Wednesday, June 1, 2011

Mediterranean Blues

On the south we have Libya, Tunisia, Egypt and the sequential overthrow of long standing Islamic dictatorships. On the north we have four of the five the PIIGS of Europe, those countries whose governments borrowed too much from the future so they could live high off the hog today: Portugal, Italy, Greece, Spain.

The Mediterranean region contains the roots of western civilization. The Egyptian, Greek and Roman Empires dominated our early history. Similarly, the noble Persian Empire was once the jewel of middle eastern culture. What happened? Today, in 2011, there is chaos where there once was culture.

How could this have happened? What lessons we can learn from the observation that the Mediterranean region is in chaos.

As a financial philosopher I have no trouble understanding the PIIGS of Europe: they pushed their luck too far. The five PIIGS nations borrowed too much money on behalf of the people. (The fifth PIG is Ireland – not a Mediterranean country.) They ran up huge debts and were unable to pay when the time came to pay. As members of the European Common Market, these have-not countries found a way to have. The Mediterranean PIGS’ governments spent way more than they took in and ran up huge debts. Their governments had borrowed their way to prosperity. And, in a democracy, prosperity leads to re-election. The governments of the European Mediterranean countries sunk their countries over their heads in debt so they could win votes and keep power. When those governments couldn’t make their monthly payments, governments had to cut back on spending and refinance. And the people rioted! Easy enough for a financial guy to understand. And easy enough for a political guy to understand too.

But why are the people of Mediterranean south suddenly rioting? Did their governments push their luck too far too? Some blame rising food prices for the north Africans’ uprisings. They argue that the dictatorial governments of these countries were benefiting from rising oil prices and the people were suffering from a punishing rise in food prices. Those dictatorships could have avoided the riots by subsidising food prices using the proceeds of excess oil profits. But the dictators had run up serious deficits and accumulated serious debt. They couldn’t help the people with food subsidies. And the people rioted! This explanation is not so easy for a financial guy to understand because we have no access to the dictators’ national bank books. We can’t verify that they pushed their luck too far. But it does seem possible that over-borrowing may be contributing to the overthrow of the North African dictatorships. We suspect the North African dictatorships borrowed excessively to keep power in their way: by maintaining a huge army and police force.

The Mediterranean theme seems to be corrupt governments borrowing excessively to stay in power. Dictatorship or democracy, the pattern is the same.

What about the people of the USA? Has the American government, in their heroic effort to kick-start house prices and create more jobs, borrowed too much money, just like the Mediterranean nations? We know that the American housing market is in shambles because big mortgage companies loaned billions to new home buyers who could not afford their mortgages. The whole sub prime mortgage financial fiasco came undone in 2008/9, and it’s still unravelling. Has the American government now fallen into the same trap as the yesterday’s over-leveraged home buyers and the Mediterranean nations: borrowing too much?

I have accused the Mediterranean governments of abusing their borrowing power in order to hold onto power. And now it’s payback time. And now it’s coming undone. But we would never accuse the American government of corrupt practices because, to us, they don’t seem corrupt. Canadians support the USA’s noble efforts to re-kindle their failing economy: it seems the right thing to do. But, right or wrong, the results will be the same in America as it is in the Mediterranean: political and economic chaos.

It’s tempting to pontificate about the rise and fall of the world’s economic and political tides. But let’s be practical. There’s nothing an individual Canadian investor can do to stop these tides. Fate will unfold according to its own agenda. We are merely observers.

Our impact will be felt only to the extent that we manage our own financial affairs in the midst of these economic storms. If the world’s economy comes undone again, as it did in 2008/9, we can’t stop it. But we can react to it.

Imagine if you had reacted to the bank crisis of 2008. If you had sold your stock portfolio any time in the last quarter of 2007 or the first half of 2008 and bought it back a year later, your RRSP would be significantly ahead of where it is now. But most investors would rather ponder the economic fate of the world and not react to it.

By now, “buy-and-hold” investors have made back most of what they lost in 2008/9. If the stock markets can rise by another 15%, they’ll break even. But if the market drops in half again, like it did in 2001/2 and 2008/9, they will be behind the 8-ball again.
In my investment book, Beyond the Bull, I wrote about having investment technique. An investment technique has two parts: (i) objectively observe the financial world, and (ii) react to it in a pre-planned way. We have observed that American consumers borrowed too much mortgage money – and this led to a 50% drop in the stock market. We now observe that over-borrowing in certain Mediterranean countries has put those economies at risk. If this Mediterranean Blues phenomenon spreads, there is a risk that the stock market could drop again.

Our advice? Don’t let the Mediterranean Blues catch you off guard. If this economic phenomenon triggers another decline in the stock market, act. In a bear market, whoever sells first wins.

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