This year’s poster child for financial excess surely had to be the Gulf stock markets. We warned on several occasions, in past issues of Executive, that the level of gambling in those markets had reached mega-bubble proportions. In fact, our cautionary words were worth about $350 billion in Saudi alone, where the leading index fell from 20,000 points to 10,000, leaving many small players and late entrants in ruin. The near vertical moves in the Gulf were not an isolated event, and while the players were mostly locals, the folly for shares was symptomatic of a larger, more global drop in risk premiums and an almost unquenchable thirst for outsized returns.
The investment landscape had been uneventful for a couple of years now. It was a simple rule of thumb: the more risk one took, the better the returns. In this environment, cautious managers were shunned and everyone, even mainstream investors, looked for “the big play”. The commodity markets obliged as they rallied dramatically, starting with oil, which as we all know rocketed from $30 to nearly $75 and then moved to metals (see last month’s Executive), which nearly doubled in price.
The mad rush continues
So, as the mad rush for performance continued, so did the parabolic rises in these markets. What seems eye catching here is that rather than serving as a so-called hedge or protection against paper assets, stocks and bonds, commodities were moving up along with them. In fact, since October 2002, when the US market hit a peak after the NASDAQ bubble popped, every single investment market has been rising in an equally fearless manner.
While it is tough to find exact cause in the markets, and thus difficult to determine which markets led the advance, it is clear that overall, globally, investors had become almost fearless. This type of liquidity-driven market is usually impossible to time, and is devastating in its randomness, much the same as crashes. When we asked an associate who manages $500 million at Societe Generale why it was that over the last three years markets had been moving up so relentlessly, he said, “think of this as an upside-down crash, a mad rush to own assets.”
Real estate, whether through funds or directly, took off nearly in a synchronized fashion worldwide, carrying with it mortgage-backed and linked securities. Meanwhile, global IPOs flourished and carried a bonanza for the ultra-wealthy and the brokerage firms. The explosion in derivative instruments, especially credit-related, swelled the earnings of multinational financial firms to preposterous, unsustainable levels.
Should investors opt for prudence in this
environment? The answer is a resounding yes.
Booms in many markets
There are many arguments as to why this near-perfect correlation in world markets produced a rave-like euphoria in all asset markets. Even the art and collectibles markets boomed and accelerated over the same period. One could argue that globalization was bound to produce more harmony in global market and investment returns. Some argue that a more global and connected world is prone to deliver contagion on the upside. This is true and verifiable, even before the internet, but somehow it has been amplified over the last few years. What has amplified this is the existence of actively managed funds, especially hedge funds. We noted in past articles that hedge funds now rule the day and with 8,000 of them currently operating, they have fostered a constant, mad, sometimes reckless search for return. Rather than being alternatives, derivatives and hedge funds have now become the norm, well entrenched into the product factories of nearly all banks and insurance companies.
Is this healthy? And could this propagation of hedge funds actually lead to greater risk ahead? Those questions are worth trillions of dollars and difficult to answer, but let’s look at the current investment climate and try to pinpoint what is relevant for readers: should they opt for prudence in this environment? The answer is a resounding yes.
Many people like to look at fundamentals, and reason that since the world economy is growing this can only be good for their investments. If only things were this simple. For one, there is way too much financial leverage in the global system, so economic growth is not the single most important piece of data to decide on. We have included a chart of the World Bank showing natural wealth creation, versus the wealth created by derivatives and the picture is frightening. While derivatives, as many central banks like to console themselves, do in fact add liquidity to the global financial system, they become a source of concern when they reach several multiples of the world’s real productive capacity.
The derivatives game
Wherever you look, banks are more and more involved in the derivatives game, either for their own book or in their product offerings to clients. We should point out that derivative instruments are genial and they have opened up horizons to companies and even individuals, simplified transactions, and served as insurance in many cases against financial calamities. But what is at stake here is a world too crowded with hedge funds, derivatives, and risk-taking. This cocktail will be lethal going forward.
Since early May, the more mature markets, such as the US, UK, Europe, Japan, and Hong Kong have slid down from their peaks, dropping an average of 6% in a couple of weeks. This may seem like peanuts but what is telling is that this seems to be coinciding with other indicators that foretell a long, hot, nasty summer.
This drop is also occurring in areas such as real estate and commodities that seemed to be the last bastion of upside. In the US, the leader of this particular pack, the drop is coming on the heels of the largest margin debt level in history. Investors are now more up to their necks in borrowed investment than they were just before the 2000 collapse. This is an ominous situation to say the least. Usually, healthy sustainable up markets need some degree of skepticism by investors, and not the near uniform excitement we see now. Most financial mainstream media today is even more encouraging than it was before the internet bubble burst. Odd, isn’t it, that the market participants are now even more committed to and excited about technology shares, for instance, than they were in January 2000, before they dropped nearly 70%? This can only mean one thing: trouble ahead.
A burst global stock bubble, which seems now inevitable from the Gulf to Brazil to China, along with a substantial drop in asset prices generally, including real estate, will have a dual effect of cooling global economic growth and easing pressure for monetary tightening (raising interest rates). Because most markets have been so tightly correlated, the debacle ahead will hit most investment markets except maybe the highest rated bond issuers.
Time to reduce investment risk
This may sound like absorbable news, but given the amount of leverage and the extent of the vast credit bubble which has mushroomed, the coming deflation in asset prices will be devastating to non-prudent investors, over-leveraged new hedge funds, and anyone who has not stepped away from risk-taking. In cycle terms, it has been a great three years to assume risk, and it seems now essential to reduce risk in investment terms and stay as close as possible to problem-free money market investments, at least until the end of 2006.
