advertisement
Soon the financial markets will return to normal. That's the current prayer on Wall Street.
The Federal Reserve will flood the market with cash -- and lower interest rates -- on Sept. 18. The Japanese and European central banks will call off plans to raise interest rates. Banks will resume lending to buyout and hedge funds. Overseas investors will again buy bundles of mortgage- and loan-backed securities. And the Dow Jones Industrial Average ($INDU) will resume the kind of steady march that took the index to 14,000 in July from 12,000 in March.
But what if the August panic isn't abnormal? What if a panic that threatens to shut down buying and selling is instead a part of the normal pattern of the financial markets?
The current panic is, by my count, the fourth of the past 10 years. On that evidence it's at least worth considering that "normal" now consists of a recurring pattern of market booms driven by excess global cash that leads to a global mispricing of risk and is punctuated at regular intervals by panics.
Crazy rhythms
If a pattern of boom, panic, boom, panic is indeed the new normal, it has profound implications for how we should invest. I'll try to spell out the case for the new normal in this column and how thinking about the market in this way suggests new strategies for your portfolio.Here's my list of the major financial panics of the past decade:
- The Asian currency crisis of 1997.
- The Long Term Capital crisis of 1998.
- The Nasdaq bubble of 2000.
- And the current contender, the subprime crisis of 2007.
On the surface, these panics seem significantly different because they all have involved different players and different market vehicles. The Asian currency crisis saw a huge devaluation of the Thai baht, the Indonesian rupiah, the Korean won and other East Asian currencies. It also saw a devastating stock market crash and stalled economies throughout the region.
More from MSN Money
The Long Term Capital crisis the next year was exacerbated by Russia's default on its debt and was the result of an over-leveraged hedge fund, Long Term Capital Management, getting swamped when currency prices moved against it. At one point, the fund had borrowed $129 billion on assets of just $4.7 billion.
The 2000 Nasdaq crash was a classic stock market bubble built on ever more feverish expectations for parabolic growth in revenue and profits.
And the current panic is rooted in a boom in home prices that produced a boom in mortgage lending to ever less and less qualified borrowers, who are now defaulting at levels above those projected by the banks that originated the mortgages and the investment banks that packaged them for resale.
Risk, bailout, repeat
But note the similarities below those surface differences:- Each was rooted in a surplus of global cheap money. Inflows of overseas capital inflated economic-growth rates in East Asian countries, sending stock prices in those countries higher and attracting more capital, because investors were more than willing to finance the large current-account deficits being run up by these countries. Long Term Capital's investment strategy required massive leverage because the profit from each transaction was relatively slight. The Nasdaq bubble required rivers of cash to chase stocks as they climbed ever higher. And the current crisis saw mortgage lenders recklessly pursue marginally qualified borrowers so they could generate more mortgages to sell to insurance companies, pension funds and foreign banks hungry to put mountains of cash to work at slightly higher rates of return.
Video on MSN Money
Jubak's Journal: Is the panic over?The stock market believes the crisis is over, but MSN Money's Jim Jubak thinks investors are wrong. To see why, look at the market for commercial paper, the short-term debt issued by corporations. As banks start to hoard cash, those companies are having trouble funding operations.
- Each required a massive mispricing of risk. Investors put so much money to work at relatively low rates of return because they underestimated the risk involved in those investments. East Asian economies were growing at 8% to 9% a year, it was believed, so their stock markets were low-risk investments. Long Term Capital took on only tiny risks in each of its bets, so the aggregate risk appeared low. Nasdaq stock prices were high, but not riskily so in comparison to projected growth. Individual mortgages to less creditworthy borrowers might be risky, but when bundled together the resulting securities, they were low-risk.
- And each cycle led the world's central banks, often led by the U.S. Federal Reserve, to limit the fallout from the panic by flooding the market with cash, thus setting up conditions for the next turn in the cycle. The International Monetary Fund led bailouts for the stricken East Asian economies. Thailand, for example, was at the receiving end of a $20 billion bailout effort. The Federal Reserve put together a $3.6 billion bailout of Long Term Capital to stabilize the financial markets. The Fed cut interest rates and cut them again -- finally to just 1% -- after the Nasdaq crashed in order to stabilize the economy. The move created a boom in housing prices that would keep consumers spending even if they'd lost money in the stock market. In the current panic, the Fed has cut rates for loans of member banks to inject cash into the markets.
Continued: Reaching for returns
Rate this Article
High