The price of everything

Pricing power: signal versus noise

“The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.” – Friedrich Nietzsche.

 

It has become increasingly accepted wisdom that commodities prices now seem to be caught in something of a speculative bubble – that speculators, in other words, have steered commodities markets away from their economic fundamentals, and are in turn triggering the growing impoverishment and in some cases starvation of the peasantry in the developing world. (As Rio Tinto’s chief economist Vivek Tulpule wrote earlier this week, high prices by themselves do not automatically constitute a bubble. It is difficult to argue, however, with Michael Jones of RiverFront Investment Group who suggests that commodities are near-term overbought.)

 

But could it be that commodities prices – those of oil, gold, industrial metals, foodstuffs – whilst evidently reflecting leveraged capital inflows are also, and more profoundly, reflecting a reality of decades of underinvestment now crashing horribly into a historic surge in global demand ?

 

To an extent, debates about the role played by speculators – whether leveraged or not – in the agricultural markets play a subsidiary role to the price action itself given the current and prospective human cost. As RJH Adams is surely right to claim,

 

“..the crux of the matter is that at these price levels the leveraged flows into grain are an imminent source of great harm. Expectations of price volatility or, where rough rice is concerned, straightforward price rises are promoting hoarding, export controls and a vicious cycle of more leveraged buying. Meanwhile, in Port-au-Prince and company, rising food expenditures have been reducing real wages by large, double digit percentage amounts.. For it does not take much of this to cause catastrophe – even though the end result, in due course, will be lower prices. The last grain boom in 1972-5 saw a major famine in Bangladesh triggered by a tripling of rice prices over a three-month period in 1974. A million, on some estimates, died.”

 

At times of volatility and human crisis, morality sits extremely awkwardly with consideration of the market. But if one is to take “speculators” to task – a definition that would have to include unleveraged individuals as well as traditional savings institutions, given the role played by exchange-traded vehicles in introducing commodities to a broader investment constituency – then one should rightly also point a finger of blame at governments themselves. As Jude Webber and Javier Blas wrote in a recent feature article for the Financial Times (“Farmers doomed to pay price for export restrictions”), moves by some countries to ban foreign sales are threatening to extend and even worsen the international food crisis. Countries from Argentina to Vietnam have either stopped farmers from selling their crops abroad or have imposed punitive taxes on agricultural exports. Given that the same farmers are beset by rising input costs (not least for diesel, seed and fertilizers), crop acreages – far from being increased as the natural response to price signals – are, counter-intuitively, being cut. As Tim Murphy wrote in response to the Webber and Blas piece, market intervention, like the proverbial flapping of a butterfly’s wings in chaos theory, leads to unforeseen and sometimes unmanageable consequences in a highly complex system.

 

Keynes famously wrote of the dangers of financial (over)trading. Speculators, he said,

 

“may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.” (‘The General Theory of Employment, Interest and Money’, p.159.)

 

Or in other words: I invest intelligently and pragmatically; you are a momentum-follower; he runs a hedge fund. It is certainly difficult to re-read Keynes’ words above without an involuntary shudder at the activities that have brought the western financial system to such an acute crisis – not exactly from “directing new investment into the most profitable channels” so much as from fooling their customers – and, quite brilliantly, themselves – into believing that mortgage derivatives of the purest lead could be transmogrified into gold.

 

At what point speculative capital starts to outweigh macro-economic fundamentals and becomes the primary fundamental in its own right is a fascinating question. But we are also living in a dysfunctional market environment where multiple price mechanisms seem, for a variety of reasons, to have broken down. That leaves classic free-marketeers in something of a philosophical wilderness. As Deutsche Bank’s Josef Ackermann commented, a little bleakly, in response to the then broadening credit crisis earlier in March,

 

“I no longer believe in the market’s self-healing power.”

 

When sovereign nations throw grit into the wheels of the market to “control” food prices, they at least have the interests of the disenfranchised at heart, even if the consequences are damaging or counter-productive. But when administrations in the developed world intervene in markets and suspend the natural pricing mechanism – most recently for mortgage-backed securities – businesses not privy to state-subsidised support (manufacturers, say, who produce things of tangible value that benefit society at large, rather than a relatively small constituency of highly paid financiers repackaging financial assets) will naturally cry “foul”. The role played by exceptional remuneration in the credit crisis was alluded to by Bank of England governor Mervyn King on Tuesday, in what is likely to be an increasingly polarising debate between City apologists and sceptics. While the Bank evidently has a watching brief to maintain low inflationary financial stability, there is precious little it can or should do to control financial sector pay in a free market. Over the medium term the governor probably need not fret unduly – the City, as a consequence of market forces, is imposing its own price control mechanisms in the form of laying off bucketloads of staff. For as long as property prices and the availability of credit are pressured, animal spirits, and headline grabbing bonuses – at least at the banks – are unlikely to be haunting the Square Mile any time soon.

At a time when the tone of equity markets has been relatively subdued, one of the week’s more prominent stock market stories was news of Mars’ $23 billion acquisition of gum-maker Wrigley. The deal was part-financed by Warren Buffett’s holding company, Berkshire Hathaway. Some commentators seized on the deal as proof of some kind of bottoming process for stocks. Making that leap seems something of a stretch; if the deal carries any significance at all, it relates to the value of Wrigley alone rather than the broader market (and, in the case of Berkshire Hathaway and Warren Buffett, to the merits of having cash on hand). But it also serves as a reminder of an investment approach barely practised in modern times – that of owning businesses outright rather than merely trading stocks. Buffett’s fortune is a testimony to business ownership and long-term stakeholding as opposed to the altogether more wildly popular practice of renting stocks. There is much to be said for owning and controlling an investment in entirety, rather than hitching a ride on the back of a tradeable asset whose momentum is ultimately in the hands of an unruly and somewhat feckless mob. That holds whether the asset is an agricultural commodity, a currency, a government bond or a glamour stock. With hedge funds controlling assets to the tune of $2.5 trillion, and more conventional managers controlling assets many multiples of that number, individual investors would do well to consider just who is truly directing any portfolio that consists heavily of listed, public securities. With some fairly blatant intervention on the part of authorities in the normal price discovery mechanism, investors may come to appreciate that they have managed to fool themselves, twice.


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Some inconvenient truths

“We are born brave, trusting and greedy – and most of us remain greedy.” – Muriel Strode.

 

Just following the investment markets this past year has been a largely thankless task. A Chinese water torture of ongoing black comedy from a now distinctly subprime banking sector has reduced formerly strong individuals – and hitherto credible financial institutions – to gibbering rubble. In the wake of Northern Rock, Bear Stearns and <insert the name of any random bank here>, the financial sector has largely taken its lumps and moved onward - if downward. Banks aren’t necessarily fairly priced yet (water may be an increasingly scarce resource; bank shareholders, however, are still in for further dilution), but the bad news is well and truly in the market. Time for the rest of us to move on.

 

In search of new enthusiasms, one opens the second section of the Financial Times with an almost giddy sense of optimism, only for one’s spirits to sag once again at around page 29 or so – the start of the London Marathon that is the Managed Funds section – lots of entrants, and plenty of them both amateurs and comedians. To view this jammed thoroughfare of third party managed funds in a vaguely positive light, it at least points to the vigour of competition in the asset management market – if not necessarily to the health of the underlying funds.

 

An anniversary that never fails to fire six bullets into one’s joie de vivre as an asset manager is that point in the early 1990s when the number of mutual funds (roughly 4,300) on the New York Stock Exchange amounted to double the number of stocks listed on that same exchange. A particularly fat tail had started to wag a somewhat vulnerable dog. Now a new book by Louis Lowenstein (the title seems to give the game away: “The Investor’s Dilemma: how mutual funds are betraying your trust and what to do about it” – John Wiley & Sons) serves to remind us of one of the financial services industry’s dirtier not so little secrets:

 

“There is a profound conflict of interest built into the industry’s structure, one that grows out of the fact that (mutual fund) management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance.”

 

The figures are startling, and drive a peculiarly large nail into the coffin of efficient market theory, or for that matter plain economic sense. Between 1980 and 2004, the assets of stock funds in the US increased 90-fold, from $45 billion to $4 trillion. Fund managers harvested a lustrous crop of fees irrespective of whether their investments rose or fell in value. (Many of the same managers spend much of their time criticizing their hedge fund rivals for charging too much fee income from the surely more ethically defensible goal of making absolute, rather than relative, returns.) What is almost painful to relate is that while the industry now manages $6 trillion in equity funds, it manages a further $3 trillion in bonds and money market funds. Portfolio theory, and plain common sense, would suggest that while there are limited opportunities to generate value (“alpha”) from inefficiencies in the equity market, there are virtually none in the bond market and certainly not overmany opportunities in the money market once fees are taken into account.

 

Mr. Lowenstein evidently marshals a number of damning arguments in his systematic dismantling of the mutual fund industry. One of the more compelling touches on the alignment of interests between manager and client. From 2003 to 2006, by way of example, the chief investment officer of T. Rowe Price (no relation) amassed ownership of equity in the management company worth over $75 million. His total personal investment in T. Rowe Price’s mutual funds amounted, apparently, to $1 million. Whatever the quality of the cooking, there was precious little eating going on. The contrast between “traditional” funds and hedge funds, in this respect, is explicit. The role played by hedge fund management fees is worthy of a whole separate jeremiad, but the alignment of manager and client interests in the form of equity participation in the underlying funds is worthy of note. Many hedge fund managers – as the failure of Peloton earlier this year revealed – have much of their personal net worth invested in their funds. That obviously betokens no guarantee of ultimate success, but if failure is the outcome, investor misery can at least enjoy some company.

 

As we have noted before, egregious fee extraction is not restricted to so-called hedge funds. Traditional fund groups are perfectly comfortable charging high fees for substandard performance. If future market returns are likely to disappoint by comparison with the now almost mythical 1980-2000 bull market, and they surely may, then the imposition of any fees whatsoever will hinder portfolio returns. As Alistair Blair, writing for Investors Chronicle, wrote last year:

 

“consumers simply cannot grasp the fact that the man sitting in front of them and the people behind him are being paid via a long-term and hugely expensive levy on the returns from their savings.. here’s a suggestion.. Investment products should be required to be sold with a warning comparing the total impact of fees over 20 years with the impact of fees on the least expensive indexed product on the market. I believe this slot is currently occupied by the Fidelity Moneybuilder UK Index Fund, which has an annual management charge of 0.1% and total expenses of 0.3%. The warning would run like this:

 

1) This product aims to deliver you a greater return than you would obtain by buying the Fidelity Moneybuilder Index Fund directly. It will need to do so because our costs are much higher. Very few people understand the effect of fees – even apparently small ones – on investment returns, SO PLEASE READ THE FOLLOWING CAREFULLY.

 

2) If you invest £5,000 in the Fidelity Moneybuilder Index and it achieves 7% growth a year for 20 years, your £5,000 will grow to £18,000. If you invest in our product and it achieves 7% growth for 20 years, the effect of our higher fees will be that you will end up with only £12,000.

 

3) But we aim to do better. In fact, even to match the Fidelity Moneybuilder, we’ll have to outperform the index by an average of 2.4% every year for 20 years.

 

4) In the FSA database of 15,000 funds offered to the public over the past 20 years, only 10 funds have achieved this kind of performance. We aim to be the 11^th.”

 

Of course, not everyone wants index performance, hence the continued rise of the hedge fund sector. But the recent divergence of the asset management industry between low-cost tracker products (now ETFs) and high-cost “market neutral” structures leaves an increasingly awkward-looking no man’s land in the middle of mongrel vehicles of no real underlying merit: funds which at best could track the market but are destined to underperform due to high active management fees. Just as the banking sector is going to see an inevitable compression in returns (if not outright consolidation) as the credit crunch allies with heightened regulation to stifle growth, so the number of managed funds should, if there is any natural justice whatsoever, finally contract as investors become increasingly familiar with both the lower cost exchange-traded proposition and with the higher cost absolute return offering. No man’s land is not a pleasant place to spend any length of time.


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‘Stuff’ versus paper

“Unfortunately, self-regulation stands in relation to regulation the way self-importance stands in relation to importance..”

-  Willem Buiter, in The Financial Times, on the latest laughable attempt by banks to weasel out of any kind of real regulatory oversight.

 

“There was a time when a fool and his money were soon parted, but now it happens to everybody.”

- Adlai Stevenson.

 

Judging from admittedly unscientific anecdotal evidence, investors seem to believe that equity markets have dodged something of a bullet. And while certain sectors (leisure goods and retailers, telecoms, financial and media – the list is not exhaustive) have all slumped since the start of 2008, the FTSE 100 as a whole is holding up pretty well against its European and even North American peers – financial relativism, perhaps, always being the last refuge of the scoundrel. But just as there is more to banking than specious attempts to evade accountability, so there is more to investing than just lobbing one’s savings into the stock market. How have other major investment sectors and asset classes fared ? We can debate subjective fundamentals, after all, until the bulls come home, but the price is where the price is. As Mrs. Thatcher said, you can’t buck the market. (And as Hank Paulson and Ben Bernanke are now discovering, you can’t market the buck.)

 

As at the end of the first quarter, the FTSE 100 index was showing a total return of -10.3%. This compares with -9.4% for the S&P 500, and with an altogether more miserable -15.6% for the FTSEurofirst 300. The Nikkei 225 was showing a total return of -17.5%, the Hang Seng an almost identical -17.4%, and Shanghai a somewhat more striking -34%. Whatever the Chinese economy is doing, in other words, its stock market hasn’t exactly decoupled from the west – more like entered a suicide pact.

 

So much for stocks. If you liked them in January, you have to love them now. As to those certificates of confiscation known as government bonds: UK Gilts, as represented by the FTSE Actuaries UK Gilts All Stocks index, have returned 0.19%. After inflation, of course, that is a loss. Bloomberg’s US Government Bond Index has delivered a total return of 4.49%. Whether that represents a meaningful real return largely depends on whether you trust US inflation data. Euro zone government bonds were almost exactly in the middle, with a return of 2.29%. As we never tire of writing, the optimal risk / reward – if there is any value inherent in government debt – is likely to be in the inflation-linked market.

 

Hedge funds, often erroneously referred to as an asset class (talent class might be more appropriate, only the phrase smacks of leaden irony given 2008’s returns), have disappointed. The CSFB / Tremont Hedge Index, as at end March, was showing year-to-date returns of -2.01% (not bad considering the stock market, but uninspiring given the essential mission to generate absolute returns in all market environments). Whether hedge fund investors are waving or drowning will be almost entirely down to strategy selection. The “traditional” strategies – convertible arbitrage (-7.6%), event driven (-3.3%), equity long/short (-4.1%) – were largely rubbish. A degree of honour was restored by dedicated short bias (+9.8% - every dog has his day), global macro (+6.9%) and managed futures (+10.4%). One does feel obliged to ask, however, whether hedge funds as a whole have just been hit by their quadrans horribilis – as FRM’s John Beech points out,

 

“The worst fear for many in the hedge fund industry has always been a bankruptcy in the prime brokerage community, and.. the threat posed by the run on Bear Stearns intensified the deleveraging process that has been occurring in one shape or form since the summer of 2007. As Bear Stearns was an important counterparty to many Fixed Income Arbitrage hedge funds, the link to losses in this sector is clear.”

 

John Beech attributes most hedge fund losses during the quarter to risk aversion trades: deleveraging, de-risking, and hedging. Hope should obviously play no role in the investment process, but it may not be inappropriate to suspect that if the hedge fund sector can weather the volatility of Q1 2008 largely unscathed, the survivors of the deleveraging cycle may be well placed to benefit from the resumption of slightly more normal market conditions. While hedge funds are supposed to benefit from volatility, you can evidently have too much of a good thing. A final aside: “multi-strategy” delivered -3.9% for the quarter. Fund of funds managers will have to work hard at regaining the trust of investors newly sceptical of their ability to locate alpha as opposed merely to creaming off fees.

 

No surprises to see the asset class winner in the first quarter’s lottery of returns: commodities. The Dow Jones AIG Commodity Index returned 9% to end March 2008. Oil itself (WTI crude for May delivery) returned 7.3%; wheat 4%; natural gas a stunning 32.7%; gold 10%. And perhaps there is more agreement here than in most sectors that commodities prices now seem to be ensnared in an uncontrollable bubble. ‘Bubble’, of course, is also how investors describe rapidly appreciating assets when they’re not themselves already on board.

 

In light of the widespread losses incurred by most asset classes so far this year and the seemingly crowded trade that is pretty much every component within the commodities complex, what are investors to do ?

 

At the risk of stating the blindingly obvious, perhaps the most critical observation is to restate the fundamental counsel: only invest what you can afford to lose. Bound up within this core advice is the requirement to identify an appropriate time horizon for investment. An unrealised loss from a quality equity investment, for example, may be nothing more than a reflection of market noise. But if the capital tied up in that investment is soon required to set against short term liabilities, something has gone awry with the investment process.

 

And while the price chart is the purest form of investment intelligence, the role played by so many ‘shadow banking institutions’, leveraged, deleveraging or otherwise, is likely to keep prices across multiple sectors highly volatile. Given the vulnerability of equity markets to fresh disappointments by ostensibly internationally diversified businesses, and the particular vulnerability of Anglo-Saxon asset markets to a still deteriorating residential property sector, there seems more than usual merit in a) a healthy exposure to cash, and b) a disciplined commitment to dollar cost averaging versus market timing. As to preferred equity market sectors, we have long advanced our preference for energy, natural resources and related support services. As we have now had confirmation from no less a business than Rio Tinto that world quality miners are unable to maintain production even with commodities prices at record highs, that commitment is – US recession or not – highly unlikely to change now.

Wall Street to write off another 300,000,000 staff

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(The PDF document is fuller and contains graphics)

“You don’t have to predict it. We’re in it.”

- Paul Volcker, former US Federal Reserve chairman, responding to a question on whether he still predicted a dollar crisis in coming years.

London, April 2010 – Wall Street firms have just announced their latest results for FY 2009;

300 million staff have been “written down”, leaving just two (Sid and Doris Bonkers) to manage the investment banks’ remaining worldwide debt, equity, merger and advisory, securitisation, syndication and prime brokerage businesses.

 

Marti Peeps, sole analyst at the last remaining research house, Teletext, welcomed the results as “a bold step in the face of ongoing bad debt provisioning,” though conceded that the City’s newly “rightsized” payroll might struggle to take on board the burgeoning supply of new issuance, namely the packet of Walkers Crisps rumoured to be hitting the primary market in late summer 2012.

 

Hopes for a recovery in Wall Street earnings have for several quarters hinged on the prospects for the successful completion of a 40p private placement of a bag of Salt and Vinegar flavour crisps on behalf of the Walkers Crisps Company. Lead underwriters JPCitigroupMerrill, a subsidiary of the US government, and Northern Rock SocGen KFW Nomura, a wholly owned subsidiary of Tesco plc (Neasden branch), are rumoured to have “solid” interest for the underwriting, most notably from Asia, itself a subsidiary of Texas Pacific Group, but declined to go into further detail.

According to a filing at Companies House, recently rehoused atop a kebab shop on Tottenham Court Road, The Walkers Crisps Company plans to use the proceeds from the placement to refinance existing snackfood operations and to fund working capital needs. The above investment banks are “focused on supporting institutional private financings, strategic partnering and the acquisition needs of both growing and mature businesses, and indeed corporate entities not necessarily restricted to those operating in the Salt and Vinegar flavour potato-based derivative snackfood market.”

 

The latest round of layoffs on Wall Street has seen personnel departments resorting to ever-more creative means for dispatching staff. A popular approach is the ‘cluster-fire’ escalating waterfall method, by which senior managers deliver ‘just-in-time’ firings to their own staff, and are then immediately fired themselves by their own line reports, who are then in turn fired by the most senior manager on the premises, at which point that manager is himself made redundant by means of a controlled tactical nuclear burst. This latest word in financial disrecruitment has been praised by Wall Street watchers as hyper-efficient, but there have been complaints that pedestrians in nearby urban centres have been clubbed to death by the falling body parts of newly superfluous brokerage employees.

 

In other popular payroll deleveraging strategies, managers have been pouring gasoline over their workforces and igniting them. This has proven increasingly difficult, however, ever since people started stockpiling oil once it surpassed the psychologically significant $1,000,000 a gallon level. Regulatory observers have also been critical of such ritual staff immolation on ‘carbon footprint’ concerns. Mass stoning, by contrast, has been deemed to be environmentally friendly.

 

Other financial sector commentators suggested that the requirement for firings was less pressing, now that dark, mounted riders in interesting robing were chasing through the streets of New York and London and skewering passers-by with sharpened, flaming spears. Others suggested that this was merely a legacy of past investments in leveraged subprime deals.

 

Marti Peeps, relaxedly smoking one of his last HBOS share certificates, posited that every indicator saw signs of renewed growth, now that there were no more analysts maintaining fatuous predictions of US corporate earnings growing by 15% this year as per the previous four centuries. In late trading, the market for broken pieces of jagged wood was $2.7 – 2.8 trillion per piece (1 Yuan in regular currency). Defra, the UK Government department for the environment, food and rural affairs, issued an upbeat assessment of prospects for the forthcoming flint harvest. Analysts also expected a flurry of transactional activity in the front month grass contract. Leaves were down $1,380,700,000 a bushel. Apples and water did not trade, being bid only. Mr. Peeps apologised that his latest research opinion on banks and brokers had been reported as ‘Sell’. This was a typographical error. He had actually titled his outlook ‘Hell’.

Living beyond our means

“Our enemies are innovative and resourceful, and so are we. They never stop thinking about new ways to harm our country and our people, and neither do we.” – George W. Bush, August 5 2004.


*Please note: there are a number of graphs in this article. Readers are encouraged to download the full, graphically enabled PDF piece, below.*

“What have we done with two decades of prosperity ?” asked Mark Pragnell of the Centre for Economics and Business Research at a recent Citywire seminar. Good question. His rhetorical remark relates specifically to the UK, but many of the conclusions have commonalities in the US economy too. UK citizens have – until recently, at least - enjoyed the lowest cost of living increases on record (the contributing factors are highlighted in yellow):

 

..with monetary conditions (the volatility of Bank of England policy rates, or rather the lack of such volatility) offering unprecedented financial stability; the number of employed has risen to over 25 million; and average earnings have grown with impressive strength, with annual growth in average earnings, according to the Office for National Statistics and the CEBR, oscillating around the +4% level since 1993. Which is where the good news starts to dry up. Other trends have been more ominous; symptomatic, perhaps, of a gathering economic storm. Household spending has been paid for by abandoning savings (US householders will be well acquainted with the principle of using the home as an ATM machine):

 

Manufacturing industry has been hollowed out, with annual growth in investment showing an alarming negative long-term trend:

 

As Mark also points out, the UK has seen a growing number of either “can’t work” or “won’t work” potential employees (the ONS refers to them, more diplomatically, as “working age economically inactive”), from under 7 million in 1972 to just under 8 million in 2007. An awkward statistical companion is that those with jobs have seen recent falls in hours worked. Without foreign migrants, getting plumbing or housework done in recent years might have been impossible. Of the 2.9 million extra “jobs” created in the UK in the ten years from 1996, half have been in the public sector:

 

And note that two thirds of the “jobs” created by the public sector have disappeared from manufacturing. There has been significant growth in red tape and taxation (Mark cites figures from BBC News and LexisNexis: the number of pages in Tolley’s Yellow Tax Handbook has risen from 6,000 in 2001 to almost 10,000 in 2007; the 2007-8 edition required a smaller font size to make it into print). Welcome, says Mark, to the “something for nothing society” where citizens expect or want:

 

• A family and the right to stay at home to bring them up
• Flexible working hours and a shorter working week
• A decently funded National Health Service and state education system
• A decent wage
• A pension and a comfortable retirement
• The state to pay for it all.

 

Mark’s carefully worded conclusion: the long term challenge is making Britain competitive after two decades of living beyond our means.

 

There is a broader problem. The financial sector, including commercial banks and investment banks, and more recently including members of the so-called “shadow banking sector” such as hedge funds and structured investment vehicles, has grown comparably fat, stupid and lazy after decades of access to easy credit and leverage. Instead of adding value, financiers have simply taken to trading financial assets, sprinkling “innovation” (not least, securitisation) upon them, and hawking them around, irrespective of suitability, morality, or “know your client” concerns. Thanks to the implosion of the US residential property market, that game is now up – though not everybody appears to have recognized the fact, judging from some of the recent rallies by stock markets on otherwise terrible news from the banking sector.

 

Here are the inconvenient truths for the bulls:

 

• 70% of US GDP is accounted for by consumer spending
• The US consumer – the “spender of last resort” – will be unable to maintain historic spending levels when the prices of residential housing are falling at their fastest level in at least 40 years: Anglo-Saxon consumers are going to have to rediscover the lost art of saving. For more, anecdotally, on the apparent self-interested desperation of US homeowners, see the Wall Street Journal story from 2^nd April, “Some homeowners leave pets behind in foreclosure”
• Ongoing credit contraction and banking writedowns can and will have only one effect on western economies, and it cannot logically be positive
• Further capital support for the banking system may have to come from the taxpayer, which carries stark implications for already imperilled government finances. Assuming it does not come from existing shareholders, those shareholders remain in danger of being diluted painfully or fatally in the event of longer-lasting widespread deleveraging.

 

As James Ferguson of Pali International points out, the equity market downtrend “has been littered with sharp, double-digit, contra-trend short squeezes”. The chart below shows the recent downtrend of the US S&P 500, but it could just as easily be showing the FTSE 100 or Japan’s Topix (or China).

 

In short, one day’s rally does not a bull market make. Whether the S&P 500 – or other key indices – make technical breakouts from their range, or not (we have to respect the price action, but it may be wholly irrational and therefore unsustainable longer term), the bulls will still have to justify how western economies can withstand widespread weakness in residential property prices, a related slowdown in consumer expenditure, an ongoing liquidity and solvency crisis amongst undercapitalised banks, and more general fears relating to a possible sea change in the macro-economic environment. To return to and paraphrase Mark Pragnell’s earlier thesis, the long term challenge is making banks relevant after two decades of living beyond their means. If the age of easy credit is indeed dead, what might possibly replace it ? For many, though not all, “smart” financiers, hedge fund managers (particularly in leveraged credit strategies), private equity players (again, hitherto using easy leverage as a replacement for more difficult decisions) and associated capital markets flotsam and jetsam long used to the zero sum trading of paper rather than generating real and sustainable economic value, the future may involve having to do some real work for a living. For all investors, a degree of expectations management may be in order. The 1982-2000 period (and the period of ultra-easy interest rates that followed, combined with a huge buildup of imprudent leverage and property-related speculation) looks like being a huge anomaly in market history. Perhaps the rational response to current conditions – it certainly has been for the last twelve months - would be to refocus on capital preservation and worry a little less about what to do with all those wondrous anticipated investment profits.

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