Between Two Worlds
[The following is an excerpt of our May newsletter. The entire newsletter is offered at no cost to those who subscribe through our website]
by Doug Wakefield with Ben Hill
Billions of dollars were lost from May 10th to May 23rd. With downturns in numerous markets, the vast majority of investors lost money during this short, but volatile, period.
Still, we'll only know the significance of this decline as the next several weeks unfold.
What is significant is the lack of awareness of the average U.S. citizen (and perhaps on a global scale, the average person) of the seemingly continuous stream of historic events that are occurring in our world. Over the last few weeks, investors have taken several shots across the bow. Yet, rather than look for their own answers, they have found it easier to accept the comforting rhetoric they see on TV. When they are confronted with unpleasant news, many would rather flip the channel or hit the snooze button and go back to sleep. We must not do this. We must engage our critical thinking, override our emotional desire to avoid conflict, and discipline ourselves to make tough decisions.
I often feel like a man between two worlds. On the one hand, with my God-given bent towards research, I see the potential degree of the market, economic, and social upheaval that we will most likely encounter. On the other hand, the vast majority of people I come across day-to-day are ignorant of these impending perils.
For the balance of this newsletter, I will discuss the implications of a Bank of International Settlements (BIS) working paper, and offset that discussion with events and interactions that have come across my path over the last month. Though, to some extent, our conclusions are sure to differ, my goal is that in looking at this proverbial elephant from different angles, we might gain a better perspective of our world and the events that will affect our investment and financial decisions.
As always, my thinking is influenced by a variety of sources. As such, a word of caution is warranted. The mention of any source or person does not mean that we adhere to all of that sources ideas and conclusions and should not be taken as an endorsement of that source, and visa versa. Let me remind you:
Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and investor psychology.
A couple months ago, Joan Veon, head of The Women's International Media Group, suggested that I read a working paper written by William White, which was released by the Bank of International Settlements. Mr. White is the Economic Director and Head of the Monetary and Economic Department at the BIS, a position that he has held since 1995. If you are unfamiliar with the BIS, let me offer you a brief introduction.
"The Bank for International Settlements was established in 1930 to administer ("settle") the reparation payments imposed on Germany under the Treaty of Versailles following the First World War. It was also envisaged that the BIS would provide central banks with an institutional forum for cooperation. The Bank's name is derived from this original role. Amid the financial and economic crisis of the early 1930s, the matter of reparations soon faded, allowing the BIS to focus its activities entirely on cooperation among central banks." 1
Although much more sophisticated today, the BIS continues to act as an intermediary between central banks around the world.
"The growth and globalization of financial markets during the final decades of the 20th century shaped the nature of central bank cooperation at the BIS. The BIS has assisted - and continues to assist - the pursuit of global monetary and financial stability by providing emergency financial assistance to central banks in case of need; and by supporting experts from national central banks and supervisory agencies in proposing measures and developing standards aimed at strengthening the international financial architecture, and in particular international banking supervision." 2
As you can see, the BIS was established in 1930 to handle a national crisis, and it has continued in its role of providing financial assistance and acting to strengthen the international financial architecture. Though most of us do not realize it, 2006 looks to be an important year for worldwide banking.
"In 1988 this Committee issued the Basel Capital Accord, introducing a credit risk measurement framework for internationally active banks that became a globally accepted standard. A revision of this Capital Accord, known as Basel II, is due to be implemented worldwide from end - 2006. Such standards aim to achieve a better and more transparent measurement of the various risks incurred by internationally active banks, limiting the possibility of contagion in case of a crisis and strengthening the global financial infrastructure overall." 3 [Italics mine]
Coincidently, Mr. White's paper titled, Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework, was released in January of 2006. In this paper, Mr. White basically outlines various financial crises and the growing stressors on the world's financial markets that have come with each "fix" over the last 20 years. Here, White takes governmental agencies to task for their increasingly myopic financial policies.
"As for domestic regulatory authorities, they might be advised to adopt a macroprudential regulatory framework, one that puts more emphasis on the health of the financial system as a whole, rather than the state of individual institutions as is currently the case. Finally, recognizing that 'keeping one's domestic house in order' might not be sufficient to provide international stability, there could be need for a new international monetary order to help prevent the build-up of external imbalances that could eventually culminate in stress on a global level. Recall that, before they broke down, this is precisely what the gold standard and the Bretton Woods systems were designed to do. 4 [Emphasis his]
Again, these are not my words. These are the words of the Economic Director and Head of the Monetary and Economic Department at the BIS, William R. White.
In September of 1931 England came off the gold exchange standard - never to return. In January of 1934 the US came off the gold standard, and its citizens were no longer able to exchange their dollars for gold. In August of 1971, Nixon announced that the US was coming off the gold exchange standard and would never again exchange US gold reserves for the accumulated greenbacks of foreign central banks.
These events were historically significant and significantly impacted the people living in those times as well as the way our capital markets operate today. With the implementation of Basel II and statements like the one above, it would appear that yet again, plans are already being considered that could have a profound influence on our world.
After speaking of the downward effect that dollar recycling, where foreign central banks use the dollars that they purchase to keep their currencies low against the dollar (to maintain a favorable balance of trade) to purchase US securities, exerts on yields (returns), White comments on the "liberalisation of the global financial system:"
"These developments have sharply increased competitive pressures in the financial services industry. Such pressures, in turn, increase the incentives to engage in risky behaviour, particularly if boards of directors increase the emphasis they put on 'shareholder value', and if structural rigidities impede cost cutting. These pressures will be augmented by any safety net provisions that might be in place." 5
It would seem that the implicit bailout "guarantees" of the Fed, the FDIC, and others have created a disincentive to avoid risk and a reckless abandon to pursue gains. As evidence of this trend consider the following excerpt from James Montier's missive called The Dash to Trash.
"The worrying sign of a surge of interest in junk equity is provided by the volumes data on the OTC Bulletin Board (OTC BB). The OTC BB is a quotation service for OTC securities (i.e. those not listed on the Nasdaq or any of the national exchanges). It is to all intents and purposes, a market for low quality stocks. Volumes have exploded in true mania style. At the time, 2000 looked like a huge surge in volumes; now it is barely a blip!
One final observation: this dash to trash is not limited to equities. As a recent Bloomberg report points out, 'U.S. companies one step away from default are selling a record amount of bonds. Even CCC rated companies, considered in so-called technical default...were able to sell bonds in the first quarter.' Doesn't sound much like prudent investment to me. Quality is being shunned in all forms." 6
But, manias don't restrict themselves to just the stock, bond, and real estate markets. While flying back from attending a conference in New York, I picked up a copy of Fortune magazine. The title, Real Estate Survival Guide, of the May 2006 Special Edition caught my attention because the May 2005 Fortune was titled Real Estate Gold Rush. Anyway, after reading the real estate article, I came across an article showing the craze in the art markets.
"In auction rooms these days, the frenzy of the bidding can be speculator. 'There is a beautiful German word for this: nachholbedarf,' observes Meyer in his office later. 'It means the desire to make up for lost time.' Among a new and emerging class of elite collectors, there is a sense of urgency - an immediate need for gratification and possession. Stevie Cohen, head of hedge fund SAC (who paid himself $500 million last year) is indicative of this new breed of rabid art buyers. Over the past five years Cohen has reportedly built a $700 million collection... Recently a rich Russian woman arrived at Sotheby's and announced that she wanted to build a collection. The expert she met with suggested that she start slowly, with a few important pieces. Her response: 'I want abundance.'" 7
These social behaviors show the changing "perception of value and risk, [which] moves up and down with the economy." In commenting on these issues, Mr. White notes:
"This tendency can be seen clearly in a large number of financial measures. Credit spreads, asset prices, internal bank risk ratings, and such accounting measures of expected losses as loan loss provisions all move procyclically. Moreover, this procyclicality then interacts with the real economy in ways that can amplify economic fluctuations. In an upswing, the greater availability of credit leads to higher asset prices, which then serve as collateral for more borrowing. Moreover, similar incentives may lead to higher levels of fixed investment, which increase demand in the short run and promise increased profits over time.
To some degree, such behavior patterns are perfectly natural and desirable. If, in an upturn, real prospects for gain are improving, markets should recognize this. However, problems of 'excessive optimism' can easily arise if markets extrapolate good times in an unwarranted way. There are many precedents for this in history." 8
As I read these comments, I think back on Edward Chancellor's book, Devil Take the Hindmost. Chancellor elaborates on these societal dislocations in his account of the Tulip Bulb Mania of the 1600s.
"The average annual wage in Holland was between 200 and 400 guilders. A small town house cost around 300 guilders and the best flower paintings sold for no more than 1,000 guilders. Against these values we can measure the extravagance of tulip prices. According to the Dialogues, a Gouda bubble of four aces rose from 20 to 225 guilders; a Generalissimo of ten aces which had sold for 95 guilders fetched 900 guilders; a pound of plain yellow Croenen which sold for around 20 guilders rose in a few weeks to over 1,200 (i.e. the price went from the equivalent of one month's pay to five years').
A contemporary pamphleteer calculated that the 2,500 guilders paid for a single bulb, would have bought twenty-seven tons of wheat, fifty tons of rye, four fat oxen, eight fat pigs, twelve fat sheep, two hogsheads of wine, four tuns of beer, two tons of butter, three tons of cheese, a bed with linen, a wardrobe of clothes, and a sliver beaker. There was little attempt to justify these prices - most speculators entered into contracts with the intention of selling quickly at a higher price." 9 (Emphasis mine)
While determining whether or not we are living in the final hours of a mania is extremely difficult for most investors, Chancellor's work, which recounts various manias and bubbles and concludes with a discussion of the "kamikaze capitalism" of "the Japanese bubble economy" and the dangers of derivatives and heavily leveraged hedge funds, makes it apparent that our current circumstances, while wildly imaginative, are not altogether uncommon. Our current level of sophistication only acts to obfuscate this most current rendition of the age-old get-rich-quick scheme.
To read the entire May Newsletter, you can sign up, at no cost, through our website. If you would like a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds, visit our website. This will also give you access to archives of the same monthly newsletter titled, The Investors Mind: Anticipating Trends through the Lens of History.
4. BIS Working Paper, No. 193, Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework, William R. White, January 2006, page 2
5. Ibid, page 7
6. The Dash to Trash, James Montier, April 25, 2006, www.bestmindsinc.com/weekly.html for the entire article
7. Fortune, May 15, 2006, Masterpiece Theater, Katrina Brooker, page 126
8. BIS Working Paper, No. 193, William R. White, pages 7 and 8
9. Devil Take the Hindmost: a History of Financial Speculation (1999), Edward Chancellor, pages 18 and 19