Tuesday, September 29, 2009

Swine Flu, Bear Markets and Human Nature

The latest news on the swine flu virus is that perhaps – according to an unpublished study – getting an ordinary flu shot makes it 30% more likely you will contract swine flu. Canadians are damned if they do and damned if they don’t. If they take the normal flu shot, they are more likely to get swine flu. If they don’t, they are more likely to get regular flu. What should we do?

Well, we’re Canadians, so we'll wait for some government official to tell us what to do.

But this dilemma illustrates an often forgotten aspect of our humanity: life contains risk. Getting the flu is an important risk. There are no 100% guarantees that we will escape the virus whether we get the shot or do not get the shot. It’s all about the odds.

As a financial philosopher and partner in an investment firm, I am often asked about financial risk. The stock market might go up or it might go down. If all my money is in stock market mutual funds, and the market goes up, I win! This is what happened during the 1990s. But if the stock market goes down, I lose! This is what happened in 2001 to 2003 and again in 2008. What should I do?

The pat answer from the investment industry is: invest in some stocks, but also hold a diverse portfolio of non-stock investments, like bonds, real estate or precious metals. But that’s not a real answer, is it? If you own $100,000 in stocks, it will go up or down with the stock market: if you happen to own real estate or bonds or gold, your stock mutual funds will still go up or down with the market. The investment industry’s pat answer does not address the basic truth that there is risk in investing in the stock market and we need to know how to handle that risk. What should we do when the market goes down?

Canadian investors are exposed to wealth risk in the same way that we are all exposed to health risk?

Health conscious Canadians are smarter than wealth conscious Canadians. They expect to take precaution and to do something to protect their health from a flu epidemic. Most Canadian investors are doing nothing to protect their wealth from the ravages of an economic pandemic. During the 2008 market melt-down, most financial advisors encouraged their clients to do nothing: to hang in there and not worry… The stock market would recover.

How would you feel if you got this kind of advice regarding the up coming flu season? “Don’t worry about the flu: if you get it you will recover. Just keep washing your hands and hoping you don’t catch it.”

In my investment book, Beyond the Bull, I point out that an important part of our human experience involves luck. When the experts believe there is a good chance we’ll have a swine flu outbreak, we see that as an increase in risk to our health. When they experts believe there is a good chance we’ll have a banking crisis or an economic melt down, we should see that as an increase in risk to our wealth. In both cases, a normal intelligent person would take precautions to protect themselves. Strangely, however, the investment industry doesn’t see it that way. The slogan “buy and hold for the long term” implies that there is no real risk in the stock market. It always goes up eventually. I suppose this is the same a saying that every flu pandemic will eventually end.

It’s about survival, isn’t it? Will we survive a flu pandemic? Will our investments survive an economic melt down? And, if it’s about survival, then it’s about protecting ourselves against reasonable risk. We hope to protect ourselves from the flu by using vaccinations. And a variety of government health experts are advising us on the vaccination process. But not a single government health agency is telling us “Don’t worry, be happy.”

What is it about the investment industry that makes professionals continually advise individual investors to do nothing – to hold onto our investments through thick and thin?

When I first entered the investment business in 1975, mutual funds guru John Templeton got it right. He used to say: “We shop the world for undervalued stocks. We hold them for three or four years and sell them when that value is recognized.” He wanted us to buy and hold Templeton Growth Fund in full knowledge that he would buy and sell stocks for us within the fund. Modern mutual funds do not talk about selling at all. They want us to buy and hold their mutual funds, and they want to buy and hold stocks within that fund. And they really do hold: how many mutual funds off loaded their stocks before the 2008 melt down? Mutual funds management has changed dramatically since 1975.

In my investment book, Beyond the Bull, I discuss the five keys to correct investing. One of those keys is to have a method of deciding when to buy and when to sell. Sir John Templeton used his value models to help him make this decision. Modern mutual funds managers seem to have methods for when to buy; but they seem weak in the area of when to sell. It seems like their business plans call for the market to go up all the time. And if the market goes down, their mutual funds go down too.

Modern wealth management is a bit like modern health management. Will we take that shot to protect ourselves from the flu? Will we sell our risky investments to protect ourselves from economic weakness? It’s up to us to decide when to protect ourselves.

Ken Norquay, CMT
CastleMoore Inc

Links to Beyond the Bull


Monday, September 14, 2009

The Second Shoe: a fresh look at the world of banking

2008 was a close call for the world’s banks. The system almost collapsed. The stock market did collapse. The only thing that saved the banks was government intervention: sovereign states all over the world poured billions into the banks to prevent the collapse. Let’s review the rules: what really went wrong?

Imagine that you and I decided to start up a bank. Our investors put up $1 billion of capital. A year later we have $500 million in deposits for a total of $1.5 billion. In Canada our bank would be entitled to loan out 17 times $1.5 billion. In other words, our bank could create $1.5 billion X 17 = $25.5 billion in loans. We make our profit by charging interest on the $25.5 billion in loans. And where does the $25.5 billion come from? It was “created.” Canada’s central bank created $25.5 billion and loaned it to us at the Bank of Canada’s overnight bank rate.

In Canada, our rule is we can “create” loans of 17X capital + deposits.
In the USA, it’s 22X.
In some countries in Europe, it’s 27X.

Years ago the world’s bankers decided to hold most of their capital reserves in US dollars [US$] assets. Mostly they would own US treasury bills or bonds. They wanted something safe. Their reserves were mostly in US$, but their loans were mostly local currency. So our bank would have held its $1 billion in reserve capital mostly in US$ and we would have loaned out the $25.5 billion mostly in Canadian dollars [CD$]. If the Canadian dollar went UP against the US$, we could get in trouble because our reserves were shrinking compared to our loans. If the CD$ became stronger and stronger, our 17X ratio might go to 18X or 19X. If this happened, we would have to call $1 or 2 billion in loans. When the banks are forced to call in loans, it’s called a credit squeeze and it is very bad for the economy. Business’s who rely on bank loans to operate need the money – they don’t have the cash to pay off those loans that have been called.

The world banking system needs a strong stable US$ to operate efficiently – and the world’s economies need a strong and stable banking system in order to operate effectively. And that’s where the 2008 banking crisis began.

In winter 2002, 62 cents US would buy one Canadian dollar. In autumn 2007 it took $1.11 US to buy that same Canadian dollar. The CD$ had gone up 79%! Another way of saying that is the US$ went down by 44%. The little bank we created for this article was under tremendous pressure. Our reserve capital had shrunk over those 5 years. The strong CD$ [weak US$] seriously impaired out ability to do business.

It wasn’t just the Canadian-dollar based banks that felt the pressure because of the long decline of the US$. The same story applied to Euro-based banks, pound-based, yen-based, etc. The US$ had been devalued against them all.

American brokerage firms had somehow persuaded the world’s bankers to hold pooled mortgage funds as part of their US$ capital reserves instead of treasury bills or bonds. Yes, they were not quite as safe as US treasury issues, but they paid a lot more interest. And with a booming US real estate market, how much risk could there be in mortgage investments?

The sub-prime mortgage fiasco became widely recognized in 2007. All the banks saw the defaults and they all wanted to reduce their exposure to this now shaky investment. Soon there were no buyers: only sellers. These vast pools of US$ paper that were now part of the banks’ capital reserve had no value. The world’s banks had lost their shirts. Our little bank would have been in serious trouble. No only did the currency of these junk mortgages go down, but the actual price of the mortgaged pools collapsed too. Our little bank would have had to call in loans to the tune of 17X the loss. European banks might have had to call 27X their losses. The US banks had not experienced the currency loss – but even so, bank after bank had to be bailed out because of their mortgage losses. The world’s banks were under pressure to call in loans on such a scale as to ruin the world’s economies. This all came to a climax as the US’s new president was being inaugurated. The nations of the world cooperated as never before and saved the banks.

It worked. The governments and central bankers actually did restore order. Here’s how:
1. Governments provided capital reserves to the banks so they would not have to call loans.
2. Banks began to raise their own capital. Canadian banks raised billions in spring of 2009 by selling preferred shares.
3. The US$ went sharply higher, stabilizing the value of the banks’ US dollar denominated capital reserves.

The stock markets recovered and now the economies appear to be recovering. The bail outs worked.

Americans do not want a stronger US$ right now. The US economy is in trouble. Their manufacturing sector is in tatters. A strong US$ makes it harder for them to sell US manufactured good abroad. Americans need a lower dollar right now.

But if a weak US dollar causes the worlds’ banks to fail, the US economy will go down too. What will they do?

In the last six months, the US dollar has dropped 14% against an average of the Yen, the Euro, the Pound, etc. If the decline of US$ continues at this pace, by New Years Day the US dollar will be back down to where it was in the height of the banking crisis. The pressure will be on the world’s banking system again.

During the last six months the worlds’ bankers have taken steps to shore up their weak capital reserve positions. They are stronger now than they were last winter. And they have already written off those disastrous sub-prime mortgage assets. So, if the US$ gets even weaker and their reserves come under even more pressure, they are better able to stand the punishment than they were last winter.

Every central banker in the world understands these dynamics. Every pension manager, every mutual funds manager, every portfolio manager understands these dynamics. As the US$ eases down, it helps the US economy and it hurts non-American banks. As long as things happen gradually, the parties involved can adjust.

What kind of adjustments do the parties involved need to make? Well, foreign banks and foreign governments need to continue to cooperate as they did last winter. Most observers believe this will work out just fine. But, what about those big investment managers? Their clients were hard hit when the stock market dropped so sharply last fall and winter. Many pension plans dropped so sharply that they were unable to meet their payment obligations. Bank stocks were particularly hard hit: after all, in a banking crisis, that’s where the maximum risk is. Will the big pension managers ride through the sharp decline as they did last year? Or will they try to sell off some of their stock portfolios? For the multibillion dollar stock portfolios, this is a theoretical question: they are so big that their selling is what forces the stock market lower. They are too big to sell. Even the adjustments they make to their portfolios must be done by stealth selling. Each day they feed a few big blocks of stock out into the market in an orderly and controlled way so as not to overly disturb the market.

What kind of adjustments do we need to make if the US dollar is devalued further? Should we sell our bank stocks? Should we sell all our stocks? We are not in the same position as the mega-money managers of billions – we can sell our portfolios in a heart beat. What do we wish we’d done last year when the US dollar was at this same level?

Those mega-money investment managers who understand these financial dynamics can’t sell out of the stock market when the going gets rough. And those investors who can sell don’t. The small investor has an edge over the large when it comes to selling out – but often doesn’t use that advantage. Why not?

In my book, Beyond the Bull, I try to persuade ordinary investors to develop investment techniques. An investment technique involves objectively observing the world of finance, looking for certain events. When the sought-after events occur, we act: we buy or sell based on pre-planned logic. In this example, we notice a decline in the US dollar and suggest this spells trouble for the banking industry. If the US dollar continued to go down and then the prices of bank shares start to go down, this would be a reason to sell your bank stocks. But that’s not how most ordinary investors behave. Instead of selling, they worry. And, instead of buying their stocks back after a stock market sell-off, they hope the stocks they held through the crash will bounce back up: worrying and hoping instead of buying and selling.

Ken Norquay, CMT
Chief Market Strategist,
CastleMoore Inc.

Links to Beyond the Bull