The price of everything

Because we’re here.

Lieutenant Gonville Bromhead:         “Was it like this for you ? I mean, how did you feel the first time ?”

Lieutenant John Chard:                       “How do you feel ?”

Lieutenant Gonville Bromhead:         “I feel afraid and there’s something more. I feel ashamed. There. You asked me and I told you. How was it your first time ?”

Lieutenant John Chard:                       “Do you think I could stand this butcher’s yard more than once ?”

 

-       From the screenplay to ‘Zulu’ by John Prebble and Cy Endfield.

 

 

Notwithstanding Ben Bernanke’s apparently extensive study of the Great Crash and the Depression, no amount of reading about such a huge market dislocation could possibly have prepared the most apt student for the Crash of 2008. And Ben Bernanke isn’t directly managing other people’s money, so much as helping (amongst other things) to divert billions of taxpayers’ cash toward the evidently deserving banksters on Wall Street.

 

First observation. Trying to draw meaningful medium term investment conclusions in response to short term market movements has now moved from the realms of camp surrealism to outright farce. As Macro Man points out, two days in October were among the worst days for the Dow Jones Industrial Average ever: 15.10.2008, down 8.2% and 9.10.2008, down 7.6%. But look on the bright side, two days in October were also among the best days for the Dow Jones Industrial Average ever: 13.10.2008, up 10.5%, and 28.10.2008, up 10.3%. Forget those plans to break the bank in Monte Carlo; just watch the value of the world’s largest capitalised companies if you really want to see where the action is.

 

On which note, let’s not forget the circus freak show that Volkswagen stock has become. As the price charts show, a blue chip component of the German Dax Index is convulsing like a penny stock charged with 58 million volts. Doubtless the German laughing stock exchange will maintain that VW market makers were only obeying orders.

 

The VW corner is not without precedent. John Brooks, in ‘Once in Golconda’ (John Wiley & Sons) charts the course of Allan Ryan and the infamous 1920 bear raid on his investment, the Stutz Motor Car Company of America:

 

“At first, Ryan lost ground. So great was the short-selling pressure that, despite his efforts, by early March the price of Stutz had dropped back to near 100. But then the tide turned decisively. By the morning of March 24 Stutz was up to 245; that day it shot up to 282, and a week later had skyrocketed to 391. In the course of the startling rise, practically all Stutz stockholders except Ryan, his firm, and members of his family decided to take their profits, and sold their stock – which was snapped up in every case by Ryan; meanwhile, the opportunity to get an inflated price for Stutz appealed more and more to the short sellers, whose number and activity increased, and Ryan bought their offerings, too. Toward the end of the month, the stock that they were selling to Ryan had first to be borrowed from him, since there was no longer anyone else who had any. Confident that he was winning, he gladly went on lending and then buying it, and the wild, uncontrolled rise to 391 on March signalled his victory. The short sellers, it was clear, had disastrously underestimated his strength; they were overpowered, and their remaining choices were to buy back the stock they owed him, at his price, thereby incurring huge losses, or, alternatively, to face professional ruin and perhaps a prison term for breach of contract. Ryan, who was feeling much better by this time, had engineered in Stutz what Wall Street calls a corner.”

 

Unfortunately for the triumphant Ryan, he reckoned without the ability of members of the New York Stock Exchange to look out for their own.

 

“In the light of this situation, certain events of March 31 appear odd indeed. Ryan was in a position to know who most of the short sellers were, since in recent days it was he and he alone who had loaned the stock; he knew, then, that most of them, like him, were members of the Stock Exchange, and some of them, unlike him, members of its key committees.. Ryan was summoned to appear before the Exchange’s Business Conduct Committee to explain the gyrations of Stutz. He might have thrown the question back at certain of his interrogators, whom he knew to be among the short sellers; instead, he explained to the committee that the scarcity of Stutz stock had apparently been brought about by the fact that he and his family now owned it all – and even, because of clerical confusion, had contracts for a few more shares than actually existed. He then named the terms on which he would settle with the short sellers, still diplomatically omitting to mention that some of them were seated in front of him. He would, he said, sell them all the shares they needed to fulfil their contracts at $750 per share.”

 

To cut a long and inglorious story short, the Governing Committee of the Stock Exchange immediately decided to suspend all dealings in Stutz for an indefinite period. A Stock Exchange spokesman, when reminded by a reporter that no rule of the Exchange appeared to allow such behaviour, replied that “The Stock Exchange can do anything.” The Exchange also refused to accept Ryan’s resignation as a member, subsequently found him guilty of “conduct inconsistent with just and equitable principles of trade”, and forced him into bankruptcy. Thankfully such venal and cynically self-interested behaviour on the part of the authorities and brokerage firms would, of course, be inconceivable today.

 

Irrespective of the high jinks surrounding the suspension of financial short selling across major exchanges, hedge funds are in any case fighting their Waterloo. While the very best managers will tend to thrive under even the most extreme conditions (i.e. now), a significant proportion of the industry will inevitably get carried out on stretchers, in part because they were never much more than hubristic potheads leveraging beta. In any event, the investment environment for the next 12 months will have the following attributes: simplicity, liquidity, transparency. The phrase “stocks, bonds and cash” would be an appropriate if somewhat simplistic shorthand.

 

“Why is it us ? Why us ?” asks Private Thomas Cole in Cy Endfield’s ‘Zulu’ – the shattering cinematic account of a historic massacre of British - and Zulu - warriors. Shocked investors may well feel like asking the same question. One answer is that we are all in the dubiously fortunate position of having lived through the greatest bubble in property valuation and credit creation, and now the greatest asset deflation, in history - whether we wanted the experience or not. Colour Sergeant Bourne’s reply is a little more philosophical:

 

“Because we’re here, lad. Nobody else. Just us.”

Schroedinger’s cat revisited

“I do not know which makes a man more conservative – to know nothing but the present, or nothing but the past.” – John Maynard Keynes, ‘The End of Laissez-faire’.

 

 

It is sometimes useful and always amusing to look back at one’s earlier thoughts. The following piece was originally published two years ago (June 2, 2006 to be precise) – an altogether more innocent age, and from the vantage point of Autumn 2008, seemingly aeons ago. I have made no alterations (other than omissions for the sake of brevity) to the original and current, languidly ironic, commentary is added in parentheses in a jaunty orange..

 

At the level of the very small, making accurate statements about “reality” is fraught, and may indeed be impossible. According to Heisenberg’s Uncertainty Principle, in sub-atomic physics we can know the path an electron takes, or we can know where it is at any given moment, but we cannot know both. The very act of observation disturbs location. Take Erwin Schroedinger’s hypothetical cat, sitting in a box with one radioactive atom attached to a vial of hydrocyanic acid. If the particle degrades within an hour, the vial will break and the cat will die. If not, the cat will live. As Bill Bryson indicates in his endearing “Short history of nearly everything” (Doubleday, 2003):

 

“But we could not know which was the case, so there (is) no choice, scientifically, but to regard the cat as 100% alive and 100% dead at the same time.”

 

Similarly, at the level of the very large, making accurate statements about “reality” is comparably fraught. In Bryson’s words again, we live in a universe whose age we can’t quite compute, surrounded by stars whose distances from us and each other we don’t altogether know, filled with matter we can’t identify, operating in conformance with physical laws whose properties we don’t truly understand.

 

So what does all this have to do with the markets ? At the risk of stretching an analogy to breaking point, making any kind of explanatory declaration – even about past market conditions, let alone current or future ones – is comparably fraught, to the extent that there are too many market participants of too many distinct types, all possessing an array of varied emotional, psychological, temporal, aspirational and fundamental approaches to investments, for any one firm or process to begin to describe the markets with anything more than a tenuous hope of capturing ephemeral “reality”. Or to use Stephen Hawking’s words:

 

“one cannot predict future events exactly if one cannot even measure the present state of the universe precisely !”

 

And Hawking at least has the benefit of scientific laws and the scientific method on his side. Investors have to do what they can with their best sense of informed pragmatism.

 

In trying to explain why, during the month of May, equities, commodities and emerging markets all fell dramatically, there has been no shortage of publicly discussed culprits. To cite one proposed answer: “political convulsions in Iran.. enormous new increases in oil prices.. limited progress in developing an effective energy policy in the US.. reacceleration of inflation..” Each of these factors may indeed have played a part, but the conclusion is hardly novel, given that the testimony comes from 1979, when former Federal Reserve chairman Arthur Burns gave a lecture entitled “The Anguish of Central Banking”.

 

And if central bankers were anguished in the 1970s, their lot has barely improved since. With economic data robust and inflation risk rising (though perhaps by less than some recent, late-to-the-party inflationists are shrieking), the Fed looks suspiciously behind the curve, whether or not its new chairman chooses to give private briefings to newsreaders. US headline inflation could easily re-test 4% year-on-year and so any pause in the monetary tightening process ought to be temporary [inflation ! higher policy rates ! remember those ?]. And while European and Japanese fundamentals put less pressure on central bankers for dramatic tightening, more tightening evidently lies ahead. It is difficult to get overly enthused about bonds in such an environment [now it is difficult not to].

 

In trying to account for May’s market lurches, some commentators have put the blame on Japan, after its recent announcement of an end to qualitative easing and the resultant pressuring of carry trades funded with cheap yen. Some have pointed the finger at fears over resurgent inflation.. Some have blamed new public offerings for Chinese banks for sucking capital away from US markets and threatening the US dollar. Some, inevitably, attribute the market’s slide to hedge funds – handy whipping boys at the best of times in the absence of any brighter ideas [no change there then]; others, to sheer complacency, or to the fact that some kind of correction was simply overdue. Strategist Barry Ritholtz offers perhaps the most ironic justification for recent market weakness: bull markets don’t typically end until the last bears throw in the towel. And in early May, the bearishly inclined Richard Bernstein of Merrill Lynch and Stephen Roach of Morgan Stanley did exactly that. [Note also that Albert Edwards of SocGen and Jeremy Grantham of GMO are now conspicuously less bearish than they have been for years.]

 

In the end, I favour the “Murder on the Orient Express” solution: they all did it. Looking for scapegoats after market weakness is admittedly something of a fool’s errand. What matters is assessing whether the market environment has changed profoundly (fundamentally, however, it feels difficult to argue that it has) – but if it has (time will tell, and sentiment has certainly taken a beating), we should re-examine how best to protect investment portfolios and prepare for the future. First, there seems little point in fighting hostile central banks. In a global environment of enhanced trade competition and generally subdued inflation outside the commodity sector, there will come a time to increase bond duration but we are probably not there quite yet [I feel the same way now, but for different reasons: multiple Niagaras of sovereign debt issuance to help bail out the banks, and anticipated slashing of policy rates to previously unseen levels, make a compelling case for sheltering at the front end of government bond yield curves]. Second, in an environment of suddenly re-sensitized investors, it makes sense to pare back equity exposure to more defensive themes. Third, taking unnecessary foreign currency risk (read: to the US dollar in particular) seems like a dangerous luxury. [180° turnaround now required: the USD is the only game in town, in part because it’s the only global reserve currency in town.]

 

Whether the recent correction remains relatively benign or turns into something altogether worse, one should bear in mind that it has made all sorts of assets suddenly cheaper. Some of those “assets” will undoubtedly turn out to be falling knives, but some will turn out to be shrewd purchases in coming months. Lower prices in isolation – particularly if one struggles to find a compelling smoking gun – are no reason to flee the market.

 

As at October 2008, I only have one thing to add. If one’s portfolio asset allocation was sensible and prudently diversified before the Crash of 2008, it is probably sensible and prudently diversified now. There is obviously a premium for holding cash (and cash proxies including short-dated high quality government bonds), because such a policy a) conserves precious capital and b) will allow patient investors to wade in and start carefully to scoop up bargains as the savage bear market rolls on. In some cases in the equity market, we are already comfortably into bargain territory. The caveat here is that there will be plenty of investors, particularly those suffering from quite urgent time horizon constraints, eager to sell into rallies to make up for precious losses. So expect bounces, but don’t expect an effortless retracement to the markets’ former highs. We are unlikely to see their like for quite some time yet – another reason to view the equity market extremely selectively.

Diamonds amidst rubble

‘A COP:                      “Anything else that’ll stop the elevator from falling ?

 

 JACK:                         “The basement.”’

 

-       From the screenplay for ‘Speed’ by Graham Yost.

 

 

It comes to something when you make a habit of watching the opening Normandy landings sequence of ‘Saving Private Ryan’ just to relax. Where conventional fund management theory is hugely deficient is in its almost complete absence of reference to the emotional impact of huge volatility, let alone both mark to market and realised losses.  As Mike Tyson once said, everyone has a plan until they’re punched in the mouth. Though to be fair, behavioural economics addresses the cognitive and emotional factors that affect investment decisions. And there’s a book on my bookshelf with the title ‘Judgment under uncertainty: heuristics and biases’. But you can tell it probably wasn’t written by Woody Allen.

 

Amid multiple markets (certainly not just equities) tossed so brutally and seemingly randomly this way and that, heuristics (“methods to help solve problems, commonly informally”) are one of the few things of practical use. To address the ‘why’ of volatility: presumptions that investors are pricing in horrific global economic contraction may be very wide of the mark, although global recession (of indeterminate length) looks like a done deal. The role of widespread hedge fund deleveraging is surely closer to the heart of the problem. To address the ‘how’ of a pragmatic strategic response: short term policy rates are almost certain to be slashed. Notwithstanding future issuance, short-term government debt is the logical way for investors to play the anticipated monetary response. Yield curves are also likely to steepen to allow commercial banks to repair their balance sheets by borrowing at increasingly attractive short rates and lending long.  Away from the government bond market, battered equity markets are starting to reveal terrific promise. The logical reaction for investors looking to increase equity exposure (pound cost averaging also looks like the prudent way forward) would be to concentrate selectively on bombed-out growth stocks (the miners are a steal if valuations don’t deteriorate further), and to consider the time-honoured defensives: food; brewing; tobacco; utilities; consumer staples and in particular pharmaceuticals.

 

One of the first rational responses to a gale of fear and uncertainty is to try and remain calm. That’s the sort of advice you get during a nuclear air raid warning. But as John Hussman asks in an excellent edition of his weekly report,

“1) How many people do you know whose bank has failed and have had any difficulty recovering their deposited funds? Anyone?

2) Do you personally know anyone whose money market fund has “broken the buck” and has not received the full assurance of the government that their claims will be paid in full?

3) Have you yourself had any difficulty making any transaction (not tightly related to your personal credit rating) in any aspect of daily life such as credit card purchases, grocery, gas, shopping, or for any other purpose?”

John also suggested that

“The only thing we have to fear is the fearmongering of Wall Street itself.

“Look – a few weeks ago, there was a $700 billion pile of money on the table, but the only way for Wall Street and bureaucrats to get their paws on it was to scare the public out of its collective gourd. They succeeded, but created the psychology that the U.S. was on the verge of depression if the bailout wasn't passed. Having created that psychology, the crisis took on a life of its own.”

The next stage of the crisis, however, is real, inasmuch as it reflects the unholy mess that is the impact of Lehman’s bankruptcy (and other shock financial dislocations) upon the hedge fund industry. HFRI index returns for 2008, an almost unbroken wall of red ink, only show part of the pain; with redemption requests falling like autumn leaves, many of the more leveraged (and / or dumb and / or simply unfortunate) players will be fighting for their survival and selling assets wherever they can. As Paul Kedrosky points out, the great hedge fund unwind is under way. The investment media are not necessarily reporting the underlying reality behind current market action. Savaged equity prices may be reflecting fears about recession, but an altogether more plausible answer, as Paul suggests, is that

 

“the selling is about broken hedge funds being forced to sell whatever is liquid to respond to margin calls, and equities are more liquid than anything else they own, so they get sold.”

 

And with 3,500 hedge funds reportedly receiving margin calls from PwC while their assets are frozen in the wreckage of Lehman Brothers, and with plenty of panicked investors issuing redemption requests now and asking questions later, the great hedge fund unwind – with all its attendant volatility across multiple asset classes – will be with us for some time to come. So if the markets are overdue a bounce, that recovery will not exactly manifest itself in the form of an orderly straight line.

 

This will, in time, leave the very best hedge funds in a uniquely advantageous position. Their rivals will be liquidating themselves out of business while Wall Street proprietary desks – those that are left – will for an extended period be just a faint shadow of the belligerent force they were before.

 

These developments also leave private clients well positioned relative to their institutional peers. Unlike long-only institutional funds and hedge funds, private clients don’t have to report their performance figures – to anybody, over any time period. But like banks, private clients can also engage in the miracle of maturity transformation – essentially, by converting their ongoing income into longer term investments by means of their savings and pension funds. The financial storm may not have abated (note the anticipated further waves of hedge fund deleveraging), but the bulk of its fury is surely now spent. It leaves in its wake a number of hugely attractive opportunities in the equity market. When stocks like BP are available at forward price / earnings multiples of less than 5, and when the entire Japanese stock market is left trading close to book value at levels, in real terms, equating to where it traded in the early 1970s, one has to wonder whether private clients look very well positioned by comparison to bombed out hedge funds and sickly prop. desks who are either unable or unwilling to take on long-only bargains. Sensible asset allocation is still warranted, of course, but as regards the big picture: fear is still widespread, and valuations have been indiscriminately thrown around. Time to get, selectively, greedy.

Apocalypse Dow

“This notion that great misadventures are the work of great and devious adventurers, and the latter can and must be found if we are to be saved, is a popular one of our time. Since the search for the architect of the Wall Street debacle, we have had a hue and cry for the man who let the Russians into Western Europe, the man who lost China, and the man who thwarted MacArthur in Korea. While this may be a harmless avocation, it does not suggest an especially good view of historical processes. No one was responsible for the great Wall Street Crash. No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of thousands of individuals. The latter were not led to the slaughter. They were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich. There were many Wall Streeters who helped foster this insanity, and some of them will appear among the heroes of these pages. There was none who caused it.”

-       From ‘The Great Crash: 1929’ by John Kenneth Galbraith.

 

“Senator Couzens: “Did Goldman Sachs organize the Goldman Sachs Trading Corp. ?”

 Mr. Sachs: “Yes, sir.”

 Senator Couzens: “And sold its stock to the public ?”

 Mr. Sachs: “Yes, sir.”

 Senator Couzens: “At what price ?”

 Mr. Sachs: “At $104. The stock was split 2-for-1.”

 Senator Couzens: “And what is the price of the stock now ?”

 Mr. Sachs: “Approximately $1 ¾.””

-       From Senate hearings in 1932, and cited in ‘The Great Crash’.

 

Perhaps the biggest mistake Goldman Sachs ever made – other than launching its eponymous investment trust in 1929 – was its decision to go public in 1999. That enabled the former partnership to retain employees otherwise then being enticed by the prospect of dotcom riches, by means of share options and restricted stock. But it also turned a tightly focused private partnership into a public company. That involves a loss of independence. And as Chris Dillow recently suggested in a Times article (“Why aren’t hedge funds failing as fast as banks ?”), the current crisis is as much one of ownership as of finance:

 

“It is not markets that have failed, but a peculiar form of ownership that we have taken for granted for decades – stock market-listed companies with dispersed shareholders.”

 

As Chris points out, the succession of hammer blows to the market this year have come from stock market-quoted companies, not from hedge funds – which, despite the misplaced mudslinging from the more wilfully ignorant members of the financial press, are largely blameless bystanders in this colossal drive-by shooting. That is not to say that hedge funds will be immune to the ferocious deleveraging gale blowing wildly round the world, not least as the implosion of investment banks and reining in of credit provision may prove terminal to more highly leveraged strategies and funds. But in Chris’ opinion (which I very much share), the principal-agent problem is at the heart of the crisis:

 

“Big, quoted companies have been unable to solve this problem. Shareholders – often, ordinary people with pensions – have little control over fund managers. Fund managers have little control over chief executives. And chief executives have had little control over trading desks, partly because they just didn’t understand the complexities of mortgage derivatives.. In hedge funds [for example] things have been very different. Very often hedge fund managers invest their own money and take key decisions themselves, or at least closely watch those who do. Their incentives to take huge risks have been smaller. So these have at least survived [in general].. What we’re seeing, then, is the cost of separating ownership and control. In private firms, or partnerships – even limited liability ones – the two are closely aligned. In stock market-quoted firms, they are not.”

 

Maybe Goldman Sachs (which by now seems to have become a placement agency for the US administration) and Morgan Stanley survive as the last remaining former investment banks. Maybe they don’t. But if they don’t make it through this crisis, expect an orchestra of the world’s smallest violins to play to their demise. The taxpayers of the world are in no mood to indulge the whims of (what’s left of) Wall Street any further.

 

But the search for scapegoats has to be relegated behind the urgency of shoring up confidence in the financial system. By all accounts the UK’s bailout plan, revealed this week, takes the right tack. It seems increasingly likely that other countries will follow a similar interventionist model. But what is needed is coordinated action as opposed to piecemeal band-aid flinging. This weekend’s G7 meeting is an opportunity to prepare such action.

 

As Redburn Partners point out, the Dow Jones has now racked up the worst 12 month performance since 1932. The MSCI World Index has recorded its worst weekly fall since records began. When does it end ? There have been plenty of false dawns throughout the crisis but the UK rescue plan has ignited a glimmering of light at the end of the tunnel. But it needs bold and international follow-through. We will know that the low is in when the market stops going down after being hit by new bad news. For investors with some semblance of a balanced portfolio, it seems late in the day to be capitulating now and fleeing the stock market. Die-hard contrarians would be selectively buying (pharmaceuticals; consumer staples; the more solvent banks; telecoms; utilities). Gold still makes sense. Gilts still make sense in a big way as inflationary pressure subsides and the likelihood of slashed interest rates builds. Taking the longer view, the ‘BRIC’ countries – notwithstanding the likely hit to the global economy over the next few years – are still better positioned to deliver growth ; G7 economies will be close to exhaustion for some while yet. “The only thing we have to fear,” says ‘The Onion’s re-imagined 1933 US President in his inaugural address, “is a crippling, decade-long depression”. By all means have the witch-hunt. But do the triage first.

Armageddon outta here !

“Last night, Mr Brown made it clear he was ready to increase the level at which savers’ deposits were guaranteed from £35,000 to £50,000 but indicated he did not want to act until the markets had calmed.” – From The Financial Times, 1^st October 2008.

 

As part of my O-level history course back in the mid-1980s, I wrote an extended essay on the topic of the atomic bombing of Hiroshima in 1945. My teacher made the useful suggestion of comparing the Hiroshima experience and related issues with those of the Dresden fire bombings earlier that fateful year. Even now I’m not sure whether either action could be easily or wholeheartedly justified and as a non-combatant (and non-civilian, for that matter) of the time in question, it still seems somewhat presumptuous even to try. What I do recall is that I concluded my study with the words of historian A.J.P. Taylor:

 

“War suspends morality.”

 

I recall these words because I am now reminded of advice given me a year ago when the crumbling of the credit markets first became manifest to a financially less literate world. While I was personally wrestling mentally with the moral hazard issues surrounding banking bailouts and the like, a South African fund manager friend made the following pertinent observation: in a shooting war, don’t waste time scrupling over moral hazard – the objective is survival. Politicians across the board and across the world seem dangerously unaware of the severity of this crisis, and of the risks they pose by indulging in partisan bickering when political leadership (sic) is so desperately needed and simultaneously so horribly deficient.

 

A year ago I was watching the run on Northern Rock from a hotel room in Rome. This time round – a full year into this crisis – I was watching certain members of the US Congress effectively voting for some sort of suicide pact from a hotel room in Sicily. Perhaps I should be forbidden from going on holiday. But watching the venal self-interest of Republicans (and some Democrats) blooming with some disbelief, it was almost easy to paraphrase the words of Bank of America CEO Ken Lewis, in that I’ve had all the fun I can stand in investment management.

 

But one of the many benefits of a short break was the opportunity to read, and re-read, Robert Shiller’s timely analysis of how we got here, ‘The Subprime Solution: How today’s global financial crisis happened, and what to do about it’ (Princeton University Press, 2008). Professor Shiller begins his measured and constructive study of the current financial debacle with an apposite quote from the master himself, John Maynard Keynes:

 

“A general bonfire is so great a necessity that unless we can make of it an orderly and good-tempered affair in which no serious injustice is done to anyone, it will, when it comes at last, grow into a conflagration that may destroy much else as well.”

 

Keynes was writing about the economic consequences of the overly punitive Treaty of Versailles imposed upon a defeated Germany in 1919. The analogy of an all-consuming fire is just as appropriate now. And I for one am getting increasingly disgusted at the sight of politicians fiddling while our entire financial infrastructure burns. The fire metaphor was also used by Henry Steagall, chairman of the House Banking and Currency Committee, in 1932:

 

“Of course, it involves a departure from established policies and ideals, but we cannot stand by when a house is on fire to engage in lengthy debates over the methods to be employed in extinguishing the fire. In such a situation we instinctively seize upon and utilize whatever method is most available and offers assurance of speediest success.”

 

Something tells me we may hear more of the name of Steagall, for it was Henry Steagall who helped establish the Federal Deposit Insurance Corporation and it was Henry Steagall who, by means of the Glass-Steagall Act of 1933, helped prohibit bank holding companies from owning other financial companies including the sort of broker-dealers who have helped ignite the current bonfire. Those provisions were repealed in November 1999. They should never have been allowed to. Perhaps Goldman Sachs and Morgan Stanley will survive as newly converted bank holding companies. Whether they do or not, their future earnings prospects look frankly, for want of a better phrase, subprime.

 

Professor Shiller cites Benjamin Friedman and his 2005 book ‘The Moral Consequences of Economic Growth’ which suggests that “when people see encouraging prospects for the future, they are better able to work together constructively, supporting democratic principles and political and social liberalization. When perceived prospects for growth falter, there are major setbacks..” In much of the world and particularly in Europe, the Great Depression of the 1930s led in turn to squalid outcomes like fascism, anti-Semitism, racism, nationalism – and ultimately a world war. But the US, by contrast, “stands out as an exception – in many respects the exception” to Friedman’s theory. Now, in 2008, it would truly be a tragedy if the US were to join the rest of the world in a retreat to profitless fingerpointing and mudslinging before confidence in the financial infrastructure was shored up by government action.

 

Comparisons with the 1930s are no longer grotesque overreactions. Since there are no private entities with the resources to recapitalise the banks, it will be left to governments and taxpayers to do the job, provided politicians can abandon their differences and finally acknowledge the threat posed by a systemic meltdown in financial confidence. But the US bailout is not a bailout solely for Wall Street interests. As the author behind Accrued Interest makes clear, if bank lending disappears, so in its wake does the housing market; secondary education; small business foundation.. Whether we like it or not, we live in a society largely built and dependent on the free flow of credit.

 

As to matters of investment, the advice remains what it has always been. Capital preservation trumps ‘growth at any cost’. Cash remains king. Fretting about bank stability is missing the point: have any depositors anywhere been allowed to lose one penny of their deposits yet ? The monetary metals still represent a superior store of value than any form of paper. The arguments for government bonds just get louder, notwithstanding the imminence of greater supply. And for those investors with the psychological resources to see beyond the fog of the present, shares in well-run businesses and well-run managed funds are starting to look (and certainly feel) compellingly attractive longer term buys. A final note on equity market pricing. If equity prices and the prices of other financial assets go down relative to our incomes or purchasing power, we become wealthier rather than poorer. This is not meant to be a sophistic argument. The danger would simply be for governments to try and shore up (housing and equity) market values – as opposed to credit availability – at unsustainable levels. So it may not feel like it – human beings are not hard-wired with the contrarian instincts to be successful investors – but we may actually be sitting on the cusp of opportunity. In the interim, nobody ever promised us a rose garden.