenomenon, just as the infection triggered by the explosion of a giant credit (and housing) pustule has spread seemingly indiscriminately and certainly internationally, attacking mortgage lenders, investment banks, portfolio managers and money market funds alike. Norwegian townships, Australian hedge funds, Floridian public fund pools – all tainted by products originated by Wall Street. While the steady expansion of the credit crisis has been widely reported since the summer of 2007, the credit infection and insidious creep of no confidence now threatens other forms of debt – namely credit cards and commercial property loans. With the US residential property market experiencing price falls at a rate not seen since the second world war, according to Yale economist Robert Shiller, the next shoe to drop will likely be in credit cards. Marc Faber suggests that nearly 12% of Americans will need to borrow money to pay their winter heating bills; 9% will use credit cards for the purpose – “the median US household’s financial position is extremely precarious”. Since roughly 70% of US GDP is accounted for by personal consumption, and since US homes are no longer functioning as ATM machines, the idea that the US will avoid recession in 2008 looks more than a little naive. It is no longer just financials and homebuilders that are trapped in this conflagration – as Faber suggests, “retail stocks are performing poorly and signalling a recession”.

So it makes little sense to favour domestically orientated US businesses when the weaker dollar (which now feels poised to extend its counter-trend rally, particularly against Sterling) will be helping exporters. But it still seems premature to be bargain-hunting amid the larger US financials. As Barron’s pointed out in its end of year edition, the options market was recently pricing in a dividend cut by Citigroup of more than 50%. ‘Optically’ cheap stocks will be a value trap if punchy dividend yields turn out to be illusory. And with Sovereign Wealth Funds representing one of the few bull arguments for international stocks, investors should be wary of jumping to conclusions about apparently ‘smart’ injections of emergency investment into Wall Street firms. As Faber also points out, the reputation of the SWFs, at least in the short term, may be overstated. Citigroup stock rose from $30 to $35 after the November announcement of the Abu Dhabi Investment Authority’s $7.5 billion investment. But at the time of writing, ADIA was still sitting on a paper loss. As was China Investment after its June investment into Blackstone Group (down by 24% following its IPO – if private equity is selling, do you really want to be buying ?). As was CITIC Securities following its October purchase of some Bear Stearns stock (down by 26% subsequently). These stakebuildings may indeed have been strategic in the broader sense of the term, but they hardly look tactically astute. As far as G7 stock markets are concerned, simply buying into the SWF bandwagon looks less like following the ‘smart’ money and more like blithely endorsing Greater Fool Theory. And as for the moral stink and conflict of interests on Wall Street – if it was bad when Buffett first made the quote, it reeks to high heaven now. More than ever before, caveat emptor.

With a trans-Atlantic property bust now firing shrapnel at the western consumer, with banks and members of the Shadow Banking System competing for increasingly scarce capital, and with that inevitable monetary policy accommodation compromised by stubborn inflation, what themes do appeal for 2008 ? As in 2007, components of the global energy, energy services and infrastructure sectors still have value, not least because demand in these areas is being buoyed by a secular uptrend from both emerging and developed markets. But equity markets will be vulnerable to ongoing pressure from a subdued banking system and fragile consumer confidence. Industrial metals would logically be victims of any Anglo-Saxon slowdown, but precious metals and our perennial favourite gold still warrant a presence in any balanced portfolio. We’d be even more explicit about gold now were it not already so universally adored. At a macro level, it remains unclear whether the ultimate outcome of the credit debacle will be inflationary or deflationary. As Tim Lee of pi Economics points out, for the inflationists “the outlook is clear. The huge debt overhang will not be allowed to wreak havoc over the financial sector” (further havoc) “and therefore it will be inflated away. Central banks will print enough money to inflate incomes and asset prices to the point where the debt is no longer a big burden and can easily be serviced.. (But) the fact that stock markets are still not far from their highs and the yen has appreciated only minimally against high interest rate currencies tells us that the ‘real’ credit bust has yet to happen – we have merely seen the opening act. When the credit pyramid begins to unwind properly, deflation will appear far more of a threat.” And as Tim Lee also observes, whenever house price inflation has been significantly below consumer price inflation, the economy has always been in recession and inflation has been set to fall. Given the nuanced nature of the anticipated outcome, our conclusion is to recommend some exposure to both conventional (but solely high quality government) debt and the inflation-protected variety. Equities are in some respects a natural inflation hedge, but not all equities, and our defensive and opportunistic biases should be clear. Compelling investment themes – a burgeoning global middle class; a growing water shortage; ecology; alternative energies; agribusiness – remain, for those with the discipline to pursue a longer term strategy whilst maintaining an ongoing focus on capital preservation. Emerging market investors, particularly in India, can handily buy for the longer term on any corrections. In the face of what seems set to be a peculiarly challenging year, there is an answer, in the form of asset class diversification, thematic stock selection over index-tracking, and a concentration on quality and simplicity versus opaqueness and complexity. We would like to wish all readers a peaceful, happy and prosperous New Year.