23 Jan 2008

The Key to the Crash

By Dick Bryan
The reversal of fortunes on the Australian stock market doesn’t change the fact that a crash has been due for some time. Dick Bryan puts the volatility in context
The stock market remains remarkably unpredictable. The ABC described yesterday's fall as ‘carnage'. That's a word usually reserved for horrific events, such as war or plane crashes, and it signals just how seriously this process is being received (as well as signalling an appalling tabloid trend in ABC news). How big the fall is remains uncertain, but it is already big enough to begin reflections.

First, some mechanics. Economists like to believe in something called ‘fundamental value' - that shares, or any form of asset, will gravitate towards a price that reflects their capacity to generate profit. That's how ‘rational' traders will price them. There is some debate about how exactly to measure ‘fundamental value' - is it price/earnings ratio, or some valuation on company assets, such as would be calculated for a private equity buyout - but there's one thing we can be sure of: shares have been trading above this price for some time.

So from the perspective of ‘fundamental value' analysis, a crash has been due. And shares have been overpriced for a few possible reasons.

One, as the fundamental value analysts would have it, is that traders have been ‘irrational' - remember that Alan Greenspan, US Federal Reserve boss for so long, introduced us to the term ‘irrational exuberance' about a decade ago. Perhaps, but it doesn't explain much. If the term ‘rational' means all-knowing and all-seeing, irrationality is the human condition, not a phenomenon of the 2007 stock market.

A second reason is that it may be ‘rational' to stay in a bull market so long as everyone else stays in. You can ride the increasing prices, so long as you know when to get out. This is the bubble scenario, and when bubbles burst, prices tumble rapidly. This spiral downwards gets faster when people have borrowed to buy shares, for when the loan is made against the value of the shares, and the value of the shares falls, the lender starts to get worried. They make a ‘margin call' - they call in more collateral to support the loan, and the implication is that many speculators have to sell shares to meet margin calls. It was the key to the crash of the Thai baht that precipitated the Asian financial crisis a decade ago - a small fall led to margin calls that required borrowers to sell baht, which caused the baht to fall faster.

A third reason is that people got carried away with stories of Indian and Chinese growth, and the profits that would flow from riding on the coattails of those booms. So people bought shares (especially resource and bank stocks) in expectation of future profits associated with India and China. The basic argument here is probably right - there will be profits to be had - but the question is ‘how right?' The optimism may be premature. And there was need to factor in the opposite trend in the US.

So the fourth factor is this US recession. There has been evidence for some time that the US economy has ‘past its peak' in a long term sense. This can be overstated. After all, US companies have spread across the world, and the profitability of the big US companies is still pretty robust: their ‘fundamental value' looks better than the ‘fundamental value' of the US itself, and it is companies, not nations, that get priced in the stock market.

But there is the US debt question looming here, and the willingness of the rest of the world to hold US dollars and dollar-denominated bonds. Was this credit-driven growth a latent crash waiting to happen? Perhaps, but people have been saying that for 20 years (last year was the twentieth anniversary of the publication of Susan Strange's Casino Capitalism - and the system keeps expanding!).

What did happen was the crash in the sub-prime market. Again, this is not necessarily a disaster for the global economy. It's shocking for the (generally black) working class people in the US who have lost their houses, and a blow to some big financial institutions that have lost billions (but not before they made billions), and, across the world, some ordinary punters now find that their superannuation accumulation had declined a bit. Of itself, it's not the profile of a generalised crash.

But if you line up these factors, there's a fragility. Share traders in a bubble get twitchy, wanting to know when to jump. Some long-term scenario about US decline is tolerable, but add to that a sub-prime crisis that keeps growing in dimension, and the twitching exaggerates. And when people say they don't know how big the costs of the sub-prime crisis will be - not just the direct effects, but the indirect ones too - then the twitching becomes intolerable. It's time to sell. And fast.

So how do we interpret recent events? Here, a diatribe could start about the evils of greed and speculation, and how they are nurtured by capitalist economic and social relations. We can put it on the record without need for elaboration.

So let's look at some narrower issues, related to the spread of information - for it is clear that what happens in these markets is all about information and impressions. A couple of points.

First, advocates of the virtues of financial market processes always talk about transparency (or the need for more transparency) so that traders know the ‘real' situation (and ‘fundamental value'), and can trade accordingly. What we have seen with the sub-prime crisis is just how ‘untransparent' financial markets can be - with organisations taking many months to find that they have a financial exposure, and still longer to determine its extent. The way the subprime crisis has unfolded on a drip feed, perhaps more than the actual losses themselves, has given markets the jitters. Best to get out before the next bit of bad news comes through.

Second, the information we are currently getting about the stock market is similarly limited. You can get raw data form the various stock exchange web sites, but when it comes to commentary on its meaning, you'll notice that it's all being done by central bankers and private bank economists. The problem here is that these bank economists are always going to talk up the market - a standard comment is: a) we don't know what will happen, but b) there are now some bargains out there in the market and we should see some new buying as those who got out at the peak re-enter the market. The word ‘bounce' will soon return to the commentators' lexicon.

Why do they talk up the market? In part because of a code of social and professional responsibility - predictions of crashes by a central banker, or even by a private analyst on behalf of a large bank, will more than likely be self-fulfilling. But in part, too, we should note that most of the commentators are employed by banks whose own share price may be dropping 6 per cent per day. They need the slump to end - and that's different from whether it will.

Where will it go? It's standard to answer that no one knows. But beyond that, a couple of pointers. One is that the predicted US recession, which is driving sentiment in the markets even if it is not profoundly driving ‘fundamental value' analysis, is an unknown quantum. Those who talk of huge levels of debt (individual and national) are predicting the BIG CRASH. Yet it can also be argued that debt means something different now from what it did before - people don't mind being in debt, in fact they gravitate towards it.

Another big issue is what happens to the US dollar. It is remarkable how well it has held up in recent weeks despite recession talk and the cut in interest rates (which make it less attractive to hold as an interest-earning asset). And finally, and slightly longer term, we need to find out to what extent Chinese and Indian industrialisation hold up even if the US falls as a source of demand.

Finally, it warrants noting, there is a conspicuous floor under the stock market, especially in Australia. The superannuation funds have oodles of money (and it just keeps growing) that they have to invest in the stock market. They can shift between particular shares, although they effectively have to invest in all the big companies. Superannuation has, no doubt, been pushing up demand for shares in the past, and impacting on share prices. This demand will not disappear with a bursting bubble.

So we all watch with interest. If I were a punter, I'd be saying that the downturn will not take too long to recover. In the meantime, had I sold out at the peak, I'd now be putting my money in New Zealand dollars (because the interest rate gap between the US and New Zealand dollars is now huge) and gold - for some primitive reason, it is seen as ‘real value'. And also I'd put some early money on Hawthorn in the AFL grand final. But I'm not a punter, and my tips are always wrong. Except sometimes.

Log in or register to post comments

Discuss this article

To control your subscriptions to discussions you participate in go to your Account Settings preferences and click the Subscriptions tab.

Enter your comments here

Posted Thursday, January 24, 2008 - 00:01

"...I'd now (be) putting my money in New Zealand dollars (because the interest rate gap between the US and New Zealand dollars is now huge) and gold - for some primitive reason, it is seen as ‘real value'..."

How is it that some of the simplest concepts escape the heads of even the Heads of the departments of Human Sciences in so many of our Western Universities? Gold has been the store of value for EVER - period.

It is true that, throughout time, market participants can be occassionally hoodwinked into accepting worthless paper as a place to store surplus wealth, but, invariably, disaster has followed this naive belief every time.

Come on Dick, the "primitive" reason gold is seen as "real value" is being perfectly illustrated right now and is clearly visible from the price of gold since that "brilliant" fool, Gordon Brown, sold England's gold at the cheapest price in decades and for 1/4 of it's current value.

Gold has appreciated almost 50% in value over the past 6 months alone, how has Kiwi paper done? in fact how have all paper assets done over the past 5 years in comparison with, say, silver? Platinum? Copper? Paladium? Rhodium? Good heavens Dick, I'll even settle for a poverty pack of a tonne of Lead and still show more "value" than anything on the paper markets for heaven's sake!

Don't knock it Dick, buy gold and hold while your fellow academics ridicule the metal as a "barbarous relic", and when those same academics find the value of their equities and paper assets insufficient to support their dream retirements, or, after their paper assets blow up in smoke, like we are witnessing right now, you will still have your gold and your peace of mind! Those colleagues of yours will appreciate that bottle of Gin which your spare ounce of silver will buy them! You could use those worthless share certificates as coasters!

To protect your reputation you could always pretend your gold was a gift from a deceased and "primitive" family member who did not have the academic capacity to comprehend that "gold is not really a store of value".

GATA will be placing a full page ad in the Wall Street Journal this week to better advise our academics and CEOs in the financial world, who have guided us all to the brink of financial disaster, that wealth cannot be printed or created as a series of electronic entries, wealth must be EARNED (PRODUCTION), you know, WORK? and wealth is the result of surplus production whose value is stored in ASSETS which do not lose their purchasing power - now between you and I Dick, honestly now, how difficult is that to understand?

George Vickers

Posted Thursday, January 24, 2008 - 12:30

George Vicker's point that the production of wealth is a critical variable in the economic health of capitalism is valid, though doesn't seem to be controversial.
The argument that gold is a proxy for real production is.
Gold as commodity is used in jewellery and some other decorative arts, as well as in industry and health sciences.
But gold has rarely if ever traded at a price reflecting those uses. Historically, the principal way gold has been used and priced is as a form of money or store of value (potential money).
And just like any other asset, it too has been subject to periodic bouts of speculative pricing, in both directions. Indeed it could well be the case that current gold prices are themselves suffering from the same sort of specualtive excess as financial markets. Gold, just like any asset can indeed lose its purchasing power - its price just has to fall.
The fact gold is accepted as valuable because of its monetary characteristics is a long way from saying that it is the proxy for 'real' production (whatever that means in an economy made up nearly 2/3 of services).
You may hold to that position, and thats ok, but it is not a mainstream view either in the academy, or in the 'real' world.

Posted Thursday, January 24, 2008 - 19:48

If it is possible to interpret from my post the assertion that gold is a proxy for real production then I have failed to express myself properly.

Since the misinterpretation is raised, however, I would point out that debt based paper currency, as a medium of exchange, is equally less suited for use as a proxy for real production but this fact has not prevented it's attempted use as a proxy for real production. Australians witnessed this during the Howard years where consumption on credit was sold to the voters as "increased economic growth". Moreover, if money can be defined as a store of wealth and a medium of exchange then I put it to you that debt based currency is far less suited for use as money than a real asset or bullion based one.

Confusing credit growth with real economic growth is sadly not confined to Howard.

In Davos, currently, many commentaries remain focused on any one of a number of issues - the sub prime crisis, the liquidity crisis, the dollar crisis or the potential for massive defaults within the banking system itself or from other counterparty players. Few seem to be focused on what’s really at stake.

Currently, on a global basis, we have a plethora of fiat currencies, none of which have the ability to provide for settlement by the central banking systems themselves. Traditionally, official settlement of trade imbalances between countries was made in gold. The US dollar was, in 1944, nominated by Central Bankers as the official global reserve currency because it could be redeemed for gold and therefore, so the rhetoric went, holding dollars meant that other central banks held reserves that were as good as gold.

What has changed? The gold reserve concept went out the window with President Nixon’s closing of the gold window on August 15, 1971 and since that time we have had what is at best described as a monetary system you have when you don’t have a monetary system.

Since 1971 we have seen the introduction of the Euro, which, so far as rapid money supply is concerned, seems to be a case of if you can’t beat them join them, as in an imitation of the US non-redeemable monetary system and the expansion of the Japanese banking system by way of increased liquidity ie: increasing debt levels, into the banking system.

The US appears to have the advantage over the other players in this game since they started it and all the other players that followed suit are stuck with the dollar as a reserve, which in and of itself may be problematic. If so whose problem is it actually?

In the monograph "Liquidity" by Melchior Palyi, published by CMRE (www.cmre.org), Mr. Palyi points out that every banking crisis dating back to the recurrent waves of Venetian bank failures in the sixteenth century had the same ingredient: the wholesale liquidation of debts was the focal point, said debts brought about by a credit expansion along non-commercial lines, financing long-term loans, speculative ventures and governmental expenditures on a substantial scale."

From Davos we hear about the central bankers increasing liquidity and yet nobody seems to ask the question as to what exactly is liquidity? Liquidity must come from capital and that capital must be directly connected to a neutral item, which is why gold was and still is the ultimate form of settlement. Settlement means the completion of a transaction and transactions that are ‘settled’ with debt are not settled transactions at all. They are increased liabilities.

Now what we have globally are central banks operating monetary systems that have little or no asset liquidity available to them. The global monetary system is dependent upon the continued acceptance of US dollar denominated debt which on a larger scale has little chance of ever being redeemed for anything that remotely resembles a tangible, widely accepted liquid asset.

Richard Russell (www.dowtheoryletters.com) sums it up when he says – "the winners in a bear market are those who lose the least." The unfolding debacle is likely to be not your run of the mill bear market as earlier debacles have not suffered from a global shortage of asset liquidity and dubious reserves within the world’s banking systems. Those who will lose the least are those who liquidate their paper in exchange for assets which are "as good as gold".

How liquid are your assets should be THE question that’s on the minds of all investors and the term "asset" does not include "debt based instruments".

Bernanke, who now occupies the chair of "Mr Bubbles", has embarked on a cure for the current crisis which can be summarised in three stages. The first stage has been to debase the USDollar, the second has been to recapitalise the banks to get them back on their feet and the third, which we are witnessing now, is putting in place a very steep yield curve to boot the banks into lending money again. The world will discover that this is not a cure but that instead it is an acceleration of the very curse which has been the cause of the very malaise it seeks to cure.

Expect many more bumps down this road and stay away from any paper except where it serves as a medium to acquire real assets.

George Vickers

Posted Thursday, January 24, 2008 - 19:56

Marx would probably have considered Buckaroo's concept of the use of gold in jewellery etc., not as use at all, but as a store of value: for Marx, the whole point of gold as a store of value or means of exchange is that is tends NOT to have any use-value, i.e. value which can be used up, but that it does have exchange value: the two tend to be mutually exclusive, either/or. A commodity has a sort of finite total quantum of use value plus exchange value (check out Capital, Vol. I, Ch. I).

And, yes, Marx would agree with George, that of course gold has value in that labour has been expended in its procurement. Its value-form is expressed in some currency or other, English pounds in Marx's day, US dollars at the moment. Perhaps tomorrow, in Chinese yuan.

So there is a sort of dynamic relationship between the amount of labour (and its cost) needed to produce a specific amount of gold and its dollar (pound, yuan, zloty) value, a relationship which tends to stay fairly constant precisely because gold is one commodity which does not get used up, does not corrode away, does not get eaten or burnt for fuel, in fact has no real use-value except to fashion into stuff to look at and admire, and for which, as well as its scarcity (and therefore high value: weight ratio), makes it ideal as a back-up form of currency.

Which makes Gordon Brown look like a total idiot now: if he were a CEO of a bank or company like Centro, he would probably earn massive bonuses for his brilliant decision-making. Marx was not just a pretty face.


Posted Monday, January 28, 2008 - 19:43

The assumption is that this is perhaps a bit of a bust in the traditional boom/bust cycles. However we may be faced with a paradigm shift in the whole economic system. A few things to consider:

* Peak Oil - world oil production has plateaued since 2005. New oil fields are barely offsetting the decline of mature fields. It would seem the peak production of oil is upon us (http://www.theoildrum.com examines the subject thoroughly). Oil drives the whole economy, not just our cars. A USA recession may defer the crunch for another couple of years...
* Climate Change will have pervasive effects. There will be a few winners but there will be many more losers.
* In particular, fresh water supplies are threatened. Higher temperatures increase evaporation, rainfall belts move away from temperate zones (Perth has had something like a 30% decline in rainfall over the last 30-40 years - the same now appears to be happening in SE Australia). Himalayan glaciers are rapidly melting which will affect India & China's major rivers. And they are rapidly depleting their ground water reservoirs. Mass starvation may disrupt their growth plans!
* Debt has been mentioned. The gloriously successful Anglo economies have all been built on foreign debt. This creates a vicious circle. The 'farm' is sold off to fund it - so increasing dividend and interest payments flow out each year. More has to be borrowed to cover these payments, interest rates rise to pull in funds, but more interest payments have to be remitted. It works as long as we are deemed creditworthy - the sub-prime crisis rather undermines that.

In a big crunch, real assets (maybe even gold) will be all that matters. Pity we are predominantly a service economy with ephemeral assets!