Inflation Control Debate Underway in Canada: Why We Need to Pay Attention

Inflation is one of those things where most often the best a citizen or investor can do is not lose ground. Whether it is a salary that does not keep up with rising expenses (just today, Canadian Capitalist was justifiably moaning about huge increases in home insurance premiums) or GIC rates that do not compensate for inflation even before taxes, we always seem to be one step behind or losing ground. The problem is especially acute for retired people where normal annuities are not indexed and a pot of money must suffice for ever longer life expectancy.

That there should be inflation is government policy. The target, characterized as "low inflation", is currently at 2% and allowed to vary within a 1 to 3% range according to the organization mandated to make sure that happens, the Bank of Canada.

Right now, the debate about how much inflation is to be created or allowed is wide open. The reason is that the five-year agreement between the federal Minister of Finance and the Bank of Canada on the target and the system to measure or control inflation expires at the end of 2011.

The most visible part of the debate, though no doubt there is lots going on behind closed doors at the Bank of Canada and the Ministry of Finance, and invisible to us ordinary schmucks, seems to be emanating from the CD Howe Institute in a series of reports. The main issues and/or suggestions include whether to:

• lower the target rate for CPI increases from 2% to 1.5%, 1.4% or even 1%, about which I ask, why not a zero percent inflation target?
• replace inflation targeting, which we have now, with price level targeting; "The key distinguishing feature of price- level targeting is that shocks pushing the price level off its intended growth path must be recouped, meaning that a temporary rise in inflation above 2 percent must at some point be offset by future inflation of less than 2 percent. In contrast, with inflation targeting, the same positive inflation shock is subsequently reversed, but not recouped: for the price level, bygones are bygones." (from Precision Targeting: The Economics – and Politics – of Improving Canada’s Inflation-Targeting Framework by Christopher Ragan at CD Howe). In other words, with price level targeting, we don't have a permanent loss of purchasing power that we somehow have to try to recoup on our own under inflation targeting. Why not let the Bank of Canada do the job for everyone through price level targeting?
  
• mandate the Bank of Canada to include control of asset price bubbles as one of its objectives in setting monetary policy. That goal does not form part of its mandate right now. Why not have the BOC prevent asset bubbles? In the last ten years we've had the painful High-Tech stock bubble and the USA/European housing bubble. Though the housing bubble that caused the 2008 crash wasn't in Canada and thus would not have spurred BOC action, would not such a policy be worth it for all central banks? Would it not have been less painful to avoid the big crashes? No doubt there would be costs and possible downsides but maybe they are less than the damage of recurring asset crashes. Authors like Robert Barbera in The Cost of Capitalism (my review here) make a reasonable case for central bank control of bubbles.
  

Do a Google search of the phrase "too important to be left to the experts" and you will find it popping up in any number of contexts - health care, finance, biotechnology, war, science and in general. If we don't say something, inflation will surely be done to us for "our own good" though we may not like the result.

Index Investing Becoming a Victim of Its Own Success

Too much of a good thing can end up being bad. That includes using a benchmark index as the basis for an investing apparently.

In the July 2010 paper (download here from SSRN; acknowledgement to Stingy Investor where I found the link) On the Economic Costs of Index-Linked Investing, NYU prof and NBER research associate Jeffrey Wurgler reviews some research results that are disquieting for investors who follow a passive index strategy based on popular indices such as the S&P 500.

Wurgler says: "... the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits ..." The problems:

• the inclusion of stocks in the index pushes up prices, by around 9% around the time of the event, a factor that has been getting worse as indexing has gained popularity; this effect is observed for other indices besides the S&P 500, like the TSX 300 (now the delicately named TSX Composite, which hides the fact the fact that it has been shrinking steadily in number of stocks over the years to 235 today)
  
• active managers who are benchmarked against the index have an incentive to overweight index members, even if they think a non-index stock will appreciate the same percentage, due to lesser tracking error
• stocks that join a leading index such as the S&P 500 suddenly begin to move much in tandem and keep doing so, which Wurgler vividly likens to the movements of a school of fish; he calls this effect "detachment"
• the S&P 500 school of fish members moves on their own and less like the overall market, a net loss of diversification for the investor
• S&P 500 membership has in the past over the long period of 1980 to 2005 conferred an increasing price premium; he cites one study that found the S&P 500 stocks got an 82 basis point annual alpha return premium; while it might seem like a good thing to get a hefty excess return, he says it might be a sign of an "indexing bubble" that will sooner or later deflate
  
• as a consequence, bubbles and crashes are more likely; he discusses the mechanism that may explain both the 1987 crash and the May 2010 flash crash
• the risk and return relationship actually does not hold - low beta(risk) stocks have been found to generate better returns, by a lot, than high beta stocks, a phenomenon he rightly calls a spectacular anomaly; he explains how fund managers benchmarked to an index will favour high beta stocks
• he raises the possibility that the S&P cap-weighted index amounts to a strategy of large-cap growth and momentum ... "Clearly, the line between passive and active investment is blurrier than usually presented."
  

Here's another juicy quote: "the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index—it may actually be contributing to their underperformance."

What does he suggest one do about it?

• instead of the S&P 500, pick a broader index like the Wilshire 5000 - "The S&P 500 Index's detachment means, however, that it is reflecting less and less the performance of the full stock market. Index funds based on the more comprehensive Wilshire 5000 (which has included as many as 7,200 stocks) are now providing more robust diversification and stock market exposure."
• exploit the observed "spectacular anomaly" through strategies that focus on low-beta stocks, e.g. employ maximum Sharpe ratio, minimum volatility and absolute returns, though I'd guess that is probably beyond most individual investors' capability

It's the inverse of the dictum that the market only moves towards efficiency if people exploit and thereby remove the inefficiencies - if too many people assume the market is efficient and therefore invest in passive index funds, then the market becomes more inefficient. A delightful irony indeed!

Tale of Guaranteed Seg Fund Payout Epitomizes How Bad They Are

Toronto Star columnist James Daw's Dentist finally collects tech-stock profits story on a dentist who during the tech bubble bought one of those Principal Protected Note funds that guarantee your money back in ten years if you lock in profits after a rise epitomizes what is wrong with those products.

Despite using the lock-in feature, Daw reports that dentist Millar:

"Someone who invested $100,000 when Millar did would have seen market losses and stiff annual fees erode the fund value to only $48,500 as of a few weeks ago.

But Transamerica would have paid $123,000, the value of the fund at the last guarantee reset. That's was only an average annual return of about 2.1 per cent, just enough to have kept up with rising consumer prices."

I don't know why Millar is so happy. Even with Millar's smart lock in timing, he only made 2.1%. There is a tech ETF, the Tech Select Sector SPDR (XLK) whose annualized total return from inception in December 1998 (i.e. the mid stage of the bubble) to March 2010 was negative but only minus 1.6%. The Daw article doesn't say exactly when Millar bought (I'm guessing it was earlier and at a lower tech market price), but the fees ate up most of the protection for Millar.

Financial Bubble Still Here with Yet More to Unravel?

Is there such a thing as a secular financial bubble? Has the financial sector become bloated out of proportion to the economy over the last few decades and is there be a contraction in store, abrupt or prolonged, back to a smaller financial sector? Was the crisis of 2008 merely the start?

I'm not sure of the answer but a couple of data points have stuck in my mind recently:

1) Below is a copy of two charts from the paper Fundamental Indexation by Rob Arnott, Jason Hsu and Philip Moore. Note how the Financial sector, both on a cap-weighted market value basis, the upper chart, termed the Reference Portfolio and on a fundamental accounting basis, the lower chart, has expanded steadily since the 1970s and now has become the dominant sector of the US equity market. By comparison, the Tech bubble was a fleeting aberration, now absent from the trends. In the same charts, updated to June 2007, found in their book The Fundamental Index, there was only a slight pullback in the share of the Financial sector in the Fundamental chart while the market value chart looked the same. Unfortunately, there are no numbers visible so it is hard to compare with today's data and I wish and hope that the folks at Research Affiliates where messrs Arnott et al work will do updates.


2) Financials have bounced back from 11.6% of US total market cap at the end of February 2009 to 16% in 2010, according to the proportions of holdings in Vanguard's Total Stock Market ETF VTI.

3) In Canada, one could almost say that the equity market consists of Financials and a few other bits and pieces - by market cap, Financials occupy 31% of the iShares TSX Composite ETF (XIC), while the Canadian RAFI Fundamental Index ETF of Claymore (CRQ), which contains 65 of the largest companies measured by a combination of sales, cash flow, dividends and book equity, has no less than a 47.4% weight in Financials. The folks who make the RAFI indices describe them as representing the companies' economic footprint. Is that really what the Canadian economy now consists of, and is it normal or healthy such that a change may happen sooner or later? The comparable market cap ETF to CRQ is iShares TSX 60 (XIU). Interestingly, it shows the market under-weighting Financials, especially insurance companies like Manulife and Sunlife, by some 13.4% (i.e. Financials are 34% of XIU) compared to CRQ.

4) The UK's FTSE All Share Index still has about 21% of its market cap weight in Financials as of the end of February 2010, judging by the db x-trackers ETF that tracks this index. Again, it is the single largest sector, though just barely ahead of oil and gas.

McKinsey deflates another bubble

Those who think that now that the recession is over, everything is fine and happy days are here again might think a second thought after reading strategic consulting company McKinsey's The Looming Deleveraging Challenge (free registration required for access to the report). We Canadians might be especially over-confident given the minimal harm our banks suffered during the 2008 crisis.

Despite having the lowest total of public and private debt amongst the 14 countries studied, Canada still likely faces deleveraging in the household sector according to McKinsey. The BRIC (Brazil, Russia, India, China) countries are all much less constrained by debt. The USA, Spain and the UK are more likely to have deleveraging in more sectors than Canada.

McKinsey says deleveraging countries face prolonged belt tightening and lower economic growth for two to three years. Given Canada's strong economic ties to the USA and their even worse state, I'd guess we are in that boat. Ssssssss is the sound of the slow leak in the hope bubble.

The good news is that GDP growth, based on past examples McKinsey studied, likely resumes strongly after that. It will again be time to take a deep breath and start inflating a new bubble.

Book Review: Why Iceland? by Asgeir Jonsson

Imagine every man, woman and child of Victoria, BC being faced with a sudden new debt of $18,000 to repay bank depositors in a foreign country. In addition, this is all through no fault of their own - the people now on the hook had nothing to do with creating the situation. That's what is facing the citizens of Iceland (whose population is about the same as Victoria's) these days as a result of the financial crash of 2008.

Why Iceland?, written by Icelander Asgeir Jonsson, examines how all this happened, how the rise and collapse of Iceland's banks in 2008 bankrupted the country. The title suggests the plaintive cry of an innocent and naive victim asking how such a calamity could come about. One might expect bitterness and incendiary language in the book. Not so however, as the author is also an economist. The approach seems more like morbid professional curiosity in trying to unravel what went wrong. He does so with little overt emotion and much fascinating detail.

Along the way, as they affect Iceland, one learns through Jonsson's succinct and clear explanations about currency swaps, Credit Default Swaps, Collateralized Debt Obligations, the carry trade, hedge funds, glacier bonds, repo funding, central banks, government interventions (or lack thereof) and consequences, credit ratings and agencies. The book is an intricate case study.

The detail is really the object lesson. Iceland did not go down because of one single error, one big villain or one event. It was a combination of many factors both local and global, mistakes at crucial moments that failed to prevent dire consequences of what had been building for some years. (There was even a small Canadian hand in the form of TD Bank whose London office merrily sold to the carry trade wagonloads of highly profitable glacier bonds denominated in Icelandic currency but sold outside Iceland.) A good summary might be the quote he includes from a 2008 Merrill Lynch credit report on Iceland: " ... rapid expansion, inexperienced, yet aggressive management, high dependency on external funding, high gearing to equity markets, connected party opacity. In other words: too fast, too young, too much, too short, too connected, too volatile."

With a little more of the human drama, this book could be made into a Hollywood movie (except of course for the heroic ending). The scene of the hedge fund managers coming to Iceland and mocking the executive of the Icelandic Central Bank as they detected weakness in Iceland's position is ready-made. Jonsson does include bits and pieces of personalities and their effects, though I would have welcomed more since I suspect such elements did influence the course of events more than is apparent in the book.

For Canadians the value of this book is the lessons and warnings. In the final chapter, Jonsson notes that the cost of bank bailout packages may yet become sovereign debt crises. He says some countries are especially at risk: a) small countries with, b) large, internationally exposed banking sectors, c) currency that is not a global reserve currency, and d) limited fiscal capacity. Jonsson asks whether even Britain itself could be in danger according to these criteria. Canada's banks escaped most of the 2008 financial havoc by their heavy reliance on stable domestic deposits so that is reassuring, as is the government's generally strong fiscal capacity, though it has been diminished by stimulus spending. However, Canadian complacency would be serious mistake.

The author does an excellent job keeping the story flowing and the tone light for what could easily have become too technical and dry. The author's position as chief economist at Kaupthing, one of the failed banks, seems not to have interfered with the presentation of a fair and unbiased account (bank executives get their share of blame).

For the individual investor and citizen, perhaps the biggest lesson from this book, is that the economic and investment landscape is highly complex, making it hard to know where things are going. Drastic bad things can and do happen, even to the surprise of highly motivated, smart, not-evil, though self-interested people. If you don't prepare for the worst, it may happen, even if it isn't your doing, and you may suffer the consequences.

Now many people are leaving Iceland, though Jonsson says Icelanders refuse to see themselves as victims. The acceptance of the 12,000 euro per person debt to reimburse Icesave depositors in the UK and Holland is being resisted within Iceland. The story isn't finished and the echoes of the crash will continue for a while yet.

A combination of an education and a good story, I highly recommend this book. My rating: 5 out of 5 stars.

Thank you to McGraw Hill for supplying a copy of the book for review..

Financial Times Video Interview Series on Future of Investing

In this October 2nd video interview in the Financial Times, the CEO of BlackRock (world's largest investment managers) Larry Fink says that investing opportunities in the next 5 to 7 years will be more attractive outside the USA. He sees on-going high unemployment, government budgets and slow economic growth constraining investment success.

Another of the FT series on the future of investing interviews Henry Kaufman, described as an elder statesman of Wall Street. He talks about the sources of the credit crunch crisis. It is evident that the causes are still there - huge financial concentration means institutions that are too big to fail, which they know of course, allowing them to take inordinate risks in pursuit of profit, which they have done and will do again, since the appetite for reform is now fading as markets and economies begin to recover. Meanwhile, a big cause of the original crisis - cheap money aka interest rates at zero - is still there. All of which means another crisis is down the road, But what happens if governments are still labouring under the large debts they assumed in bailing out the last crisis?

A priceless moment in this interview occurs when the interviewer asks Kaufman, who has just said he thinks institutions should be allowed to fail as a means of keeping them from taking too many risks, whether he thinks it was correct that Lehman was allowed to fail. Kaufman happens to have been on the Board of Lehman at the time. Delight as we might at Kaufman being hoisted on his own petard, we might ask where was the line between having to make less than ideal decisions while firmly holding one's nose and self-serving favoritism.

Yet another interview with Daniel Putnam of Grail Partners predicts that retail investors will see more and more complicated products, like mixes of active and passive, guaranteed and not guaranteed, personally tailored for each person. Bye, bye mutual funds, hello structured products. I see a great danger that individual investors won't be able to understand them and the providers will take the opportunity to build in very handsome profit margins. Will regulators step up to ensure that investors receive enough understandable information to make intelligent decisions about whether he/she is being offered a fair deal?

There are also interviews with Benoit Mandelbrot of (now growing in fame) Mis-behaving Markets doing an "I told you so" and a series of principal players in the Lehman Brothers collapse doing "it wasnae my fault" for the first year anniversary of the incident that confirmed that some financial institutions really are too big to fail.

Economic Recovery after the Crisis - How Long? Lasting Effects?

Yesterday James Hymas of PrefBlog posted on the papers coming out of the recent Jackson Hole Symposium on Financial Stability and Macroeconomic Policy. One of the papers Hymas links to is Financial Crises and Economic Activity, written by Stephen G Cecchetti, Marion Kohler and Christian Upper.

They study the severity and duration of the numerous past banking and financial crises (no less than 124 between 1970 and 2007, out of which they pick 40 since 1980 to dissect). They estimate that the US and the UK will recover to pre-crisis levels of GDP by mid 2010. Japan will have had the shortest but the most severe recession. Canada is not mentioned. I guess that's because it did not have its own banking and financial crisis, it merely got sideswiped by that of the USA and the others.

They also conclude that there is no such thing as an average crisis and therefore trying to predict based on averages is useless. But they do identify a bunch of factors that influence severity of fall and speed of rebound to come up with their estimation, which is couched with the usual "results can vary a lot from the point number".

One interesting observation they make is that countries with sovereign debt crises who default have much shorter and less severe economic contractions. The money that need not be paid back to foreign lenders then gets used to fund domestic expansion. Hmmm, maybe the USA should stiff the Chinese who own so much of their government debt.

The bad news is that recovering to get to where GDP would have grown to had a crisis not occurred takes years, over 4 years on average. That's even when growth is faster after than before the crisis, as it often is. It's a version of the problem all too familiar to investors - a 50% decline needs a subsequent 100% increase merely to get back to the starting point. Worse, some countries have even suffered from on-going long term lower growth rates after the crisis ends, in other words they suffer lasting damage. Will that be the case this time with the USA or the UK?

For investors, possible longer term post-recovery effects - here the authors offer no opinion as to whether we are likely to face any of these negatives - include:

• higher real interest rates as hugely increased government borrowing crowds out private borrowers, making capital investment costlier
• rising actual and expected inflation
• higher risk premia as both estimates of risk go up and willingness to take on risk goes down, which would lower returns of riskier things like stocks as safe haven assets are favoured
  

Book Review: The Panic of 1907 by Robert Bruner and Sean Carr

Financial history distilled into a thriller, that's what this book is. The short chapters tumble along and I found myself being caught up in an exciting story as the authors capture the mood of that time when the whole edifice of banking was poised on the brink of collapse and minutes at times lay between catastrophe and survival. The cascade of events, one crisis overlapping and exacerbating another, created extreme pressure under which both the public and the professional, supposed leaders, often wilted and panicked. But some men (and at the time, it seemed all were men) excelled in making the correct instantaneous decisions of huge consequence, chief among them the famous financier J. Pierpont Morgan.

Those who think the crash of 2008 was unique or more severe should read this book. You may find yourself thinking of all sorts of parallels between 1907 and 2008 - a sort of ironic "panics 101, as in 2008-1907 = 101". The authors deliver on the subtitle's promise of "Lessons Learned from the Market's Perfect Storm" in a last chapter where they provide a most helpful summary of the seven factors (with lots of references, being the good academics they are) that allow such deadly storms to occur:
1) System-like architecture to enable trouble to travel and propagate
2) Buoyant economic growth, engendering false optimism
3) Inadequate safety buffers, to stop a small slide before it becomes an avalanche
4) Adverse leadership, both political and economic, create an environment vulnerable to shocks
5) Real economic shock - the spark of the panic is an event of consequence that everyone understands is bad
6) Undue fear, greed and other behavioral aberrations create a self-reinforcing excess
7) Failure of collective action, which is necessary to prevent or put an early stop to a panic

The book's concluding "Coda: can it happen again? ... Almost certainly, it can." was written in 2007 (date of publication) it seems. Too painfully prescient. My one criticism of this book is that this conclusion is too timid. Since 1907, there have been numerous other crashes, 2008 being only the most recent. Though specific lessons are learned and defects fixed after each crisis (1907 led eventually to the creation of the Federal Reserve to improve the flexibility of the money supply and to institute deposit insurance to stem bank runs), the nature of our financial system has not changed in a way that can prevent future crashes. Governments, regulators and industry are always one step, one crisis behind.

The inevitable conclusion should be: IT WILL HAPPEN AGAIN. One needs to take measures both to try to detect the next bubble and subsequent crash and to organise finances to be able to withstand it in case one gets caught in the storm anyways.

My rating: Highly recommended. 4.99 out five stars (0.01 deduction for the slightly wimpy prediction)

Book Giveaway Winner and Reader Predictions for the Next Bubble

Congratulations to Jordan who won the draw for the free book The Cost of Capitalism (and if you did not see my note to send me an email with your name and address, this is a reminder).

Robert Barbera, the book's author believes that bubbles are an inevitable recurring part of our capitalist system. So I asked for opinions on what would likely be the next bubble. Here is the tally from the comments:

• Green tech - 3 mentions
• Infrastructure - 3
• Water - 2
• Food/rice - 2
• Technology - 2 (again?!)
• Health care, China, India, energy, alternative energy, the US Federal Reserve - 1 each

My own vote would go to green tech related to energy (into which I lump alternative energy) for these reasons: it sounds good, has a real basis and there is a strong need for it (just like the tech bubble was based on the powerful reality of the Internet and computing) which means people can believe in it but be fooled in the assessment of the value of individual companies; big money players like venture capitalists (the same ones who were instrumental in the tech bubble), pension funds, governments, mega-corporations, investment banks all have a strong incentive to create another bubble and are pouring large sums into it already; it's new and people will be able to say "this time it's different".

Book Review and Giveaway: The Cost of Capitalism by Robert J. Barbera

The cost of capitalism is repeated market mayhem, bubbles and crashes caused by financial system excesses, according to Robert Barbera, an economist with one foot in the practical world as a long time economist with investment banking firms and the other foot in the theoretical world as an academic professor.

This slim volume of 200 pages expounds the central idea with a series of fascinating, even entertaining vignettes of the bubbles and crashes of the last 30 years - the 2008 crisis and its current aftermath (the book was completed in January 2009), the 2000 tech bubble, the Japanese real estate bubble and subsequent lost decade, the 1998 Asian currency crisis. It is a book of economics for the non-economist, with no jargon and simple, but precise explanations of events, illustrated by pertinent graphs. The writing and language is engaging and flows smoothly, perhaps the by-product of Barbera being obliged to communicate constantly with non-economists in his job.

The author exhorts us to heed the ideas of Hyman Minsky, who stated that people's attitude towards risk changes with stages in an economic cycle: with prolonged good times in the recovery and growth phases, individuals get complacent and believe that the good times will continue forever, leading them to take on ever-increasing risk and leverage, goaded on by the financial system, till a typically small negative event, which he calls a "Minsky Moment", pricks the bubble and the violent slide destroys wealth, at which point everyone gets very (too) risk-averse. The financial system itself, as the holder of all the "cannot be paid back" debt, then has to be bailed out by the government. As he puts it, "Thus, government rescue operations are an inescapable part of capitalism."

There is a brilliant example on page 31 contrasting a homeowner with a conservative mortgage and one with a very large mortgage predicated on rising house prices to sustain affordability, such as was common in the USA in the years leading up to the housing crash there. The easy-to-follow table shows how a small rise in interest rates or a small decline in house prices will cause catastrophe for the large mortgage holder. This example is then extended to explain to show how the risky mortgage default effect can cascade into the general economy through financial institutions and create havoc even for those home buyers who have been cautious, or for completely unrelated companies and sectors.

Barbera thinks that destructive capitalism of most businesses benefits society by cleansing bad businesses with better ones but he says that the financial system is an exception and must be prevented from failing to prevent destructive deflation such as happened in the 1930s - thus he severely criticises the decision to allow Lehman to fail in September 2008. Barbera has an ax to grind and that ax is what he believes is the mis-perception by governments, central bankers and the mainstream of economic thinking on how the financial system works to create recurring bubbles.

Overall the book is a highly engaging and well-argued essay on what ails capitalism and the financial system. Barbera advocates that central banks should be mandated with controlling not just inflation but also asset bubbles to nip them in the bud before they grow too large and wreak havoc. He does not want to see overshoot on the regulatory side in reaction to the 2008 crisis, saying that the huge engine of wealth that is capitalism should not be hobbled too much - one might characterize it as "as much new regulation as necessary but only as much as necessary".

What is the value of this book for an individual investor?

• a cautious attitude - understanding that bubbles are inherent and inevitable in our system makes one cautious and on the lookout for the next one; that is a powerful message of this book
  
• awareness of bubble signs - it helps to know some signs to monitor since bubbles originate from the financial system, like high and climbing levels of debt and leverage; once a bubble exists it is impossible to predict when it will collapse as a slight seemingly innocuous event starts the fall
  
• awareness of calamity indicators - if financial institutions do start failing whether due to government neglect or powerlessness, then it really is time to look for escape and safety, certainly financially and perhaps even physically
  

My rating: four out of five stars

Giveaway! The publisher McGraw Hill has kindly provided me with a copy to give away. So leave a comment on this post with some kind of unique name, i.e. not "anonymous", by closing date of midnight EDT Thursday May 28, 2009. If the fancy strikes you, in your comment say what you think will be the next bubble - green tech, gold, oil ... I will do a random draw to pick a winner and then I'll need to get a postal address from him/her to mail it. Good luck everyone!!

Historical Arguments for What the Stock Market Bottom Will Look Like

Stock markets have already seen a huge decline but has the bottom been reached yet? A couple of commentators with serious-looking historical data and credentials seem to say probably not.

Yale prof and Irrational Exuberance author Robert Schiller in this short note and video interview on Yahoo Finance says the current S&P 500 P/E ratio (calculated using his Cyclically Adjusted P/E Ratio - CAPE - which averages the last ten years instead of only the most recent year) of just under 14x indicates there is likely some way to go - he's looking at 10x, which would mean almost a 30% further drop from where we are today. Yikes! That would entail the S&P 500 at 550 or so. If the TSX followed suit, the TSX Composite would go down to 5600.

A similar view is the cheerily titled While Rome Burns by John Mauldin on the Big Picture blog. Two of charts titled Reversion Beyond the Mean near the bottom of the long post shows how the S&P 500 has overshot what is termed long term average P/E value of 18x in past major crashes to go below 10x.

These values are not too far off the study by the IMF I noted in Recession to Last 2-3 Years? back on October 28th, which related average stock market declines of 50% in a credit cum real estate crunch.

To use an airplane analogy, we are in the midst of severe turbulence, a number of passengers who had not fastened their financial seatbelts have been bruised, people are screaming and scared for their lives. The heartening thing to remember is that as long as our "pilots" don't screw up, planes rarely (11-13% of the time according to Wikipedia) if ever crash because of weather. More than half the time it is pilot error. Are Harper, Brown, Obama, Hu, Merkel et al going to be good enough under pressure?

2008 in Historical Perspective: Credit Suisse Global Investment Returns Yearbook 2009

The bible of historical equity and bond returns has just come out with the 2009 issue. The Credit Suisse Global Investment Returns Yearbook 2009 puts 2008 in long term perspective with data going back over a century. There are 20 pages of commentary by authors of the acclaimed book Triumph of the Optimists Elroy Dimson, Paul Marsh and Mike Staunton (DMS) as well as Jonathon Wilmot, chief global strategist in investment banking at Credit Suisse. Canada, the UK and the USA are among the 17 countries with one-page profiles of their performance. The 48 page document is superbly produced with colourful, insightful graphs instead of tables of numbers.

Two reasons to read this document:

1. gain proper expectations for recovery of markets, for return levels of bonds, t-bills/cash and equities
2. general ideas for investment winners and losers in the short to medium term in the brave new world of less debt
   

Quotes of note:
"We believe the basic principles remain true – that stocks still offer the best long-term returns despite their volatility – and that investors should keep faith with stocks." DMS page 5
"... even a decade is too short to judge stock returns. ... The last decade has been the lost decade." DMS
"... even in a crash, when correlations rise significantly, global diversification still makes sense." DMS
"... increased consolidation and industry concentration has in the past always been a feature of depressions or periods with a substantial overhang of excess capacity. Large firms with strong balance sheets, resilient cash flows, the ability to finance growth internally and/or continued access to credit markets are the potential winners in this process. As long ago as the 1870s, the depressed state of the economy and credit markets allowed people like Carnegie and Rockefeller to buy many smaller firms and competitors at fire sale prices, and build vast new business empires." Wilmot

Best performing equity markets from 1900 to 2008
1 - Australia at 7.9% real compounded return
2 - Sweden 7.2%
3 - South Africa 7.1%
4 - USA 6.0%
5 - Canada 5.9%
6 - UK 5.1%

It comes as a bit of a shock to read that in that lost decade of 1999 to 2008 bonds beat equities by 1.9% compounded annually for Canada, the same relationship being true globally as well. As DMS put it, equity investors "... received a savage reminder that the very nature of the risk for which they sought a reward means that events can turn out badly, even over multiple years.

DMS suggest we should expect equities to return only 3 to 3.5% more than t-bills from here on (as opposed to the 4.2% world average in the past). Later Wilmot shows a long term trend line (back to 1850) of 6.2% for US equities. There are some notable periods as long as 15 years of negative returns. So who knows, huh?

Another striking figure is DMS' estimate that the Dow Jones index has about a 50% chance of breaking through its all-time high by (start holding your breath) 2022, 13 years from now! Are your expectations getting lower like mine?

I am also considering praying for the banking system given the comments on page 23 about the effect of collapse of banking and credit in 1857 and in 1931. It seems that in the big big picture, Nortel going under doesn't matter, nor will GM and Chrysler (as they surely eventually will) but much as many hate them, if the US/UK/Canadian/Japanese/European banks start to go down en masse, we will be in for a much worse time than we are now experiencing.

Hat tip to Mebane Faber's World Beta blog where I found the mention and link to the document.

The Future: Even the Wise Can Pull a Gigantic Blooper

Mr "Stocks for the Long Run" Jeremy Siegel peered into the future in the CFA webcast The Impact of an Aging Population on the World Economy recorded on May 1, 2007.

The talk presents some fascinating projections of how the world is likely to look based on demographics and possible economic growth in the USA (and by extension other western countries with similar characteristics) and developing countries, especially China.

The future according to Siegel includes such dramatic possibilities as:

• people in the west will have to work substantially longer - over 11 years more than today - in their lifetime assuming even healthy 4% p.a. world economic growth
  
• the US, Europe and Japan will see their share of economic output fall by 2050 from 46% today to 19%, to be equalled by China alone
• globalisation is a good, necessary process to allow the transfer of capital from western countries to developing countries, i.e. to enable the Chinese and others to buy up our assets (and we use the money to fund retirement)

However, Siegel utters one monumental blooper in the webcast, which I am sure he regrets and was probably more a quick comment than the result of deep analysis. It does show the hazards of forecasting and estimating. Caveat lector and auditor, always!

Around the 50 minute mark, he says: "I don't believe we're over leveraged. I don't believe there's too much debt."

Maybe he (and we) can laugh a bit at our fallible attempts to forecast in these witticisms.

Book Review: And The Money Kept Rolling in (And Out) by Paul Blustein

A brilliant book in every way - as exciting as a movie thriller, as intricate as a detective story with multiple intertwined plot lines, as gut-wrenching and sad as a human tragedy that could have been avoided, as fair and detailed as a commission of enquiry into a man-made disaster - this book about Argentina's financial and economic collapse in 2001-2002 is a must-read for anyone interested in the current financial and economic crisis. Though written in 2005 before the crisis started, Blustein takes a few pages to talk about relevance to the USA and states outright: "It could happen here. Americans who give Argentina's story fair consideration and conclude otherwise are deluding themselves." ... or maybe, it's already happening here?

The technical reasons for Argentina's accumulation of a crushing debt load on which it eventually defaulted with dire consequences are fairly straightforward. In his words, "They spent more than they should have, taxed less than they should have and borrowed more than they should have..." while living within the dollar-peso convertibility currency system that required much stricter fiscal discipline.

The individual and collective (both organizational and societal) human reasons that created and exacerbated the technical reasons are the really fascinating elements and this is where Blustein excels at digging them out and presenting them in a gripping story. Self-interest, groupthink, willful blindness, self-deceit, avariciousness, stupidity, panic reactions, vanity, political expediency, official misinformation and spinning, ideology, gamesmanship, it is all there in various people and organizations. The author doesn't pull punches in his criticisms but there aren't many who escape blameless. The IMF, Wall Street investment banks, the US government, the Argentine government, even to some degree the Argentine people, share the burden of responsibility.

The book is not an "anti-" diatribe, whether it be anti-globalization, anti-IMF, anti-privatization, anti-Americanism, anti-capital, anti-bailout or even anti-debt (though it clearly shows that too much debt is a recipe for disaster). He says, "Policies such as open trade, privatization, and deregulation were not responsible for the events that brought Argentina to such a pitiful state."

For those who wonder why our governments are currently so anxiously propping up banks and trying to get credit flowing again, "... The nation's banking system was ceasing to perform its vital role as a provider of credit and dispenser of payments, the result being an accelerated contraction in all sorts of economic activity" and "... the shortage of funds spread through the economy like a debilitating virus". The latter is especially in play at the moment. For example, part of the reason for the 45% drop in GM's sales is lack of credit to buyers wanting to buy vehicles even if they are perfectly qualified good credit risks. And look where GM is today. A company with problems suddenly is a company in crisis with insurmountable problems. Same goes for home buyers, if trying to get a mortgage isn't possible, few can buy, prices decline etc.

The helicoptor departure scene in the prologue, where an IMF banker flies out of the country having informed the President of Argentina that the IMF will no longer provide support, abandoning Argentina to inevitable default and collapse, makes a striking image worthy of a movie. Hollywood, where are you?

My rating: Five out of five stars.

An Exceptional (note Canadian understatement) Year in the Stock Market

Economist Greg Mankiw posted a histogram chart of the S&P 500's returns this year compared to every year since 1825 that dramatically conveys how unusual it has been so far. The only year as bad as 2008 is 1931, the depths of the great depression. Of course, the year isn't over yet but how much stock market recovery can we hope for as the downward slide of the economy continues apace?

Origins of the Financial/Economic Crisis - One Chart!

A nice compact flow chart explaining the current mess the world finds itself in can be accessed at Jeff Frankel's Weblog in the post Origins of the Economic Crisis - In One Chart!

Signs that the Market Panic is Over

In the month of October 2008 financial markets struck real terror into just about everyone. The panic phase now appears to be over, replaced by mere worry about the severity and length of the recession. Here are some signs of the change in mindset:

• stock markets seem to have stopped huge 10+% day to day to day swings upwards and downwards
• perfect correlation of markets has stopped, where everything is either green/up or red/down, in other words investors are beginning to look at the differential prospects of stocks ... the holdings in my portfolio with various asset classes has a comforting mix of ups and downs - diversification is beginning to work again

• politicians have gone from saying that we are all in this together to blaming each other for the mess
• the tone and body language of hosts/presenters on Bloomberg TV has shifted from end-of-the-world history-in-the-making to normal blasé cool just-another-recession
• mainstream media is doing the customary never-let-it-happen-again analysis of the mistakes that led to the crisis, e.g. CBS' 60 minutes on Credit Default Swaps.
  
• rich investors are still talking about opportunity or even recovery - see Steve Forbes interviewed October 25th on BBC, Warren Buffett's opinion on October 16th in the NY Times, one of the few with a positive view at that date

All is not sweetness and light, however. Rich investors like George Soros, Jim Rogers, Peter Schiff and Marc Faber who predicted the crash are busy cashing in as the credit deleveraging process they predicted continues painfully to unfold.

Recession to Last 2 to 3 Years? ... or More?

Robert Peston of the BBC blogs that a Bank of England report on the financial crisis tells how a similar banking credit crisis and contraction in Norway, Sweden and Japan lasted two to three years. Is that how long the recession will last? Or Perhaps even longer if there is a lag after lending and business investment and consumer spending start again? Incidentally, there are always lots of comments on his frequent posts and many of those comments add an interesting perspective. London is, or was(?) and major financial center so many insiders seem to want to get the dirt out and they comment away.

Global Financial Crisis: How Long? How Deep? over at Vox EU shows that crises such as the one currently underway have had the following effects on average:

• credit crunch - average two and a half years with about 20% decline in real credit
• housing bust - average four and a half years with 30% decline in real prices
• stock market crash - average two and a half years with 50% real decline in equities

Worse news, recessions associated with the above are much more severe, with economic output declining up to 1% and lasting over four years. As the authors say, "The main take-away of the past episodes is that some tough times are ahead for the global economy before matters get better." Their short article is based on a just-released 80 page study by the International Monetary Fund Systemic Banking Crises: a New Database by Luc Laeven and Fabian Valencia.

GlobeAdvisor reports that the CPPIB is on the prowl to acquire real estate properties at bargain prices in the US and the UK and it apparently anticipates the bargains will be there for about two years, i.e. that's how long they believe the slump could last.

Credit Crunch Humour

A little stress relief in the form of humour can help these days. Here are some of my favorites.

BBC video clip of John Bird and John Fortune doing a take-off on bankers and a series of their gems of market volatility and sub-prime loans. The same site has an interview with a Playboy Playmate describing her investing approach.

Here's pro golfer Mike Weir looking very awkward and silly doing a serious commercial for mutual funds. Stick to golf Mike.

And then there are the Monkey waiters in Japan.

Dad explains the financial crisis to son.

RhettandLink sing the Economic Bailout song.

The whole financial history of the last 20 years in a 2 minute song.

More at the Marignal Revolution blog; love that monkey joke!

The Daily Mash satirical joke site has a deadly barb aimed at Local Authorities in the UK who deposited large amounts in Icelandic banks.