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  • A Brief History of Asset Bubbles (part IV)

    This week’s article marks the conclusion of series of pieces on trends in the global economic landscape. In this edition, we outline the main investment themes and opportunities that have been created by what might be the biggest bubble in recent memory: The financial crisis of 2008.

    Please, click the following link for part I of our piece on asset bubbles.
    Please, click the following link for part II of our piece on asset bubbles.
    Please, click the following link for part III of our piece on asset bubbles.

    What goes up must come down
    – Sir Isaac Newton (1642-1727)

    It is likely that we are transitioning from a period of declining inflation to a period of rising inflation, similar to what happened in the mid- to late 1970s. While this may take some time to play out, the thesis is built on the following:

    1) Governments and central banks have “solved” a crisis created by excess liquidity (the credit crunch) by spending and borrowing even more. History has shown that the only outcome of reckless fiscal and monetary policy is higher prices. In other words, printing money to boost growth at any cost will trigger rises in inflation.
    2) The credit crunch will limit capital investment, meaning that capacity constraints will become more of a threat, and thus raise the likelihood of rising inflation.
    3) The “easy money” from globalization has already been made, and we have run out of countries with declining unit wage costs to outsource to, which is also inherently inflationary.

    In addition, because of the credit crunch access to debt and securitized debt issuance will be limited going forward, meaning that there will be less leverage in the corporate sector. Because the global economy is built on debt, expect several years of lacklustre growth, particularly in the developed world. The next cycle will be all about survival, so corporate health will hold the key to who emerges a winner.

    Keeping all of this in mind, crisis breeds opportunity, and although it will be difficult to grow your wealth via investing in a “stagflationary” environment (low growth with high inflation), there are several ways that one can at least preserve their wealth.

    1) Focus on “real” assets… Be really picky in real estate

    Simply put, in the current environment, rising commodity prices will lead prices for essential items such as food and gas. In an effort to counteract rising costs of living, investors should buy into food, energy, and precious metals. Already, gold has broken out to new highs in recent weeks, and oil has more than doubled since bottoming almost a year ago. There is potential for more upside, however, especially in precious metals. As we have highlighted previously, after adjusting for inflation or growth in the money supply, gold is still cheap from a longer-term perspective. Property normally also does well in an inflationary situation, but for those who wish to buy real estate the key will be to make purchases in places that have not experienced a boom/bust (such as Germany).

    Gold prices from 1970 to 2009
    Gold prices in constant Dollars
    * Prices deflated by U.S. Consumer Price Inflation

    2) Favour stocks in companies with strong balance sheets

    Credit will be much harder to come by in the future, and should one be “fortunate” to be able to borrow, the terms will likely be materially less favourable that they have been in recent years. Following this logic, companies that are less levered (to debt) will have the best chances of survival, and even better if they have positive net cash positions.

    Our ranking system is designed with this in mind, and selects companies with solid balance sheets and growth prospects. Click here to learn more…

    3) The U.S. dollar is toast

    With the exception of during periods of economic and financial market stress, the U.S. dollar has declined materially over the last decade. This is reflective of the sloppy fundamentals of the U.S. economy: A persistent current account deficit, record fiscal irresponsibility, unfunded pension liabilities, defunct housing market, excessive leverage, and so forth.

    U.S. Dollars Trade-Weighted


    With the above showing no signs of changing anytime soon, this is no time to be “bottom-fishing” the greenback. The banking system is in a shambles and it will be years before credit problems are resolved to a degree that will permit a steady expansion of the U.S. economy. Continue to avoid banks and consumer discretionary stocks, but stay in commodity- and export-related plays as they may continue to benefit as the dollar weakens further.

    4) Favour cash over bonds. For fixed-income investors, shorten duration and avoid spread product and most corporate bonds.

    Higher inflation means higher interest rates and lower bond prices (one way to counter this may be to invest in real-return bonds). Higher rates also mean slower growth, which adds an additional dimension of risk to corporate bonds. Furthermore, the level of disenchantment with fixed-income products is extremely high, and will take several years for the stigma surrounding this asset class to dissipate. Quality is the key word here, and the only sector with the potential to make money is high-quality (top-notch investment-grade) corporate bonds in real industries: The value is there and has the highest chance of outperforming other types of bonds. Spread product in the U.S. is flat out worthless after controlling for the value of the U.S. dollar: The country is bankrupt, so risking your principal for a few extra basis points does not make sense in this environment.

    U.S. 10-year Treasury Yield

    Happy trading,

    Jason F. Moschella
    Consulting Editor

    Disclosure: No positions at the time of writing.



    Disclosure: No positions
    Dec 01 9:47 AM | Link | Comment!
  • A Brief History of Asset Bubbles (part III)

    Over the next few weeks, I will be writing a series of pieces on trends in the global economic landscape, and what the implications of these trends are for investors. In this edition, we take a look at what might be the biggest bubble in recent memory: The financial crisis of 2008.

    Please, click the following link for part I of our piece on asset bubbles.
    Please, click the following link for part II of our piece on asset bubbles.

    What goes up must come down
    – Sir Isaac Newton (1642-1727)

    Because the global financial system is heavily levered and dependent on debt, a prolonged downturn in growth can have devastating consequences for the economy. Policymakers are cognisant of this, which is why they attempt to buoy the real economy via expansionary monetary policy (i.e. more debt). The result of this is that the economy begins each cycle from a higher level of leverage and the lack of purging of prior excesses leads to even greater vulnerability and thus a greater necessity to continuously limit the downside of the economy. This phenomenon is commonly referred to as the debt “supercycle”.

    OECD Broad Money Supply - GDP

    At the turn of the century, the bursting of the tech stock bubble amid a fragile global economy was of great concern to policymakers. As a result, interest rates were relaxed significantly all over the world, creating a housing bubble in the process. Similarly, over the past two years, global central banks and governments have slashed rates to near zero and have implemented, to varying degrees, quantitative easing programs and stimulus packages designed to spur economic activity.

    In many respects, the financial crisis of 2008 resembles what happened in the savings and loan crisis of the late 1980s, where a collapse in the commercial real estate completely shut down the securitized debt market and junk bond market. Like in the 1980’s, aggressive policy easing provided an incentive for financial institutions to lend to higher risk borrowers. Heading into 2004 and 2005, financial innovation turned into mutation as CDOs and other new structured financial products were purchased by a large pool of investors seeking yields exceeding those on government debt, given that yields on government securities were at secular lows

    US-10-year-treasury-yield

    The credit bubble followed the historical script almost to the letter, with spreads on virtually all non-government securities being driven to record lows and deep into overvalued territory. Investors were sobered in February 2007 when house prices moved against the consensus that they would rise “forever”. Naturally, this posed a significant threat to the balance sheet health of financial institutions, and to this day we have yet to see any concrete evidence that bank write-downs will stop. Stocks tumbled, bond spreads spiked, and yields on short-term government securities were pushed downward as investors dashed for cash.

    S&P 500 Housing Bubble Crash

    However, the consensus remained that the problems in the U.S. housing market were isolated and would not have knock-on effects to the rest of the economy. Credit problems returned with a vengeance, sending stocks into a bear market. The Federal Reserve capitulated and has pulled out all the stops to reflate the U.S. economy and bail out the ailing financial system. In addition, the world’s other major central banks have joined the party in attempting to restore order in the credit markets, with the ECB, Bank of England, Bank of Canada, among others, having injected over USD 1.5 trillion into the system. While the coordinated action of central banks and government appears to have limited the damage caused by the financial crisis, the underlying problem of too much debt in the system remains. The only difference is that now, government is doing the borrowing in lieu of the private sector.
     

    Fast forward to today. The stock market appears to have bought into the idea that a recovery is here. After all, earnings are beating expectations and recent economic releases have been encouraging (or not as discouraging with respect to employment). So what’s next? We’ll look at the investing implications of the methods employed to alleviate the crisis in our next piece. Stay tuned!

    Happy trading,

    Jason Moschella
    Consulting Editor

    Disclosure: No positions at the time of writing.



    Disclosure: No positions
    Tags: Debt, Bonds, Housing
    Dec 01 9:44 AM | Link | Comment!
  • A Brief History of Asset Bubbles (part II)

    Over the next few weeks, I will be writing a series of pieces on trends in the global economic landscape, and what the implications of these trends are for investors. In this edition, we continue our examination of prior well-known asset bubbles in order to better establish a context and an investment philosophy for the coming years.

    Please, click the following link for part I of our piece on asset bubbles.

    What goes up must come down
    – Sir Isaac Newton (1642-1727)

    Inflation across the world surged in the 1970s following rampant increases in commodity prices and over-spending by government in response to the baby boom in the preceding decade. The major developed economies, led by the United States, unable to maintain the gold standard due to persistent trade and current account imbalances, call on the IMF to create a new synthetic currency, which essentially severed the ties between these countries’ currencies and gold. Investors flocked to commodity markets en masse following this decision out of fear that the ability of governments to print money without retribution would cause inflation to spiral out of control. Gold enjoyed a spectacular run, rising tenfold from 1973 before peaking intraday in February 1980 at $850/oz.

    Gold Prices


    Even after having adjusted for inflation, gold prices have yet to breach the highs observed almost thirty years ago. Towards the end of the mania, futures exchanges raised margin requirements in response to increased volatility and speculation in the precious metals markets, and an unanticipated bold move by Fed chairman Paul Volcker in the late 1970s to tighten policy in an attempt to rein in inflation provided the deathblow to commodity markets and also triggered a brutal global recession.

    Gold Prices in 2008 Constant Dollars
    * Prices deflated by U.S. Consumer Price Inflation

    Manias in the 20th century were not confined to the U.S., as investors became infatuated with Japanese shares and property in the late 1980s. Japan had been enjoying robust economic growth since the 1960s, and the deregulation of the financial industry in the early 1980s resulted in an aggressive increase in mortgage lending and small- and medium-sized loans. Property prices skyrocketed and the stock market soared. P/E ratios expanded materially and valuations became stretched, with earnings yields (calculated as 100 divided the price-to-earnings ratio) falling well below bond yields during this time. The boom in property and stocks busted after tighter monetary policy and moderating global growth in the wake of the collapse of the U.S. commercial real estate and junk bond markets and triggered an unprecedented decline in both equity and real estate prices and debt deflation. Japan is still reeling from the crisis of the early 1990s as economic growth remains lacklustre and stocks have failed to rebound materially following a 70% decline since the early 1990s.

    Nikkei 1990 Bubble
     

    Technology shares exploded in the late 1990s as excitement relating to the Internet and the “new economy” gripped investors globally. Nasdaq stock prices increased tenfold after the U.S. economy came out of recession in 1991, with the majority of the gains being observed in the latter portions of the decade. Consistent with previous episodes of “manic” behaviour, prices overshot fundamentals by a vast margin, with P/E ratios on the Nasdaq index soaring to over 60. Valuations, as measured by equity earnings yields relative to investment-grade corporate bond yields became ridiculous and completely detached from underlying prospects for growth (earnings yields were 1.5% compared to investment-grade corporate bond yields of approximately 7.5%.

    NASDAQ 2000 Bubble


    Again, it should be fairly clear that while markets can behave normally most of the time, the fact that markets are merely an extension of human impulses makes them vulnerable to the same distortions that human behaviour can succumb to. In our next edition, we’ll take a look into one of the largest bubbles (and bursts) in human history: The financial crisis of 2008. Stay tuned!

    Happy trading,

    Jason Moschella
    Consulting Editor

    Disclosure: No positions at the time of writing.



    Disclosure: No positions
    Dec 01 9:41 AM | Link | Comment!
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