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Over 140 years ago, German biologist
Ernst Haeckel developed the idea of an evolutionary family tree. Calling this visual aid for
ancestor/descendants relationships phylogeny, he sought to map out a logical
categorization of organisms. The
idea was to make evolution much clearer for the scientifically
uninitiated.
But it lacked the rigor that science demanded and
did not take into account the simplest of facts: ancestors pass down traits
but each new species is an evolutionary dead end.
Something happened the other day that might reveal
just such a financial cul-de-sac.
Does the worldwide plunge in stock indexes signal the eve of a new
financial species?
Far too many investors disregarded economic news - good or bad. With an appetite for risk and a thirst
for free flowing, cheap cash to fuel that appetite, they simply plowed
forward. Those days may have come
to an end.
For investors who actively manage their portfolios,
the past days have left them frantically parsing each tidbit of news
wondering what new twist will affect their holdings. Economist and money
managers have been trotted out offering some of the best metaphors, each
lovingly adopted by Wall Street historians for just these types of events. “Don’t
try to catch a falling knife,” one said while another suggested
investors “keep the powder dry”. Both are references to a “wait
and see” approach, the hallmark of a more conservative, long-term
investing philosophy and not necessarily advice.
Yet, the recent sequence of events seemed to leave
even these sage investment experts baffled. The requisite reassurances were
proffered and expected after such a fierce and unexpected gyration but they
all seemed shallow. Long-term
investors were told ‘that they need not worry’. It was advice no doubt given by
analysts with one eye on the ticker.
Many concluded that one possible trigger for the
recent worldwide drop in stocks was the Yen carry trade. This news caught
both novice and experienced investors by surprise.
The Yen carry trade thrives on low volatility. It is
important to keep in mind that when low volatility thrives, the largest investors
have greater difficulty predicting potential losses, which in turn permits
riskier borrowing strategies. Okay,
but why would this affect the plain vanilla index
fund investor?
The carry trade works
like this: An investor buys currency (borrows money) from a bank offering low
rates. The money is then
exchanged for dollars to buy a bond, preferably one with high yields and good
quality.
The Yen, which has been
available at a 0.5% interest rate, was the prefect currency to borrow. By borrowing in Yen, trading that
currency for dollars and then using those dollars (the carry) to buy high
yield bonds, investors profited from the difference. When rumors surfaced that Japan may be
considering yet another rate increase, investors panicked, flocking in a
so-called flight to quality to US Treasuries. This pushed up prices and
yields fell closing the profit gap further.
Or it may have started in
China. The Shanghai Stock Exchange has been on a tear of late – up 174%
since mid-2005 largely fueled by easy credit. Individual investors jumped into the
markets leveraging their houses in the hopes of catching the upward
surge. These novice investors
panicked when rumors surfaced that the government was debating a capital
gains tax to help slow the fast growing economy.
This sent ripples through
the commodity markets as well. The phrase Asian
Contagion, a throw back to a 1997 event that started when former then
chairman of the Federal Reserve Board Alan Greenspan suggested
“irrational exuberance” has surfaced again
Classic Greenspan
doublespeak was now suggesting that a US recession is possible. It is a sort of retraction from a
comment he made in Hong Kong predicting that a year-end downturn was
probable. What better way to promote his upcoming book ”Age of
Turbulence”?
Sandwiched in-between is
Mr. Greenspan’s replacement, Ben Bernanke. The Fed chairman has attempted to
remain resolute in the face of so much unwarranted white noise.
In a time gone by, the
current Fed short-term rate would have performed as expected. It would have moderated inflation
while keeping employment at a sustainable level. Although Mr. Bernanke has begun to
question this inflation/employment relationship, the 5.25% level seems about
right. But you have to wonder how long he can ignore some of the economic
cries for help on the home front.
The US role in the global
economy has evolved. Our appetite for goods has kept equity markets both here
and around the world well lubed.
Increasing the cost of borrowed money domestically has succeeded in
slowing our economy. How slow is
slow enough?
The homes-for-sale
inventories in the US have skyrocketed.
There are now roughly four new houses available for every one
buyer. Sub-prime financial
institutions have failed to set aside enough cash to cover their risky bets
and now, the gray market, the one nestled in-between poor credit quality and
excellent is beginning to feel the crunch. GDP has been revised
downward.
After all the dust
settles and it may after a few more exciting percentage point drops in the
next week, will we be witness to a new breed of investor? Will this new investor be a shell-hardened
predator steeled by several jarring downturns able to slough off the
correction as nothing more than potholes or something wholly opposite?
We hope that Mr. Bernanke
realizes that we are no longer alone.
Events unfold around us in far-flung corners where we never expected
our investments to venture. While this is neither good nor bad, it presents
us with a new global reality
Dr, Haeckel would
be tempted to add a new branch to this global family tree. But only if we
have successfully changed into a new species of investor; one that brings a
healthier respect for risk and volatility to our investments; one who is able
to navigate this new worldwide landscape with skepticism and do so with the
understanding that this is just the beginning.
Paul Petillo
www.BlueCollarDollar.com
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