Before we start…
- NWM has been writing about these issues for some time and we expressed them in good detail during our March seminar (you can view the video online). Nothing is going on here that is much of a surprise to us.
- We are not market timers, we are asset gatherers looking to acquire assets that are diversified and that generate cash flow. That, in our opinion, is how one builds long-term wealth.
- This crisis will provide additional opportunities to buy good assets at better prices.
Was Thursday’s sell off in U.S. markets simply a trading error, or the start of a new phase in a secular bear market that we have been experiencing since 2000? Is the panic in European debt markets just a result of intransigent Greek unions rioting in the streets, or the tip of a debt iceberg that has been created through years of reckless government spending?
Yogi Berra had it right when he said: “Prediction is very hard; especially about the future.”
Nevertheless, we have some thoughts about both questions and comments regarding how this might affect your own asset allocations as we move forward.
The eponymous “Fat Finger” is a Wall Street phrase used to describe a trading error presumably due to a typo. In this case, it is suspected someone accidentally replaced the ‘M’ in ‘$16-million’ with a ‘B’. As a consequence (or perhaps additionally), Thursday saw unprecedented volatility in the U.S. equity markets with the Dow Jones Industrial average dropping a record setting 1000 points intraday before recovering to close the session down nearly 348 points, or 3.2%.
While most of the drop has been attributed to the as-yet undetermined trading error, the market was already down triple digits before the dramatic plunge during the last hour of trading. In fact, the market had been weak for the past few trading sessions with the currency and commodities markets also showing an unusually large increase in volatility.
So, what’s going on? Is this volatility justified? While there have been a number of concerns given to explain the correction, concerns that the debt problems in Greece would spread to other European nations and derail the global economic recovery is the most likely cause. The Euro has been consistently losing ground against other major currencies and investors have flocked to the safety of the U.S. dollar and gold, which gained over $22 on Thursday alone.
It was hoped that the $110-billion Euro-Greek bailout would shore up confidence in the European debt market, but a steady stream of news clips showing rioting on the streets of Athens has clearly undermined the process.
Over the last few months we have expressed concerns about both government debt and equity markets. These concerns were not alleviated by Monday’s massive rally in global stocks that has all but eliminated last week’s correction. Markets are volatile and we are likely to see more of these conditions.
Here is what we wrote in our last newsletter If PIIGS Could Fly:
Greece is broke and the fallout will depend on how the stronger Eurozone members deal with their weaker partner and how they deal with the rest of the iceberg (the other PIIGS).
There are a few points I would like to make here:
- Greece is just one example of how even sovereign nations can hit the debt wall hard. There will be more to come.
- Reinhardt and Rogoff’s book (This Time Is Different: Eight Centuries of Financial Folly) suggests that if countries make the hard choices to get their debts under control and do not default (or try and inflate away their debt), then the outcome is almost always a very long, tough and extensive climb out of that debt – a process which surely results in either deflationary or disinflationary pressure. Governments cut back services and may increase taxes, which will reduce overall spending. Perhaps the best long-term medicine, but painful nonetheless.
- If our current fiscal mess is causing all of this grief, how will we ever fund the pension and health care promises we (as with many other countries) have made? In my opinion, the short answer is: we will not be able to fund these promises and they will change because they cannot be afforded. If we want to live well during retirement and have access to the best health care, then we will be relying even less on government entitlements.
- Countries are no different than individuals or companies; they cannot borrow their way to prosperity. To be fair, a certain level of debt does improve productivity and wealth, but it has to be well within the capabilities of the borrower. We are now fast approaching debt levels where there will be a point of no return.
Since that was written, the bailout requirements for Greece alone have more than doubled and the Euro has dropped in value by about 10% against the US dollar. There are some calling for both the Pound and the Euro to be at par with the U.S. dollar in the not too distant future (please see our newsletter The End Game for a more detailed analysis).
We have been of the mind that the equity markets were overdue for a correction and valuations were not properly discounting the risk present in the global economy. The deleveraging process that has just started will take a number of years to play out and will result in slow economic growth as government stimulus programs wind down and debt burdens are reduced. Current economic trends in the U.S and Canada are actually encouraging with employment numbers reported on Friday confirming that a recovery is in fact in progress. We can probably expect a number of rallies and sharp corrections over the next few years as the deleveraging process evolves.
It is important to remember a few key points about crises and how they affect returns:
- Overall, our clients have about 30-35% of their assets in equity markets (including Global) and no exposure to any Greek debt.
- Crises create periods of time when certain assets become cheaper. Eventually, high quality assets drop sufficiently in price to be very attractive to acquire. A diversified asset allocation allows investors to buy well, especially when supported by strong cash flows. This is a cornerstone of our investment philosophy and the foundation on which we build our clients’ portfolios.
- Government debt levels in many countries have hit the wall (they are experiencing a “Minksy Moment” — for more information about this, please have a look at our newsletter, Ponzi Investing and the Plankton Theory).
For many of these countries, the only long-term solutions are reduced spending and higher taxes. This will be a considerable drag on economic growth.
Nations, however, can fix these problems. Canada did it between 1993 and 2010. Our debt-to-GDP hit about 100% in 1993 and with some very tight spending controls we have since reduced that to 60% (including the provinces). This is well below the OECD average. It is also important to remember that our dollar dropped from about $0.80 US to $0.61 U.S. before recovering to almost par today.
As Bette Davis said in All About Eve, “It’s going to be a bumpy ride.”