Greed & Fear: Top Market Drivers

Some hard facts: On Sept. 15, 2008, the unthinkable happened. Lehman Brothers, a Triple A-rated U.S. investment bank, 158 years old and the country’s 4th largest, was forced to file for bankruptcy. Merrill Lynch was rescued and sold to Bank of America, and one day later, AIG, the world’s largest insurer, announced what was effectively a nationalization. This set off a chain of notorious "firsts" – a $700 billion bailout of the U.S. banking system that nearly did not pass, an entire country (Iceland) teetered on the edge of bankruptcy, and several of the largest UK banks were clearly in trouble.

By the time International Monetary Fund (IMF) met on Oct. 13, two additional disasters had struck.

Global stock markets had fallen 20% in a week, the entire global banking system had almost collapsed. It took the collective resolve of 27 European governments and the U.S. together to institute forceful emergency circuit-breaker measures to temporarily calm governments and investors and prevent a catastrophic breakdown of financial markets worldwide.

Home ownership ($20 trillion) and equities ownership ($20 trillion) are central to the American middle class dream of becoming wealthy. Borrowing money is equally ingrained – the U.S. household debt today is larger than the country’s GDP (Gross Domestic Product). America became the world’s largest consumer of cheap imported goods, and China became the world’s largest producer.

Through a confluence of events, a deadly cocktail was being concocted.

But let’s take a step back. First came an increased demand for home ownership in a boom time. Next came easy credit (1% US Fed Funds rate), and a relaxing of credit standards by commercial banks (zero down payment) to lend to sub-prime borrowers (with minimal income), springing from the belief that home prices would forever rise and protect the loans from defaulting.

Third came the securing and packaging of these loans ("mortgage-backed securities") by investments backed up by credit agencies’ rating the top slices as Triple A credits. Finally, came the sophisticated risk models and the commercial banks and hedge funds that greedily bought into these instruments as a means of increasing the yields on their books.

Initially, all was rosy. Home prices soared 20% as the bubble grew with triple leverage (housing loan, investment bank securitization, and hedge funds buying). What was not apparent was that due to lax U.S. regulation, investment banks had debt-to-equity ratios of 35 to 1, and unregulated hedge funds had ratios of 30 to 1. On the way up (2002 to 2007), everyone made money.

The key message from all this should be "back to the roots." You have to sow your seed before you harvest. Defensive portfolio management – a transparent strategy with a long-term focus – should be established to gain maximum profits in the future.

This is the theory – without the passion, excitement, greed and fear. The reality is somewhat different. Eight months down the road, we are back to the old game. In a recent study, 80 funds that showed a 30 – 70% recovery in value since May 2009 are regarded as "normal returns" after stocks have fallen sharply since 2007.

Fears of market meltdown have evaporated, and we are chasing stocks to new highs. In fact, money is pouring back into the market: The German DAX, for example, has risen from 3600 to 5500 in six months. Volumes are increasing, and turnover is picking up, once again neglecting the fundamentals.

If the sun is shining, why talk about the bad weather? If the learning curve of investors were as steep as the expected return on investments over time, the average investor would understand that anticipated returns 20 times higher than the current interest rate set by the European Central Bank (EZB) at 1.00% must be linked with exorbitant risks.

But no one is paying attention, and investors are promised returns that are as far from reality as a Hollywood movie, and the stock market is operating from a script straight from Who Wants to Be a Millionaire. "The Show must go on," as Queen pop star Freddy Mercury used to say.

Let’s spin the wheel of fortune once more… until the next episode of "portfolio diversification." Stay tuned.

 

Richie Rich is the pen name of a market analyst living and working in Vienna. This is the first of what will be a regular column.