What is Going On in the Financial Markets?

The only question that matters: what is going on in the financial markets right now?  Here’s my attempt at an answer.

Usually in investing you can trust the fundamentals that underlie the economic performance of businesses to ultimately win the day.  Warren Buffett says it this way: in the short run the stock market is a voting machine, but in the long run it is a weighing machine.  In other words, whatever emotional tides are slamming the investment coasts are ultimately trumped by how well businesses run their operations.  In fact, this is a more detailed way of saying that to invest well you need to buy great companies and then hold them for a long enough time for them to apply their knowledge and talent to generate profits.

Let’s look at this relationship between emotions and business performance in the context of investing a little more closely.

Financial markets are driven day to day by big sweeping waves of emotions.  As I write about in The Intuitive Investor: A Radical Guide for Manifesting Wealth, emotion distorts reality because it is usually charged with preference.  As an example, many people invest in Apple stock because they love Apple products and to such a degree that it has a cult following.  The danger is when these folks continue to hold Apple in the face of continued bad news about the company, such as Steve Jobs leaving or anti-competitive practices, or increased competition.  They continue to hold their shares because they prefer to continue to believe their version of reality.

These sweeping waves of emotion eventually slam into the immovable continent of truth.  The tidal forces often rebuild momentum again and they create oceanic storms and then they hit the continental truth shelf again, never moving the earth.  In other words, truth always wins.  It’s important to remember that underneath the anxiety waves is the rock solid truth.  That’s another way of saying remember that the ocean (emotion) actually rests on top of the earth’s (truth’s) surface and flows over it.

Emotional waves tend to act as attractor forces, such that rumor and innuendo can often create bizarre distortions in the financial markets.  The more emotional attention given to an issue the greater the force of the wave.  Obsession about the Greek debt crisis is a perfect example of this kind of attractor force at work.  What began as an anxious few turned into a puking force of selling activity that saw $trillions lost in the financial markets.

When these problems attract enough energy they can become tsunamis slamming into the truth coastline and cause permanent, irreparable damage to the coastline.  That is, sometimes anxiousness can actually manifest the very outcome it fears and create the force necessary to alter the truth.

So these problems, like the Greek debt crisis, were there all along, but by and large people ignored them.  Then they over obsessed about them then sold stocks and caused the loss of tremendous value.

When these types of big problems arise, and they happen several times a decade, the normal, laissez faire investment community allows its anxiousness to insist that forces outside of the financial markets intervene.  Here I am talking about politicians and central bankers being asked to involve themselves.

These outside authorities are asked to bring their considerable resources to bear to help solve, or make more bearable, a problem.  Think: just after the Lehman Brothers collapse of 2008 and the Federal Government acting in conjunction with the Federal Reserve at the insistent of Wall Street to try and stave off the market panic, bank failures, real estate bubble popping, and the seizing up of money markets.

The earth/truth moving tools brought to bear in these situations are of two types: first, the Federal government, which includes Congress and the Executive branch who implement fiscal policy to affect reality; and second, the Federal Reserve which uses monetary policy, chiefly through manipulating interest rates/the price of money, to affect reality.

Now this brings me to a bit of an interlude.  There are two ways of actively trying to manage these big problems.

First is intervening in a situation with such energy that it convinces people to move their obsessive anxiety onto a different problem; yet the real problem is not really fixed.  But the truth ultimately prevails and the problem is solved.  How?  While people turn their anxiousness to new problems the interaction of people actually directly affected by the problem actually leads to an accord with reality.  That’s fairly abstract and we need an example.

Think about the Taliban in Afghanistan.  The Taliban didn’t just come out of nowhere and occupy Afghanistan.  No, they filled the power vacuum created when the United States and Soviet Union both lost interest in the region because their leadership moved their anxiousness toward other problems, but without having solved the first problem.  That problem is that Afghanistan’s boundaries were drawn up by Joseph Stalin to intentionally make Afghanistan weak.  The boundaries intentionally divide the country in half with a massive mountain range and they do not respect ethnic differences.  These factors mean that Afghanistan will never have a cohesive central rule and will always be subject to internecine warfare.  Even the Taliban were in rivalry with the Northern Alliance before, and now after, 11 September, 2001.

Have the actions of the power brokers addressed reality, yet?  No.  Are the Afghans dealing with the problem anyway?  Yes, they are fighting for control and dominance.  Will their current path ultimately solve the problem?  No, because they think by strong arming their rivals that it will solve what is fundamentally a geographic problem.  Will a solution ultimately reflect the truth?  Yes.  In fact, there is some talk in Afghanistan of dividing the country by its tribes, rather than on some arbitrary map-based boundary.  The truth/earth is almost completely immovable versus tidal forces.

The second way of addressing a big problem is to submit to the truth and to change yourself so that you are in accord with reality.  This is like the Japanese negotiating with the United States for an end to World War II after two atomic weapons had been exploded on their soil.  Up until that point the Japanese people felt that they could win the war despite having a very small industrial base relative to that of the United States and its allies.

The truth of this situation was dealt with by the Japanese Imperial war machine by trying to rile up the Japanese people to distract them from the reality.  Doubtless the Japanese war machine hoped that the United States would be exhausted by the problem and move on.  Until those weapons were dropped the reality of the situation wasn’t apparent to the Japanese people to such an extent that they would surrender to reality.

Interlude ended.

So what is the truth of the financial situation that exists?  The fact is that the institutions, people and ideas that led us into the financial crisis of three years ago have largely not changed a whiff.  We still have a world that has focused on economic growth as an end without considering the means.  That means that gross domestic product has been generated through massive use of debt/leverage.

We have consumers that were over leveraged through student loans, credit cards, car payments, mortgage payments, second mortgage payments, home equity loans, etc.

We have banks, the heart of any economy as they pump out the money/blood throughout the economic corpus, that focused on the wrong set of risks which allowed them to over lever their balance sheets.  The risk that all banks should always focus on when money is being lent is the credit worthiness of the borrower.  But instead every bank on the planet felt that the appropriate risk to focus on was portfolio risk.  By bundling together a pool of mortgages, regardless of the creditworthiness of the borrowers, banks deluded themselves into thinking that portfolio diversification had shrunk the underlying risks.

Lastly, we have nations that have engaged in the same behavior by levering up their budgets to pay for whatever it is they felt was necessary including bailing out other risky choices made with too much debt.

In the past, debt was issued relative to the value of an underlying asset and was collateralized.  So if there was a default, there was security in taking possession of the underlying asset.  When borrowers have their own assets at risk then they are incentivized to repay their debts.  But now debt is largely issued against a promise of future repayment.  And people and institutions led by people break promises.  Which is why debt should be issued with collateral in the first place.  As you can see this is a house of cards.  But a mitigating factor is that at the same time non-financial businesses have continued to run their operations with talent and excellence.  In fact, the majority of businesses around the world are better run now than at any time in human history.

So there was a chance that the power centers could bring their tools of fiscal and monetary policy to bear on the corrupt, debt laden reality I just described.  There was an opportunity that these institutional efforts could distract people away from their anxious obsessions such that market forces would ultimately correct the underlying issues.

In fact, this is exactly what was done in 2008.  Governments and central banks around the world invoked both fiscal and monetary policy tools to try and shift the attention of the anxious world onto the success of its businesses.  Yet, this attention shift didn’t really deal with the real underlying problems.  That’s another way of saying that the amount and focus of the institutional energy brought to bear on the problems was incorrect.  The amount was too little to actually permanently move the underlying earth/truth of the situation.  And the focus of the energy was on distracting people away from the real issues.  In other words, the symptoms were treated, and not the disease.

We still have in place many, if not all, of the same structures that led to these problems in the first place.  That is, while the investing world applied their anxiousness to more mundane problems, like corporate quarterly profits, the massive over leverage of the world’s economies and the corruption of its financial institutions was ignored.  But truth always wins in the long run.

Given that fiscal and monetary authorities applied solutions to the global financial crisis that used more debt to raise money to be re-injected into the debt laden system means that now there is no more room to use leverage to solve a leverage problem.  That means that there is very little ability for external market participants, governments and central banks, to affect change.  That is, they have made themselves impotent.  And the world knows it.

At this point the gravity of the situation is inescapable.  The world has to delever.  Economic growth must be based on innovation and productivity, not just excess use of debt and the excess consumption that entails.  What’s more, in the absence of a financial community being able to root out and manage its own corruption there needs to be regulation put in place that assumes corrupt activities will take place as long as there is so much damned money involved.

If you read my very first post on this blog I said that I was opposed to a bailout of the financial system because I felt that it was time to truly address the underlying rot of the economic system.  And yet, if you look at my blog posts over the past two years I have been a buyer of equities because I know that in the long run that businesses and the people that run them never stop looking for a better way to do things.  I consider this to be inbred into the human.  I recommended buying equities because there was substantive talk about dealing with the growing realization that the world’s economy was based on an incorrect philosophy: leverage.  And recognition that financial institutions needed to be regulated.  I was confident that fiscal and monetary authorities were coming into accord with the problem and that they had successfully distracted the anxiousness of investors away from the problem and onto the heart of investing: business success.

But now, three years on from 2008, the size of the leverage across the globe is even larger and more greatly distributed through more of the world’s economies, like China.  Now the fiscal and monetary authorities have very little power to change this situation.  Governments have increased the size of their debts to mitigate the ills of an under-regulated financial community.  While interest rates, when adjusted for inflation, are actually negative.  All the while businesses around the world are doing very well.

So how do you navigate the tidal forces that are being caused by a fault in the earth causing a massive earthquake?  In all earthquakes you have to surrender to the earth’s movements until the earth settles in a new equilibrium.  Then you can start rebuilding.  What I am saying is that I think the financial markets, equity and debt alike, are going to get worse before they get better.  When institutions and governments begin having public discussions that address the real issues of:

• too much corruption,
• too little regulation,
• too much financial industry greed,
• and way too much debt
• and real actions are taken to mitigate these problems going forward

only then will the earth come to a new equilibrium and the earthquakes stop.  Is everyone taken down when an earthquake happens?  No.  But good luck predicting the specific timing and outcome of an earthquake.  Right now, my intuition tells me that there will be more tremors.

In the meantime, it would be a great time to consider different ways to invest your hard earned money.  It’s not just stocks and bonds, folks.  Every decision you make is an investment and all investing boils down to four words: buy low, sell high.  There will be many investments trading at once in a lifetime lows.  Yes, like stocks in the aforementioned excellent businesses.

But buy low, sell high can also be turned into: sell high, buy low.  I would strongly suggest you find a way to invest in a way to benefit from market declines and volatility.  Convertible securities often do very well in these kinds of environments, as do long-short funds.  But also real estate in economically depressed areas is cheap.  But I also am suggesting investing in things like your career.  If your labor is priced lowly, invest in a new skill set so that you can sell your skills for a higher price in the future.

Buy low, sell higher.  There will be a greater proportion of the time where you can execute on the first two words of that equation: buy low.  And a smaller proportion of the time when you can sell higher.  You need to be nimble and/or find other people who are nimble to help you.

Jason