By Paul Petillo
Over 140 years ago, German biologist Ernst Haeckel developed the idea of an evolutionary family tree. Calling this visual aid for ancestor/descendants relationships phylogeny, he sought to map out a logical categorization of organisms. The idea was to make evolution much clearer for the scientifically uninitiated.
But it lacked the rigor that science demanded and did not take into account the simplest of facts: ancestors pass down traits but each new species is an evolutionary dead end.
Something happened the other day that might reveal just such a financial cul-de-sac. Does the worldwide plunge in stock indexes signal the eve of a new financial species?
Far too many investors disregarded economic news - good or bad. With an appetite for risk and a thirst for free flowing, cheap cash to fuel that appetite, they simply plowed forward. Those days may have come to an end.
For investors who actively manage their portfolios, the past days have left them frantically parsing each tidbit of news wondering what new twist will affect their holdings. Economist and money managers have been trotted out offering some of the best metaphors, each lovingly adopted by Wall Street historians for just these types of events. "Don't try to catch a falling knife," one said while another suggested investors "keep the powder dry". Both are references to a 'wait and see' approach, the hallmark of a more conservative, long-term investing philosophy and not necessarily advice.
Yet, the recent sequence of events seemed to leave even these sage investment experts baffled. The requisite reassurances were proffered and expected after such a fierce and unexpected gyration but they all seemed shallow. Long-term investors were told 'that they need not worry'. It was advice no doubt given by analysts with one eye on the ticker.
Many concluded that one possible trigger for the recent worldwide drop in stocks was the Yen carry trade. This news caught both novice and experienced investors by surprise.
The Yen carry trade thrives on low volatility. It is important to keep in mind that when low volatility thrives, the largest investors have greater difficulty predicting potential losses, which in turn permits riskier borrowing strategies. Okay, but why would this affect the plain vanilla index fund investor?
The carry trade works like this: An investor buys currency (borrows money) from a bank offering low rates. The money is then exchanged for dollars to buy a bond, preferably one with high yields and good quality.
The Yen, which has been available at a 0.5% interest rate, was the prefect currency to borrow. By borrowing in Yen, trading that currency for dollars and then using those dollars (the carry) to buy high yield bonds, investors profited from the difference. When rumors surfaced that Japan may be considering yet another rate increase, investors panicked, flocking in a so-called flight to quality to US Treasuries. This pushed up prices and yields fell closing the profit gap further.
Or it may have started in China. The Shanghai Stock Exchange has been on a tear of late up 174% since mid-2005 largely fueled by easy credit. Individual investors jumped into the markets leveraging their houses in the hopes of catching the upward surge. These novice investors panicked when rumors surfaced that the government was debating a capital gains tax to help slow the fast growing economy.
This sent ripples through the commodity markets as well. The phrase Asian Contagion, a throw back to a 1997 event that started when former then chairman of the Federal Reserve Board Alan Greenspan suggested 'irrational exuberance" has surfaced again
Classic Greenspan doublespeak was now suggesting that a US recession is possible. It is a sort of retraction from a comment he made in Hong Kong predicting that a year-end downturn was probable. What better way to promote his upcoming book "Age of Turbulence"?
Sandwiched in-between is Mr. Greenspan's replacement, Ben Bernanke. The Fed chairman has attempted to remain resolute in the face of so much unwarranted white noise.
In a time gone by, the current Fed short-term rate would have performed as expected. It would have moderated inflation while keeping employment at a sustainable level. Although Mr. Bernanke has begun to question this inflation/employment relationship, the 5.25% level seems about right. But you have to wonder how long he can ignore some of the economic cries for help on the home front.
The US role in the global economy has evolved. Our appetite for goods has kept equity markets both here and around the world well lubed. Increasing the cost of borrowed money domestically has succeeded in slowing our economy. How slow is slow enough?
The homes-for-sale inventories in the US have skyrocketed. There are now roughly four new houses available for every one buyer. Sub-prime financial institutions have failed to set aside enough cash to cover their risky bets and now, the gray market, the one nestled in-between poor credit quality and excellent is beginning to feel the crunch. GDP has been revised downward.
After all the dust settles and it may after a few more exciting percentage point drops in the next week, will we be witness to a new breed of investor? Will this new investor be a shell-hardened predator steeled by several jarring downturns able to slough off the correction as nothing more than potholes or something wholly opposite?
We hope that Mr. Bernanke realizes that we are no longer alone. Events unfold around us in far-flung corners where we never expected our investments to venture. While this is neither good nor bad, it presents us with a new global reality
Dr, Haeckel would be tempted to add a new branch to this global family tree. But only if we have successfully changed into a new species of investor; one that brings a healthier respect for risk and volatility to our investments; one who is able to navigate this new worldwide landscape with skepticism and do so with the understanding that this is just the beginning.
