Today’s Markets: Not Business as Usual

We are too busy mopping the floor to turn off the faucet.

~ Author Unknown

This time is different. Experts often say that these are the four most dangerous words an investor can utter. The expression refers to the tendency to extrapolate current trends far into the future. Usually, people who expect trends like the dot com boom of the early 2000s or the recent housing bubble to persist forever pay dearly when the trend inevitably reverses.

This Time Is Differentis also the title of a frequently referenced book by Ken Rogoff and Carmen Reinhart that examines “eight centuries of financial folly”. One of the things they found in their research is that banking crises like the one we had in 2008 are often followed by sovereign debt crises like the one that is beginning to unfold right now in Europe and which may eventually spread to the U.S., U.K., and other indebted nations. By selectively bailing out banks, insurance companies and automakers, global governments have effectively relocated debt from corporate balance sheets to public ones.

Who cares? How do the problems of countries across the ocean or outside of our borders affect us? In a nutshell, these problems, along with some of the others I’m about to describe for you here, will make the investing and overall economic climate a lot more challenging over the next few years. I addressed the European sovereign debt situation in a recent guest post at The Digerati Life. No one knows exactly how this will all unfold, but a basic awareness of the main issues will help you decide how you want to manage your personal finances through these unique times.

What’s Different about Today’s Financial Environment?

I’m not going to contend that this time is different here, because previous generations have encountered debt problems before. I will, however, say that those were not good times, and if that is the climate we’re in now, we need to be aware of it and plan accordingly. I will further submit that there are a few factors in today’s market that were not present in previous debt-induced crises:

1. Bailout Epidemic: The series of bailouts we have instituted to solve successive financial crises from the Long Term Capital Management fiasco to the dot com bust to the recent housing and debt crises are unprecedented. As the introductory quote infers, we have spent too many resources on short term fixes that have not solved the underlying problems, and have in fact only served to exacerbate them.

A recent article by Mohamed El-Erian of Pimco on courage, vision, and the dangers of short-term expediency sums this idea up beautifully:

“Industrial countries are running out of balance sheets that can be levered safely in order to minimize the disruptive impact of past excesses. This lies behind the recent (warranted) concerns about the explosion of debt, and the related surge in sovereign risk measures.”

Put simply, we are running out of options. It’s time to stop mopping and turn off the faucet once and for all. Boyd Erman of the Globe and Mail had an article out last week called The End of the Road for Rescue Plans that echoed these ideas. I wrote about the bailout cycle as well in Financial Spilled Milk: Macbeth Meets Ponzi. (Update: Barry Ritholtz echoed my Emerson Lake and Palmer reference from Spilled Milk in a post entitled The Greatest Show on Earth.)

2. Complexity: This is not your parents’ stock market. The emergence of complex financial products like derivatives make this marketplace very different from the one in which our parents and grandparents invested decades ago. It’s very difficult for the average person to understand what credit default swaps, high frequency trading, or dark pools of capital are, let alone make use of them or comprehend how they affect the marketplace where their life savings reside. I will address the idea of complexity in more detail later this week.

3. Transparency: While financial innovation has lead to more complexity in the market, that complexity has also lead to less transparency.  There are forces acting on the markets each day that most investors aren’t aware of. They can and do affect the value of your savings. This became abundantly clear during the flash crash on May 6th. I’m going to write about this in greater detail later this week as well as the investing implications for adherents to Modern Portfolio Theory.

4. European Union: The European Union wasn’t established until 1993. The mechanics of 27 distinct countries operating under a single monetary policy are complicated. What if one member has run up huge debts and can’t pay them back? Should the healthier nations be obliged to rescue them? How would you feel about Canadian taxpayer money going to help out another country that hasn’t been a responsible steward of its capital? Incidentally, once the IMF (International Monetary Fund) becomes involved, all member countries are contributing, to some extent, to the bailout. It’s no coincidence that the IMF recently signed agreements to triple the Fund’s lending capacity.

One big issue with a union of countries operating under a single currency is that individual countries do not have the option of devaluing the currency to reduce the value of their debt and make their exports more attractive. Greece faces this problem at the moment, as will any of the other EU member countries that are up next with debt crises of their own.

The TBTF Dilemma

The dilemma we now face globally, like the one involved in the decision to bail out corporate entities, lies in the too big to fail (TBTF) concept. If we allow a company or country to fail, that has the potential to bring us all down. If a “systemically important” institution fails, the banking system might collapse. If GM or Chrysler go bankrupt, unemployment will skyrocket and seriously harm our economy. If Greece defaults on its debt, the banking institutions and countries that hold that debt will be on the hook for very large losses that could in turn spark yet another banking crisis.

The problem with the TBTF bailout doctrine is that it is inherently contrary to the principles of capitalism on which our economic system is founded. It introduces moral hazard, or the belief by market players that they can take on excessive risk because they will be bailed out if it all goes wrong. This is unfair, since many companies were allowed to fail and their employees, having lost their jobs and pensions, will now be asked to shoulder the burden (through taxes) of paying to bail out other failed companies. I’ve discussed the need for failure in capitalism before, so I won’t belabour the point further here.

And Another Thing . . .

The 4 challenges I outlined above are just a few of the factors that make this particular debt crisis unique. We also face a significant number of other challenges that will affect the functioning of the global markets and economy. That means they will also affect your mortgage, your investments, and even the prices you pay at the grocery store.

I’ve already passed my pixel limit for the day, so I’m just going to mention some of these other factors quickly. If you’re interested, I can write more about them later. At this time, we also face the prospect of a housing bubble unwind in several countries, including Canada, Australia, and China. We may experience deflation, inflation, or both as a result of the current climate. The latter fact alone will make investing decisions extremely difficult. Countries wishing to improve their balance sheets, heavily damaged by serial bailouts, will likely raise taxes. If austerity measures continue to be imposed in countries carrying large debt burdens, the potential for civil unrest rises. We have already begun to see a backlash against corporate entities and large banking institutions worldwide.

I know that the picture I’ve painted here isn’t pretty. It’s not my intention to incite panic or despair. I just don’t want to see folks get caught off-guard by this crisis. I believe we will get through this and hopefully emerge with a stronger, healthier economy. I just don’t know exactly what the road to that new economy will look like.

Tomorrow, we’ll look at a few different ways to manage your money through these uncertain times. You can’t control what happens in the world economy, but you can control your response to it.

Do you see the current market climate as unique, or is it just business as usual?

Written by Kim Petch

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