World Economy Trends from McKinsey: Long Slow Recovery in Progress

Consulting firm McKinsey Global Institute's Debt and deleveraging: Uneven progress on the path to growth tells us that the recovery from the global credit crisis, three years later, has only just begun and will still take many years to complete. That's the bad news. The good news is that this is in line with past similar crises.

Canada used to be so much better off than the USA in terms of total debt but now things are fairly equal as Canadians have added debt while Americans have shed it. Amongst major economies, the USA is going fastest in the right direction according to McKinsey. Breaking the debt down by sector, another chart (Exhibit E4) shows that Canadian financial institutions have considerably more debt proportionally than those in the USA.

Exhibit A4, copied below from the long version of the report, shows that counting unfunded US government pension and health benefits for retirees pushes the US debt burden up to 140% of GDP. That still leaves it no worse in total than countries like Spain and France. The two countries by far in the worst overall debt shape, both of which have not even started deleveraging, are Japan and the UK, yet their borrowing costs are not at crisis levels. Huh?

Takeaways for investors: 1) Canadians should not be smug and should not count out the USA (you don't get to be number 1 for no reason); 2) Expect 3-4 years more of uneven weak economic times before things get much better though the "getting worse" phase seems to be finished; 3) Opportunities will arise for companies in infrastructure and public sector projects since governments won't be able to add more debt to build them; 4) Consumer demand won't be strong.

Book Review: Uncontrolled Risk by Mark T. Williams

"Occupy" protesters would benefit from reading this book. Instead of the mindless directionless opposition to everything capitalistic they would know a lot better who and what to blame for the narrowly averted collapse of the world's financial system in 2008. Better, they would know the kinds of reforms and controls that need to be implemented to make the system operate with more stability to avoid a future recurrence.

In fact, every shareholder and voter needs to know this stuff too. After all, when things go wrong with the financial system, we all get a rather severe smack as a result. The scary fact of the matter is that the conditions that allowed the crisis to build up, the way the system works, have not substantially changed.

Williams informs us by telling the story of the rise and fall of investment banker Lehman Brothers. The story method is very effective in showing how the situation built up over decades as the people, the company, the industry, the regulatory bodies, the political scene all evolved to the 2008 climax of Lehman's collapse and the ensuing beginnings of financial Armageddon. Along the way the author introduces and explains in terms the layman can understand what might be called the technical stuff, the financial products and structures like CDO, MBS, CDS that ended up being the bombs that blew things apart.

We learn that it wasn't just the "greedy bankers" at fault. Things are not that simple in the real world. Williams takes a whole 25 page chapter to list the bad guys and institutions and summarize to what degree they did wrong, everyone from Dick Fuld, Lehman CEO and other key Lehman players, Boards of Directors, the US Congress and several Committees, the Federal Reserve, the SEC, the media, academics, accounting firms, credit rating agencies, lobbyists, the FASB, US Treasury Secretary and former Goldman Sachs CEO Hank Paulson and last but not least consumers who binged on debt and housing.

Apparently, the bankers (and others) weren't simply greedy, they were also stupid and did not truly understand the risks being taken. Prior incidents that should have been learning and warning signs, like survival and recovery from the 1998 LTCM fiasco, instead made people over-confident. Risk models used by industry that work well most of the time failed utterly in times of extreme stress when they would be most useful.

Williams sticks to the facts in the book but it would have been fascinating to get more into the psychology of the players to see what was the mix of flaws and vices. The 2008 crisis could provide valuable insight into how the thinking of institutions and societies go wrong.

The last chapter contains Williams' ten point plan for changes to reduce chances of a new financial systemic risk event. Some can easily form the basis of policy lobbying and legislation - things like mandating higher capital levels, imposing leverage constraints, creating a systemic risk regulator. Others can lie with investors - things like requiring greater executive accountability, improving Board oversight, creating smarter compensation schemes. (In the case of this latter set of changes, I am left wondering how this jives with passive index investing where investors are distant, ignorant and often uninterested in the individual companies like Lehman where dominant managers held sway and escaped control with destructive results. It's another reason I like the idea of pension savings being managed by a body like CPPIB with the motivation, resources and power to kick butt in corporate governance.)

The book and its story unfortunately contents itself, except very peripherally, with happenings in the United States. The reader therefore does not get to see how the worldwide systemic contagion occurred, or how events and conditions elsewhere exacerbated the problem.

Favorite Quotes and Notes:

• "... the U.S. government has failed to find the perfect balance between excessive regulation - viewed as stifling to bank profitability and economic growth - and lax regulation and oversight - viewed as a recipe for financial and economic instability" - which I find to be a far more balanced and rational worldview than the strident "capitalist system is rotten" view of some people
• "Companies that take no risk go out of business just as easily as those that take too much risk."
• in 2006, Lehman's Chief Risk Officer Madelyn Antoncic received an industry award for best risk manager of the the year; a year later Fuld/Lehman removed her from the job and demoted her; i.e. the elaborate risk management structure at Lehman was just a facade to fool credit rating agencies into giving Lehman a lower cost of borrowing/capital to increase profits.
  
• Value at Risk (VaR) the commonly used industry measure of risk is described by a Lehman shortseller in a quotation as "an airbag that works all the time, except when you have a car accident"
• the boyhood home of Fed Reserve chairman Ben Bernanke, since then sold on to several others, was subject to a sub-prime mortgage loan foreclosure - how symbolic!
• "Post-credit crisis, executives from TARP-taking banks continue to express public support for re-regulation of the financial markets while their paid lobbyists attempt to defeat or weaken any new regulations."
• Canada is cited by Williams as a model to emulate, praising the consistently strict oversight and regulation here
  

For the individual investor, the important lesson is first, that the financial system and consequently investment markets, are still very exposed and subject to severe shocks and second, that risk assessment and management are essential never-ending tasks.We need to be ever aware and wary of what is going on. Since some risks are not controllable or often not knowable by the individual, the idea of diversification, spreading investments, gains reinforcement.

A quick 220-page read, it is well foot-noted and indexed. The writing flows smoothly too. Don't be surprised if you come out of reading it a bit angry and less confident in the capabilities of business and political leaders.

My rating: Though missing the greed vs stupidity assessment and the international linkages, it is excellent on what it does present - 4 out of 5 stars. Definitely worth reading.

Thanks to publisher McGraw-Hill for providing a review copy. The book comes in Adobe's eBook format (see McGraw-Hill site)as well as paper.

Market Integrity and Today's Free-fall Drop

Today's mind-blowing momentary stock market plummet is more significant than just a record. It is extremely troubling to me as an ordinary investor.

Why? It is the patently unfair decision to cancel trades executed during the momentous drop. If I have a brain fart or a fat finger moment, my brokerage doesn't say, "oh yeah, that's ok, we accept that you didn't really mean it and send me back to where I started." The CTV news report Markets sent reeling after possible trading error says that automated programs caused or accelerated the fall. Well, if the people and companies who build and use such programs get a speed advantage over me then it is only fair that they suffer the deficiencies as well. If a few companies get wiped out by their unwise reliance on program trading then others will be a little more careful about testing and putting limits on them. Let's remember, someone else was on the other side of those trades, buying when the machines did their panic selling. Why should they be denied their opportunistic profits? Caveat emptor is a basic principle of commerce. Having made the oops trading mistake myself, I am a lot more careful to check what I am doing before pressing the "Trade" button.

The fact that all markets suffered the same drop at the same time means that it wasn't a problem with markets functioning incorrectly (indeed, Nasdaq is quoted in the CTV news item as saying its systems worked properly). It was big trading house computers bailing out in a crash before the ordinary joe. There cannot be two sets of rules for different types of investors.

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
  

Market Timing Can Work ... If You Wait a Few Decades

Mebane T. Faber shares his intriguing market timing system in A Quantitative Approach to Tactical Asset Allocation on SSRN (original 2006, revised February 2009). His system produced significantly higher compound returns and much lower volatility / standard deviations over many time periods and multiple asset classes (US equities, MSCI EAFE international equities, US REITs, US government bonds and commodities). The intriguing aspect is that the paper was originally published in May 2006 and went through the trial by fire of 2008, during which it performed beautifully and would have protected an investor. Instead of the 37% loss of the S&P500 with buy and hold, Faber's method would have given a 1% gain!

Faber's buy-sell rules are ultra-simple: buy when the month-end price of the asset is greater than the 10-month moving average and sell when it is less, keeping the money in cash until the signal changes. That would have kept an investor in the five asset classes he looked at invested about 70% of the time and generated less than one portfolio turnover per year (i.e. minimal effort and low transaction costs required). It's a system akin to Larry Macdonald's One-Minute Portfolio for Canadian RRSP investors, which also escaped 2008 relatively unscathed with only a 10% decline according to his Dec. 18th update.

The downsides?

1. Will the future be like the past and will the system continue to work? Fitting a system to past data can be made to work - it is a statistical version of "hindsight is 100% accurate". Faber's worked in 2008, after he had developed the system in years prior, but what about the future? One never knows for sure.
2. In strong upmarkets such as the 1990s (Faber is upfront about this in the paper - see Appendix D on pages 39-40 for the S&P500 vs the timing system stats decade by decade), the system underperforms, and can do so by a lot. Could you stand being left behind over the two decades of the 1980s - by 2% annually - and the 90s - by 5% a year? How much return should one sacrifice for disaster crash avoidance? After 2008, many "deferred-retirement" folks might regretfully say Faber's system is worth it. Just because we've had one shock in 2008 and things seem to be on the rebound for now, that doesn't mean we couldn't have another big drop soon (e.g. suppose the swine flu gets deadly in the fall, then as they say, "you ain't seen nothin' yet" for market turmoil).
   

TSX Prediction Survey Results Are In - Is The Crowd Wise?

Thank you to those 22 intrepid souls who dared to predict where the bottom of the current stock market slump might end up.

A three-word summary of the survey opinion is "watch out below!". Though we are substantially above the low of 7724 set when I started the survey - at least as of right now the TSX Composite is around 8640 - pessimism, or is it hard-nosed realism, reigns. The median and the average of votes was that the TSX will fall to 6000 before we reach the base of the abyss. That's more than 30% down from now.

This post's title refers to the popular book by James Surowiecki, The Wisdom of Crowds, in which he gives numerous examples where taking the average of estimates from independent, diverse sources can give better predictions than those of experts. Part of the problem with the market these days however is a seeming lack of independence because everyone is tainted by a common negativity. Is our survey "crowd" wise or are we just a mob carried away by our own pessimism to a form of group-think?

We'll find out for sure within the next few years, at which point, if the survey prediction proves correct, I'll write another post claiming credit for how wise the readers of this blog are! ;-)

I'm not about to short the TSX, though. I'll just stick with my asset allocation and wait it out because in five to ten years the market will have recovered. That's my prediction.

Understanding the Turmoil - Credit Derivatives

Came across this clearly-written explanation by Daniel Amerman about the problem of credit derivatives, whose value is larger than the whole world economy. Very sobering. He includes a bit of his advice about to cope.

A Modest (and Cheap) Proposal for Solving the World Financial Crisis ;-)

The global financial crisis in its current phase apparently boils down to the fact that banks won't lend to each other, to businesses or to individuals as we are told by the BBC, Bloomberg, MarketWatch, the Times, MSN MoneyCentral, etc. Everybody agrees on the problem, even Socialist Worker!

We have seen governments try every inducement - buying off the toxic debt, provide unlimited liquidity, nationalising banks, lowering interest rates. Nothing has worked.

"Nice" is not working. Time for a somewhat harsh solution, but hey, the world's future is at stake and in the past governments have not shied away from being somewhat heavy handed when the occasion called for it (here you can fill in your own favorite example, depending on which country you hate the most).

My solution rests on the fact, at least I believe it to be so, that the banks are run by people. Now, all people have emotions, even bankers, and the one emotion stronger than greed is, you guessed it, fear. Right now, bankers are afraid of lending. So we must replace the fear of lending with a greater fear of not lending.

All the heads of the various governments, being on a first-name basis with all the head honchos at the banks, or so we are constantly told, must therefore have their phone numbers and addresses. Therefore, George (Bush), Gordon (Brown), Stephen (Harper), Angela (Merkel), Nicolas (Sarkozy), Taro (Aso) ... should pick up the phone and "suggest" to bankers that they start lending. I'm sure their people and communication skills will be more than adequate to convey the "accidents" that might happen to them and their families should the bankers fail to change their destructive non-lending policy forthwith. Using certain specialist human resources to back up the suggestion, it would only take one unfortunate uncooperative banker for word to get around and things to change rapidly. Surely that would be a small human sacrifice compared to the untold misery facing millions of citizens who would suffer in the hard recession that is developing as a result of the banking freeze-up.

I don't know the going rates for such specialist resources but it surely is much cheaper than the several trillion dollars already spent by the US alone. And my fee for this suggestion is a standard investment banking rate, discounted by half as my contribution to these difficult times, only $0.001 trillion (and pay that in Canadian dollars please because I suspect the USD will soon be toast).

... later on ... Ha, ha ha! Just found this column by Robert X. Cringely in which he seriously suggests something similar - the heavy he suggests is Jack Welch, famous former CEO of GE.