Punishing the Pretenders
By Wynn QuonA man in a forest is digging a hole. Two feet, three feet deep he goes. Soon he is in over his head. Seven feet, ten feet, fifteen, twenty. Now the sky is a small square patch of blue above him and he realizes he is in trouble. How does he get out? He announces his plan: He will keep digging in the hope that he will uncover a ladder.
This summarizes the approach taken up to now by the U.S. and European governments in the face of the largest debt crisis since the 1930s. And who can blame them? The debt bubble has been building stealthily for decades. Yet all this time politicians have gotten away with a) doing nothing or b) pretending to do something (but actually doing nothing) and c) fantasizing.
With the events of the past month though, the times are a-changin’. In August, after weeks of partisan grandstanding over the U.S. government’s debt ceiling, Congress came up with a much-ballyhooed scheme to chop US$2 trillion from the budget. But the harsh truth, given the future entitlements in Social Security and healthcare, is that Congress actually needed to find US$15 trillion in cuts and/or new taxes . Standard & Poors downgraded the credit rating of the U.S. government, and stock markets nose-dived. The rating agency’s action and the markets’ reaction signaled to the world that the Age of Pretending is over.
In Europe, where the sovereign debt crisis (see our October 2010 column) is even now threatening to spiral out of control, the same game of pretending is on its last legs. European leaders have held eleven debt crisis meetings in seventeen months. Loans are dribbled out to Greece in a make-believe effort that the country is still solvent. But markets are getting wise to the endless parade of half-measures. Either the Eurozone gets its act together with a solid debt restructuring plan or there will be a signature event, a Lehman Brothers-like implosion with chaotic consequences.
The good news is that the stage is set for some hard decisions to be made. The bad news is that even if politicians rise to the occasion, recovery will still be painful and long.
The world is struggling with the aftermath of the greatest borrowing binge in history. From the mortgage bubble in the U.S. to the sovereign debts in the Eurozone and the increasingly precarious infrastructure bubble in China, we’ve dug ourselves into big trouble. (Despite what you may have read in the paper, Canada is no paragon of virtue either. People are walking around with $500,000 mortgages with 5% down, a financial crime in any other time).
The historical record bears repeating. In the two prior examples of major debt crises in the twentieth century, the usual economic prescriptions don’t work. The three prescriptions are stimulus spending, austerity, and relaxed monetary policy.
With stimulus spending, government payouts are supposed to encourage people to buy goods and services. The stimulus can come in the form of make-work projects and tax credits. In theory, the increased demand results in more business activity, and companies in turn hire more people, pay them salaries and so on. But because of the huge amount of debt that consumers and businesses have amassed over the last decade, the ripple effect of government expenditures is limited. People will take the payouts and use them to pay off debt or build up a safety cushion. The debt burden simply gets shifted from private hands to public ones. Case in point: Japan. After its real estate bubble collapsed in the 1990s, the government tried to soften the blow with bailouts, debt extensions and stimulus spending. Twenty years later the country’s zombie economy is a poster-child for a post-bubble collapse. Its stock market is still down 75% from its 1989 peak. The government owes US$12 trillion, three times its annual GDP.
What about austerity programs? Debt got us into trouble so surely the answer must be to slash spending. There’s certainly fat in government bureaucracy but the lion’s share of government spending is in social programs. Cutting payments to the poor and elderly will have a huge negative impact and will likely result in another recession. Perhaps the most famous historical austerity champion was Andrew W. Mellon, Secretary of the Treasury in the United States at the onset of the Great Depression. He famously advocated a cutback program that would “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people." Unfortunately, it didn’t work out too well. Gross National Product in the U.S. fell by thirty percent from its peak in 1929. Unemployment reached 25% and without a social safety net, many families were financially devastated.
The final weapon in the policy maker’s arsenal is a looser monetary policy -- lowering interest rates to allow individuals and businesses to borrow money. Because um, in a debt crisis, you really want more debt. Seriously though, lower rates don’t work because lending standards tighten up and would-be borrowers are few and far between. In the U.S., the era of zero-money-down real-estate purchases is over. A bank that is losing billions of dollars because of foreclosures isn’t likely to issue new mortgages unless the applicant has a sterling credit record. In a debt crisis, of course, there aren’t too many of those people around. (Incidentally I believe our own banks are going to have their own day of reckoning soon. Despite what you may have read about how solid the Canadian banking system is, the reality is that it has not been tested. Wait a couple years for our own real-estate bubble to burst and let’s talk again. Until then my inclination as an investor is to stay clear of the Canadian banking sector). To see how ineffective low interests are in pumping up a debt-addled economy, we return to the Japanese example. Throughout their twenty-year bear market, they kept lowering their borrowing rates and now it stands between 0% and 0.1%. This eerily resembles the recent move by the Federal Reserve in the United States to keep interest rates “exceptionally low” until at least 2013.
Are we doomed to repeat the historic disasters of the Great Depression or the Great Japanese Recession? The good news is that every crisis is different. The bad news is that the debt bubble that we’ve gotten into dwarfs both the Japanese real-estate bubble and the 1920’s stock market bubble that led to the Great Depression. The recovery will take a long time because the mountain of debt has to be unwound. Governments have a role to play in making this process as orderly as possible. But the sheer length of time it will take for things to get better holds a danger of its own. Voters may fall into despair, casting about for simple solutions that would make things worse.
What to do?
In our October 2010 column we said that 2011 would likely turn out to be a watershed year for stocks. I would venture to say that we reached a multi-year peak in stock prices earlier this year and the coming months will see negative action. (It is not only stocks that are turning. I should add that in Canada we have likely seen the peak for real-estate prices as well, perhaps even a generational peak).
What should one do in face of this financial turning point?
Well here’s one piece of advice that you shouldn’t follow. No doubt you are familiar with it because variants of it pop up every time stock markets lurch downward:
"Don’t worry about stock market fluctuations, step back and think about the longer-term positive trends in the economy and earnings. They will ultimately matter more than the market's short-term ups and downs."
This sounds harmless enough doesn’t it? To see why this is terrible advice, think of preaching its equivalent to a mountain climber. “Don’t worry about falling into a crevasse because we know in the long-run you’ll be back safe and sound at home.” A mountain climber who takes this to heart will get home alright. Home in a pine box.
A good mountain climber doesn’t assume everything will work out fine. He studies the worst case scenario. He undergoes rigorous training and he carefully selects and packs the right equipment. He’s pays attention to the weather. He picks his climbing companions carefully. He’s the last person in the world to pretend that everything will work out just because he wishes it so.
The same applies to the successful investor. He’s studied stock market history. He knows that once every few decades severe weather hits the stock markets. The storm can last for a decade or more. Stocks become universally reviled. He would also know that getting angry when this happens is as foolish as a mountaineer cursing the mountain. Instead he grasps that universal revulsion is a sign that the weather may soon change for the better. (For the record I don’t believe we are anywhere near the bottom yet).
He is aware that during the Great Depression, even though stocks fell 90% from their peak, and didn’t recover their highs for over two decades, someone who held dividend stocks recovered their investment within ten years. He also knows that many were not able to persevere because they had lost their jobs, ran out of money and were forced to sell at record lows.
The successful investor never puts more into the market than he can stand to lose. When the market falls, he makes prudent purchases but doesn’t recite slogans like ‘buy the dip’. Instead he picks price points ahead of time, he knows exactly how much he will buy if (for instance) the Dow Jones Industrial Average were to fall to 8000, 6000, 4000 and 2000. If he holds a 50/50 stock/bond portfolio, he’s comfortable knowing that even at the height of the Great Bear Market of 1929-32, 60% of his assets would remain intact. It would not be pleasant but like the prudent mountaineer he would not run out of oxygen.
If he happens to use a financial advisor, the advisor would have a deep knowledge of bear markets. He would know the details of what happened during the great bear markets we’ve talked about here. He should also understand the bear market of 1973-74, the crash of 2000 and the credit crisis of 2007-08. The North face of Everest is the wrong place to learn what to do when the rock ledge gives way.
Finally, the successful investor is not infallible nor does he aim to be. He may hit a stretch of bad luck. He may not emerge intact from such a setback but through superior planning, he will prevail.
Wynn Quon is chief investment analyst at Legado Associates (www.legadoassociates.com). You can send e-mail to me at wynn_quon@hotmail.com