Riding Out the Financial White Waters

May 9, 2010 at 10:35 pm Leave a comment

After the dam burst in 2008 with the collapse of Bear Stearns (JPM), and subsequently Lehman Brothers and AIG, the financial waters began to finally settle in early 2009. Equity markets experienced relatively uninterrupted, smooth sailing over the last year – the exception being some tame Class I rapids occurring in late spring last year and early in 2010. Now sovereign debt risk is rolling throughout Europe and a cascading wave of trading errors last week left traders and investors thrashing for their lives. So now that the white waters have intensified to Class IV rapids, can we navigate through this turmoil to reach stable waters? Or will we be tipped into the icy cold waters, left to fend for our lives?


De Ja Vu All Over Again

As Hall of Famer baseball player Yogi Berra said, “This is like deja vu all over again.” Crises are nothing new, but the emotion of the moment can feel worse than reality. Getting continually bombarded with data in this globally interconnected world with 24-hour non-stop news cycles contributes to this lost perspective. The fact is our country has survived multiple wars, assassinations, banking crises, SARS, mad cow, swine flu, widening deficits, recessions, currency crises, and yes, even breakdowns in exchange mechanisms – witness the October 1987crash (Black Monday) drop of -22% caused by an overused and flawed portfolio insurance strategy. Today, the rise of the high frequency trading machines and fragmented exchanges are being blamed as causes for last week’s dislocations.

Rather than put current events in proper context, misrepresented facts and irresponsible, knee-jerk conclusions are often spread like a virus. Extremism has pervaded all aspects of our culture, especially in throughout our media and politics. In this sour environment, nothing can seemingly carry shades of gray…it must be either black or white. The events of the last few days, weeks, months, and years are nothing new. We have seen this financial crisis movie before, even if it is a different title, with different actors, and shuffled characters. These messes start with a great, profitable idea, thereby attracting other participants, which breeds speculation and greed, and eventually stimulates a bubble to burst. This negative cycle in turn manifests itself into a manmade fear machine, which leads to panic and recession. At that point, inefficient capital eventually becomes weeded out, people go to jail, and rules get created to prevent similar bubbles from forming again.

These cycles can be slowed or delayed, but not stopped. Greedy capitalists are creative and they have a proven track record of planting new seeds of growth in the soil of our democracy. Our system may not be the best, but as Winston Churchill stated, “Democracy is the worst form of government except for all the others forms that have been tried from time to time.”

 The European Crisis: Where from Here?

A lot has been going on in the markets, so much so that investors shrugged off the news that +290,000 jobs were added in April (and numbers were revised higher the previous month). Market participants instead chose to focus on the escalating Greek headlines. Currently the consensus thinking believes there is a significant probability of Greece defaulting with the financial downdraft spreading to neighboring countries as evidenced by widening interest rate spreads (see chart below).

Chart from The Financial Times

Much attention has been directed towards the PIIGS countries (Portugal, Italy, Ireland, Greece, and Spain) due to their poor fiscal criteria, but not all PIIGS are created equally. Although, I am less worried about Portugal and Ireland due to their minimal contribution to European GDP (Gross Domestic Product), I am concerned about the potential deterioration in Italy and Spain’s ability to pay back there borrowers or refinance their debt. Time will tell.

If you want to compare Europe’s debt and deficit problems with the United States, I encourage you to read my past article on D-E-B-T: The Four-Letter Word


Source: Barclays Capital; OECD via The Financial Times

Surviving the Choppy White Waters

Although the Federal Reserve and the government came to the country’s rescue by implementing massive monetary and fiscal stimulus, the “great bounce” of 2009 has recently lost some steam. A recent -10% correction should not be surprising considering we have just undergone a +100% & +83% explosion in the Nasdaq and S&P 500 indexes, respectively, last year from the March lows. In fact, the correction should be viewed as healthy. After gorging on a large, heavy meal, one needs some time to digest the provisions (just as time is necessary to absorb large financial gains).

Presently, there’s a tug-of-war going on between an improving economy and legacy structural issues (e.g., debt, deficits, entitlements, taxes, healthcare, regulatory reform, etc.) If I had to guess, with all the major national issues we face, I expect trading to be choppy for the next six months until we make it through the mid-term elections (relieving some uncertainty). Until then, take a deep breath, put current events in historical perspective, so you will be able to profit from the rough waters (volatility), rather than react late and become hostage to it. If you correctly follow these guidelines, you too can survive the rough financial waters.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and an AIG subsidary structured security, but at the time of publishing SCM had no direct positions in JPM, Lehman Brothers, AIG, or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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