Tuesday, February 2, 2010

Happy Groundhog Day

Punxutawny Phil knows its not different. Same thing, different year, and yet the masses are hopeful.

"Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that 'this time is different.' That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy."

- This Time is Different (Carmen M. Reinhart and Kenneth Rogoff)

The Reinhart/Rogoff book is one of the stars of the financial books published in 2009 and for students of markets and history it is a good, if at times weighty, read. Much of what we presume to be conventional wisdom is in fact thinking constrained by our relatively short term experience. Reinhart and Rogoff looked back over hundreds of years to find parallels and the McKinsey Group found 32 examples of financial crisis followed by sustained deleveraging such as we are experiencing now. At a time of such uncertainty we are well advised to look at events from 30,000 feet and not from within the maelstrom.

Looking at centuries of debt cycles the Reinhart/Rogoff book reports that on average a country's outstanding debt nearly doubles within three years of the crisis. Unemployment rates on average increase seven percentage points and remain elevated for five years. Finally, once a nation's public debt exceed 90% of GDP economic growth slows by 1%.

Many of the historic models and forecasts being touted this year are based on post WW-II experience which may turn out to be less than useless, even harmful. Trillions of dollars of financial espresso can get the consumer pretty jacked. It doesn't mean necessary that it is sustaining.

Instead of econometric models of the past 40 years an analysis must look for examples, sometimes centuries old for relevant examples of deleveraging economies. Ironically the assets that look less risky now are in the developing nations. That is also where the growth is likely to be found, where the consumer sector is still very young, where national debt levels are low, where reserves are high and trade surpluses abound. The developed world has lost its position as drivers of the global economy.

Each of the developed markets presents its own challenges for investors in both equities and bonds. Japan has its aging population and need for external financing. The U.S. has large deficits and exploding entitlements on the horizon, and Europe faces such disparate members one wonders how it will remain united. Germany the extreme saver and producer while at the other end Spain and Greece are awash with debt.

It's never different, but you may need to be the better part of 100 years old to remember when it looked like this.

John Barnyak
Stonehouse Asset Managment