Sorry, folks, but this is probably spot on.
*** DEAD CATS and LIVE RABBITS ***
ONE DAY THERE will be an uncontained financial accident. Within
hours credit facilities will be withdrawn, and there will be forced
derivative position liquidations at organizations around the world.
Modern derivatives will be the brokers’ loans of 1929, resulting
in margin calls, liquidations, the evaporation of confidence,
spectacular losses, a credit squeeze and financial chaos. The
liquidations of assorted off-balance sheet positions will cause
the realization of big losses in many highly geared positions. This
will in turn cause dramatic re-ratings of the creditworthiness of
many borrowers.
The crisis will develop rapidly in the international bond markets
– where corporations and western governments have borrowed
cash consistently and cheaply. Borrowers whose worst excesses are
currently hidden off balance sheet in the derivatives markets will
find themselves insolvent, and their bonds and shares will plummet
in line with their credit ratings. Oversupply of bonds from hurried
sellers will drain the markets of cash and the selling of further
bonds into the market will become impossible - even at distress
prices for good bonds.
The bondholders – pension funds, deposit takers and other
collectors of the public’s surplus cash – will be drawn in, and
will see that they are in no position to pay back their depositors.
Insurance companies will watch as the portfolios which back their
obligations are destroyed. Their capital will be inadequate and
they will suspend paying their annuity holders. Property secured
lenders and banks will be standing in-line, having lent widely in
the mortgage, debt and derivatives markets. Of the £600,000,000,000
of gross sterling deposits in the UK much is on relatively short
periods (e.g. 30-day deposit accounts) and lent long term as
mortgages on overpriced assets. Not the tiniest fraction of this
amount of money can possibly be delivered by the banks in cash back
to their depositors.
In 'normal' times it does not matter if a bank's withdrawals exceed
immediately available cash resources, because the bank can gather
up some cash in bond and money markets. But in a credit crunch they
cannot do this. There will be queues at the bank but the doors will
be shut, Argentina style.
Houses will appear on the market, as the equity rich seek to secure
the cash which they regarded as their savings. But no-one will have
the cash or the finance to buy them, and house prices will slump in
search of a few brave buyers. Mortgage lenders will go hunting cash
to stay afloat - they'll suspend new lending. The banks and building
societies will increase borrowing rates, without increasing deposit
rates, and they will suspend withdrawals. Industrial businesses
will face a slump in demand like they have never seen. Unemployment
will explode.
Only the debt free who have invested in super-cautious organizations
and instruments will emerge with liquid assets.
Like most predictions these particularly wild ones are almost
certainly wrong. But they show a possibility which many savers are
simply not aware of. Most readers – even those who broadly agree
that the future could get that bad – will smile inwardly in the
confidence that they are shrewd enough and fast enough on their
feet to get out at the first sign of trouble, before the storm
really hits.
Maybe they are in that tiny number who will achieve it, but it is
unlikely. Not only is there simply not enough cash to pay out more
than 1 or 2 per cent of savers there are other great difficulties.
In times of crisis the marketplace makes it very difficult to act. At
every stage of an implosion it introduces elements which obscure
the ultimately successful line of action. Prices, for example, do
not descend in an orderly straight line. Almost all the sharpest
rises in the markets occur directly after the steepest falls.
Market professionals have a black humor expression for these
rallies. They call them "the dead cat bounce", because even a dead
cat will bounce a few minutes or a few hours after the slump.
[He's wrong here. Dead cat bounce refers to the idea that if you throw a dead cat from the roof of a 50 story building, after hitting the ground, it will bounce. This should not be mistaken for its' rising back to the roof, it merely bounced. When stocks fall hard, and then briefly rally, it's a dead cat bounce. -ed.]
People who lose 10% of their portfolio value on Monday morning,
when the market phone isn't being answered, and then gain 8%
on Monday afternoon, will choose to do nothing on Tuesday. While
they're dithering the market will encourage inaction by greatly
increasing the trading spread between buying and selling prices –
leaving investors with the feeling that to trade is to be fleeced
by the professionals. They will decide to hold on rather than lose
another 10% of their money by selling while the prices are wide
and the markets illiquid; and every time the prices narrow again
they will wrongly think the worst is over and will still do nothing.
Of the few investors with a trader's mentality, almost all will
be over-affected by the repeated market swings. Sucked out on the
falls they will buy back in on the rally – on consistently wide
spreads. Meanwhile any assets which offer protection to savers will
boom in price, just to the point where they are uncomfortably –
even dangerously expensive to buy.
This should be understood by all investors – but it isn't and it
never will be. The market doesn't wait conveniently showing the point
at which we should get out. It hangs between greed and fear. When it
falls it tempts us to hold on with the prospect of recoveries which
don't happen, yet it punishes us repeatedly if we start selling,
with bounces which would have saved us from our loss. Bit by bit
it turns the shrewdest market operator into a rabbit.
The significant majority of the tiny number who eventually succeed
in such chaotic market circumstances will be those who acted before
the storm broke. By the end they will have been through the mill,
having endured countless hours of anguished doubt. But aided by the
initial profits they make as the storm breaks they will have been
able to ignore strong but temporary market movements against them,
provided of course they have the fundamental confidence in their
own judgment of the process of economic unwinding.
But even then only a handful will exit their wealth preservation
strategy and go back into productive businesses within 20% of the
bottom. This is what it is like to be a successful investor. Even
in the good times it is painful to sell well, and painful to buy
well. But during times of crisis the pain is amplified by extreme
volatility, wide pricing, and thousands upon thousands of column
inches of popular newspaper analysis recommending entirely the
wrong action.
"Perhaps never before or since have so many people taken the
measure of economic prospects and found them so favorable as in
the two days following the Thursday [24th October 1929] disaster,"
writes J.K.Galbraith in 'The Great Crash 1929'. However, "on Monday
the real disaster began."
The disaster of 1929 was to continue – first down, then up;
horror, then hope, then horror, for 6 months. It sunk the bulls,
the speculators, the bottom fishers, the momentum trackers, the
chartists, the value investors...everyone.
Virtually no-one who had ever been involved in the markets came
out of the other side with any money at all. So perhaps the last
word should be left to someone who did.
"The complexity of this era of credit liquidation is far too great
for the mob mind to grasp," said Robert L. Smitley, writing in his
usual style and with his normal regard for the intelligence of the
average investor in his hugely entertaining book 'Popular Financial
Delusions' – published in 1933.
"It is hardly possible for them to see the picture wherein about
700 billion dollars of physical and intangible wealth is attempting
to be turned into about 5 billion dollars of money."
