Boiling a frog

Al Gore was describing the extent to which glaciers were receding all over the globe. Slowly, according to our own perception, but dramatically if you were to suddenly jump a couple of decades by comparing two photos taken before and after.  His analogy was brought home by showing 2 ways to boil a frog. Either you can bring some water to boil and then put a frog in it, in which case the frog will receive a shock and jump out immediately. Or you can put the frog in the saucepan at room temperature and slowly increase the heat. This way the frog is very comfortable and seemingly unaware of what it happening to him.  He becomes successively accustomed to ever higher temperatures. By the time he realizes that the saucepan is too hot for his liking its too late. Someone has put the lid on.

At first credit just makes everything a bit easier and accessible. It enables students to pay for college and new families to buy a house. Managed within limits it makes a great deal of sense. Taken a step further it even becomes exciting. Assets prices start rising, which creates the ability for further credit creation. Then prices and credit spiral higher in an apparently virtuous circle. Before long everyone suddenly seems to have access to more money than they could earn, creating a spending boom. Why should anyone want to stop such a glorious process? Come in the water feels so warm and nice. Before you know what, there is no end in sight to the rising level of debt. It becomes too much of a risk to stop the process, so yet more credit has to be created to keep the whole thing going further still. It has been rising so high for so long that no one dares to stop the process as shown below. Normal behaviour starts to change as people become accustomed to growing rich by doing very little. Asset prices always rise and access to credit is always available, so no-one needs to work too hard. Borrowing and spending become the norm. Saving, direct investing, sweating hard and living within our means? Not so much.

 

The thing about debt

“If there is a lot of debt, a small error in our appraisal of asset values can be fatal because leverage magnifies mistakes.”  - Jean-Marie Eveillard.

Most people are familiar with the story of Long Term Capital Management (LTCM), the hedge fund that went bust in the summer of 1998. With their Nobel Prize winning brains they leveraged up to $100bn in assets on just $4.7bn in assets, and, by the way, also had an additional $1 Trillion in derivative bets. When you are this leveraged it does not take much to blow yourself up, however smart you might think you are. 

The US economy has become a uniquely financial or leveraged economy. This means that there is a record amount of borrowing and lending, just look at the credit card or mortgage business. The number of Hedge funds has exploded, along with the size of outstanding derivates.  Alan Greenspan explains that derivatives allow great flexibility and spreading of risk, but J.P.Morgan alone has $27 Trillion in outstanding derivatives, that is almost 3 times the size of the US economy’s annual GDP. Like the Nobel Prize winners at LTCM, it is easy to make the case that theoretically all will be well.

It is just as easy to explain the growth that the credit boom creates as remarkable underlying strength in the economy, with incredible productivity and profitability. Just don’t look under the hood and we can all believe it’s not just the biggest credit boom anyone has ever seen.

In the end, however, the truth is revealed, but there is a great deal of damage done in the process. In the beginning there seem to be more winners than losers, but in the end it swings around are few winners can be found. The chart above shows the mountain of credit that will become the monument to Alan Greenspan’s stewardship at the Federal Reserve. Alan Greenspan took over the helm at the Federal Reserve in 1987 and the chart shows how more than anything else credit expansion has been the hallmark of his tenure. As a percentage of GDP credit market debt has now exceeded the peak during the 1920-1930 period. Greenspan has always been ready with yet more credit and liquidity whenever there has appeared to be an economic or market “problem”. However, he never takes it back once the “crisis” passed.

Easy policy has always been the Federal Reserve’s bias under Greenspan. Even now after 9 months of rising interest rates, real interest rates are still around zero, depending on how you measure inflation. This is still a highly stimulating level. If they really thought the US economy was entering a strong sustainable period of growth, which is the impression they like to foster, current policy is still remarkably loose. Clearly they are more concerned than they let on, and the real reason is that their history of excess credit creation has produced a very unbalanced and possibly fragile recovery. So they continue to worry and continue to keep an excessively easy bias, even when they are tightening policy ever so slowly.

What’s an investor to do?

To understand how to go about the job of investing, therefore, we crucially have to appreciate the consequences of a persistently easy policy bias. Excessive credit has principally three outlets:

1. higher prices of goods and services,

2. rising prices of financial and tangible assets,

3. rising trade deficit.

This is the reality that we now see very clearly. However, the Federal Reserve will always deny this, they can never admit to excessive credit creation. Indeed the Federal Reserve has to turn things upside down on occasion to maintain their credibility. Ben Bernanke’s recent speech was remarkable in this regard. He suggested that a “global savings glut” was the cause of US trade deficits and low long term interest rates. Coming from a central bank representative of a country with a zero savings rate this is rich indeed, particularly on top of his previous statement that the Federal Reserve could always resort to the printing press to avoid deflation.  But this seems to be the language that politicians like to hear and Ben Bernanke now seems destined for promotion to a White House post.

So much for the Federal Reserve. Our beat is investments, but this background is highly hazardous for investors, particularly when credit expansion reaches a highly mature phase, as it is now. We are already makings records on the trade deficit, the CRB has broken 10 year highs and is currently as far above it’s 200 day moving average as we’ve seen. Also asset prices across the board from house prices, to equities are all at record valuations. It is hard to make money as an investor when so much is already highly valued.

The most successful investors of recent decades have a simple solution – cash. Warren Buffet has $43bn of cash in Berkshire Hathaway. He has had this level of cash now for over a year. He looks for something to buy every day but nothing qualifies as good value. He has learnt from experience that the best thing to do is simply waiting. Similarly Scott Van Den Berg whose firm Century Management has achieved over 15% annual return for 30 years, has no problem explaining to his clients why he has 60% in cash throughout 2004. He looks at valuation a little differently but has very valid concerns about current levels, and very clear criteria for buying stocks.

Most of us investing mortals find this level of abstinence quite difficult. If so it is key to distinguish between trading positions and investment positions. With a diverse set of assets each with predefined risk management it is possible to potentially prosper in the current environment while protecting your capital. The trick is to realize that although we cannot know how or when good valuations will return we need to have a clear understanding that this has now become a very dangerous investment environment. The transition to low valuation levels is never easy.

The endgame of a credit cycle is so problematic because there is apparently no end in sight for a committed central bank’s credit creation. They can almost indefinitely extend credit, even when they are raising interest rates. This creates an environment in which risk is continually encouraged and support is always forthcoming in the case of a set back. However, if there is no restraint applied sooner or later the discipline has to be applied by investors, and the risk is that at some point credit stops abruptly.

In the current situation the role of international investors has become key in this regard, for it is they who will impose the discipline. While they have been coerced into providing support for the Federal Reserve’s extravagance in order to boost world growth, there are growing signs that even they are reaching their limits. 

Summary

We all need to understand that we are in the Greenspan easy money era. We can’t know when or how but sooner or later this era will end. Perhaps the greatest investment challenge in the next few years will be surviving this transition. The era is clearly mature as the current account deficit has already reached an extreme and asset prices across the board are at high valuations.

The investment geniuses of our time see no issue with holding a huge percentage of cash in the current circumstances and so this should be regarded as one approach. But clearly this is a time where we should be very careful both with our own level of debt as well as the level of debt in any assets we own. 

Beyond this we need to be flexible in our investment approach. While there is still a high bias in favour of stimulating the economy, and growth can always be extended a little bit further in the current expansion, we are at a stage where this could go badly wrong at any time. There are always opportunities but we need to make sure that risk management is in place to protect capital.

For investors who are always committed fully to the market, it is tempting to believe that the Federal Reserve will always bail you out. Unfortunately, at the end of the credit cycle they become unable to do so one way or another. We all have to understand the game we are in if we to survive let alone prosper.

 

 

 

 

Notice

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

Communications from the author are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors, and other contributors do not necessarily reflect the opinions of the author, and should not be construed as an endorsement by the author, either expressed or implied. The author is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided “AS IS” without any warranty of any kind. Past results are not indicative of future results.