ECU IN THE MEDIA
1998 - Back to basics
In the final analysis markets are about fear and greed. After all, they are driven by human beings, who although individually rational, when acting collectively obey the often illogical rules of crowd psychology, says Michael Petley, Chief Investment Officer at ECU .
These excessive directional plays are often hard to shake off whilst investors continue to play the same old tune over and over again, confusing myths with reality in the heat of the moment. However, logic suggests - and history shows - that there is always a time and a level where enough is enough.
Here today, gone tomorrow
Despite the need for a sharp reminder every now and then, there simply is no such thing as a one way bet. Even in the most ardent bull markets, markets need to catch their breath after and exhaustive run and consolidate their gains. Failure to do so always seems to create and ever steepening exponential curve which ultimately climaxes with a truly spectacular crash.
Major bull markets are born amid dire pessimism and thrive amid scepticism. It is only when markets are full of optimism, factoring in all the fruits of tomorrow in today's prices, that one needs to start to look for the signs of the market beginning to tire, since markets tend to crash amid euphoria - just when it seems virtually impossible to investors' minds that anything could go wrong.
Whilst a long term strategy is vital, the sheer scale of the shorter term movements in today's markets cannot be ignored. Events in Asia and beyond demonstrate the necessity to be quick to react to market events.
Roller coaster
The herd instinct has indeed excelled itself throughout the 1990's. Stock markets in Asia this decade rose by anything from three to six fold, only then to lose between 50% and 90%. Within the G7 nations (excluding Japan where the Nikkei simply lost 79% of its value), the patterns are the same, albeit if the rallics (tripling or quadrupling) and subsequent declines (20% to 40%) are a little less extreme.
Currencies, so often referred to as "a zero sum game", have also undergone spectacular contortions. For example: Blinkered and seemingly deaf to the overwhelming evidence and rational argument that would suggest a more appropriate directional play, global investors chose, in their infinite wisdom, to halve the $/¥ rate in 5years from ¥160 to just under ¥80. Eventually persuaded by the argument that this was perhaps not such a good idea after all, these same players - who were then only too happy to buy every yen in sight - then proceeded to sell and borrow as much yen as anyone was prepared give them, thereby helping the pendulum to swing back from whence it came.
Despite the seemingly clear writing on the wall, speculative greed - fuelled by the interest rate differential argument - continued unabated for three and a half years before the pendulum actually started to swing back again turning, once again, the greed into fear.
Given the overextended nature of the $/¥ move this Summer, it should not have come as much of a surprise to any lateral thinker that the resultant rush for the exit was as spectacular as it was - eroding over 50% of the previous 3½ year's $/¥ bull run in less than two months and precipitating the $/¥'s greatest move (in terms of time and distance) ever.
Technicals versus fundamentals
The effect of significant increases in the amount of leveraged or borrowed money playing the market is that cycles are becoming ever quicker and steeper. Increasingly, we are subjected to market moves that have been pushed to wholly disproportionate levels and beyond only then to flip over and come all the way back. With such flighty funds in existence in today's markets, market movements that may appear appropriate over an 18 month period are now capable of occurring over 18 days forget the weeks or months.
Increasingly, the relationship between the economic fundamentals and a market's actual directional movement is becoming ever more disproportionate. The occupational hazard of today's market economists is to attribute excessive rationality to market pricing. In reality, the only safe forecast on currencies is that what goes up eventually comes down. The better economists show why and how. Only occasionally do they show when.
Technical analysis, on the other hand, is often a concept that investors find both alien and unbelievable. However, the reality remains that it is an essential component of day to day tactics and, as such, should remain at the heart of any balanced trading strategy in order to survive in today's roller coaster world.
Demand versus supply
The biggest problem in today's market place is the fact there is much, much more money flowing into market moves than there is notional value beneath them. The growth in the so-called "hedge" fund industry, whereby directional position taking can involve mind-boggling degrees of leveraging, has been overwhelming.
In recent years, the obsessive hunt for superior returns swelled hedge fund managers' books to the extent that handing back cash to investors became commonplace. As with all investment vehicles that permit extensive powers of gearing, all is well until the proverbial spanner is thrown into the works. Furthermore, unless or until something goes wrong, the superlative returns merely act to attract yet more funds, which, in turn, have to be employed.
Consequently, due to the speculative content behind today's market moves, when enough is deemed to be enough the ensuing setbacks are becoming increasingly harrowing. The "weight of money" argument is indeed a compelling one and is ignored by market participants at their peril. One need look no further than the $/¥ rate of late to see the dramatic effect such a phenomenon can have.
The symptom or the cause
At the epicentre of the degenerative spiral in the Spring of 1995 was the $/¥ exchange rate and the market's sheer belief that is was a one way ticket down. Three years down the line, the market became equally convinced that the $/¥ rate was a one way ticket up. The small detail that the yen had doubled or halved against the dollar in each of these time frames seemed to have escaped the attention of many, who, no doubt, preferred not to let such facts get in the way of a good story.
The cyclical nature of currencies usually prevails, since a major swing in a currency's value has easily identifiable effects on the underlying economy. If the currency deviates too far from the prevailing fundamental economic reality, then the resultant improvement or deterioration in subsequent economic numbers tends to have a self-corrective effect in bringing such a discrepancy into line.
History shows that sustainable bull markets require an orderly wave pattern of rally - setback - consolidation, rally - setback - consolidation, whilst at the same time recording a consistent pattern of higher lows and higher highs. Any market that goes flat without pausing to catch its breath tends to burn itself out and flop clean over. Investors and the media always seem to then be surprised by the suddenness and extent of the about-turn of a market that, only days before, could seemingly do no wrong. It is not so much the level a market reaches that is the main cause for concern, but the time and manner in which it does so.
The Myth versus the reality
Whilst "the trend is your friend" is one of life's better trading clichés, there is, of course, an inherent danger in following a too well-trodden path. Following media hype - which, after all, is full of "yesterday's news" supported by comments of traders eagerly talking their own books - is equally hazardous. In fact, the more convincing the story, the more cautious and disciplined one should be since the market price of anything can be expected to reflect all such freely available market information, news and opinion.
Quite apart from good old basic investment principles like "by low, sell high" basic common sense should indicate that reliance upon one way ticket scenarios is dangerous at the best of times. Irrespective of the forgivable temptation to follow such fiery market moves from time to time, it is critical to one's longer term financial well-being to recognise a speculative bubble the you see one and remember that bubbles have a nasty habit of bursting.
Over the ensuing three and a half years from its heady Spring '95 heights, the yen's enforced "correction" steadily developed into a speculator's paradise. Global investors increasingly sold their low yielding - yet, over time, the strongest - currencies in favour of the higher yielders. Aided by considerable interest rate round-tripping by more the dynamic hedge fund speculators, this "correction" process continued relentlessly. Furthermore, as the acceleration in these price movements began to kick in, more players joined the game in the belief tat there really was a holy Grail after all.
In the eyes of the beholder
Once the market has armed itself with a good story, whether originated by fear or greed, the new tune has a habit of being played over and over again and, together with the weight of money argument, the resultant entrenched sentiment can itself create a continued self-fulfilling prophesy. This chemistry can continue for some considerable time, irrespective of any marked changes in economic fundamentals or performance that may warrant a change in price direction. A fine example of this can be seen in the behaviour of Sterling since the 1970's.
"Go for a walk, get some fresh air or take a long cold shower until the urge goes away". Despite the economic landscape in Britain changing out of all recognition over the 25year period from 1970, middle aged city types grew up with this sagacious, yet flippant, piece of advice every time they wanted to get bullish about Sterling. Such intransigent market psychology can drive economists to the nearest bottle of Prozac. At the same time, however, such realities underling the importance of paying close attention to the technicals, since visible change in the trend will occur well before any turnaround in market sentiment.
Market participants have had to adapt to these compelling forces since spitting in the wind has never been a particularly enjoyable pastime. Most central banks have now learned that simply pouring more money into a system that, in turn, haemorrhages it back out again is not the answer, nor is throwing money at the market in order to defend something which is seemingly indefensible in the market's eye.
Although free market movements of capital are deemed critical components of a healthy global economy in the long term, such strong sentiment-driven movements can go too far and degenerate into a spiral of destruction. In the case of the yen, for example, we have seen two extremes in three years, both of which threatened major financial turmoil and severe global repercussions.
Full circle
For such a deep tooted market sentiment to change, it requires either a sizeable market shock from out of the blue to break the spell or an overwhelming raft of economic data that would justify a change in direction. In analysis the sequence of events, one can see that it was the former as opposed to the latter which gave rise to the stratospheric ascent in the yen's value.
The facts are plain for all to see. Consumption was plummeting as were imports, industrial output was shrinking, import and wholesale prices dumping, inventories rising, unemployment soaring, overtime hours plunging and employee incomes falling. "Package fatigue" became the new market buzz-word, reflecting the fact that traders were no loner impressed by the content of the colossal stimulus packages or the upbeat banter that supported them. Add to all of this an endemic credit crunch, the Asian crisis (which had the dual effect of hitting Japanese exports and threatening to increase the volumes of cheap imports), it is difficult to come to the conclusion that the yen's recovery was born out of a genuine change in sentiment.
To some, therefore, the yen's stratospheric ascent of late will always seem illogical given the indubitable full house of chronically bearish economic data. The reality, however, is that excessive price movements due to an overplayed store line (however good) always have this uncanny knack of self-correction. The yen's sudden volte-face is living proof of such.
In understanding the conditions that can lead to such seemingly unexplainable and disproportionate moves, the yen story is as good a subject matter for step by step analysis as any.
Money-go-round
By this Spring, Japan's current account had almost doubled to 2.7% of GDP in the previous two years because its trade balance has ballooned, a state which would normally provide a persistent and formidable source of yen demand capable or supporting a rising yen. However, it was also the case that Japan's capital account deficit had swollen to over 4% of GDP, reflecting a massive and accelerating flood of capital leaving Japan.
By now, despite vehement government denials, the "D" word began to be whispered in investment circles. Deflation is a word that sends shivers down the spines of all, given its indelible association with the Great Depression of the 1930's. Deflation occurs when consumers do not spend because the believe goods will be cheaper in the near future. This can have a desperate effect on corporate profits because companies end up with inventories which are falling in value. A vicious cycle then emerges whereby companies hold back on capital investment, reduce production and cut wages, overtime and bonuses, which, in turn, causes employees to spend less.
In short, Japan's own appetite for foreign assets (or, put another way, its reluctance to invest in Japanese assets) became much greater than the money coming into the country to buy its goods.
Back to the drawing board
The facts were clear and so was the message tat was derived from them. In order to reverse the yen's demise (or, in the first instance, at least halt it), Japanese policy makers had to initiate concrete (and permanent) policies that improved the relative returns of Japanese financial assets so that capital remained at home of its own volition.
With regard to forex intervention, traders were evidently quite happy to take as much of the Bank of Japan's money as it cared to throw at them, simply confirming that not even the Bank of Japan, with its immense foreign exchange reserves, could buck the market.
Given the interest rate differentials prevailing globally, the degree of interest rate hike which would make any difference was clearly not an option due to the desperately fragile state of the economy. The burden of adjustment had, therefore, to fall on fiscal and regulatory policy. This had been the overwhelming message of G7 finance ministers for some time but it involved the precise areas which were traditionally met with the greatest hostility through the Japanese government machinery.
Nothing succeeds like success
By sharp contrast, the US headlines simply could not fail to impress. Strong GDP growth, unemployment at a 28 year low, a booming property market, investment in capital equipment surging in leaps and bounds, consumer spending continuing at a fiery pace and yet, at the same time, inflation at the lowest level for 34 years and domestic prices at a standstill for the first time since 1954.
Efficiency savings derived from widespread investment in high technology, deregulation and flexible labour markets within the US, coupled with the lifting of trade barriers and fiercer international competition from outside the US, all contributed to keep inflation down. In the absence of such attributes, higher interest rates would have come and spoilt the party long ago. Throughout its continued pat to glory, this "New Paradigm" or "Goldilocks Economy" received an ecstatic endorsement by Wall Street.
Strength through exuberance
Those who were perplexed by the continuation of this seemingly incompatible economic cocktail needed to look no further than the stock market. By 1998, twice the number of Americans held shares than did in the mid 1980's. By boosting household net worth - adding some $1,000bn in the first quarter of 1998 alone and over $6,000bn since 1990 - Wall Street's relentless climb encouraged households to keep spending. It was also the propelling force behind he personal savings rate falling to a 57 year low in 1997.
On the corporate front, strong growth generated rising earnings - thereby pushing up share prices which, in turn, nurtured greater investment (particularly in the information technology related equipment) which, again in turn, increased capacity, thereby keeping the lid on inflationary pressures.
Low inflation prevented the Fed (already unsure of the knock-on effect of the Asian crisis on the US economy and certainly not wishing to add to Asia's problems)from feeling the need to raise interest rates further and give yet another shot in the arm to the Wall Street bulls.
Stock market strength even helped to push the federal budget into surplus as vast tax receipts from capital gains boosted government earnings.
Up, up and away
The rising stock market also helped hold down compensation expenses. Benefit costs were restrained because many companies did not have to make contributions to defined benefit plans since the stock market rally had done it for them. Pressures for higher wages were also suppressed as share options -which have become a greater component of compensation in today's profit related pay culture - added hugely to overall earnings.
The demand for high performance US assets was not just a domestic affair. Such spectacular real returns in US assets did of course attract a flood of capital from overseas, most notably from Japan where investment choices remained bleak. This demand underpinned the dollar's appreciation against the yen, which, in itself, boosted the overall performance even more for Japanese investors and only served to whet their appetite for more. The stronger dollar, as good fortune would have it, then, in turn, played a key role in keeping down inflation. The cycle went on and on.
Bubble and squeak
The roll played by the stock market in keeping this virtuous circle intact cannot be underestimated.
The question then was whether or not Goldilocks was turning into an asset bubble. The classic symptoms of an asset bubble (a rampant bull market in shares, merger mania, a property boom and an acceleration in monetary growth) were all there.
Asset bubbles, as Japan is our witness, always end in tears. The dilemma with which the Fed was faced became very real indeed. The lesson derived from history is unmistakable: the longer an asset price bubble is allowed to inflate, the louder the eventual bang when it bursts. However, in the absence of rising consumer price inflation, a pre-emptive interest rate hike to prevent asset inflation from spilling over into consumer prices was a political hot potato.
During a stock market bull run, buyers join the party at different times, increasing in numbers as time goes by. However, if a hike in rates (on asset price concerns alone) was to be taken by the market as being "the party's over - time to go home", the herd instinct to all rush for the exit at once could have turned into a bloody affair, not only for the US, but for everyone else to.
Potentially, therefore, this virtuous circle stood to be stopped dead in its tracks. Worse still, the entire process could then reverse. Once reversed, the "Goldilocks" fairy tail would surely end and the "Nightmare on Wall Street" begin. No wonder Alan Greenspan looked ill.
Chain reaction.
As the storm clouds gathered, technical analysis could see the end, clear as daylight, in a whole range of currency and equity market chart patterns, However, the majority of market participants remained unfazed since no-one ha come up with a credible "how" or "why" or "when". As can so often happen, events unfolded in a way quite different to that which anyone was expecting.
In hindsight, the most remarkable aspect about the Asian contagion then coming full circle, globally, and ripping through Russia, among other ripe targets, was surely in the market's blissful naivety and self-denial that it cant happen here, because, because, .". It could and it did.
No man is an island, however independent and alone he feels himself to be. We are all part of one creation. This is never more apparent than in the currency markets, where it is not possible to make even the slightest change to one rate without reacting across the entire matrix of relationships to affect everything else.
Poetic justice
It is, perhaps, a little more than ironic that it was within the hedge fund industry (the pariah of globe in the minds of Dr Mahathir and no doubt, others who blame the hedge fun industry for "creating" the Asian crisis in the first place") that colossal losses were incurred whilst being caught on the hop as the domino effect claimed Russia a its next victim.
It is even more ironic that the ensuing run for cover, led by the leveraged clan (those, of course, who were able to run at all as opposed to those who were swallowed up by the enormity of the hole that suddenly appeared beneath them), was to act as the trigger for a truly spectacular recovery in the yen, the incessant weakness of which acted as one of the Asian region's biggest bugbears.
No bid
The single certainty surrounding all pyramid selling schemes and chain letters is that sooner or later you run out of new people to join and the whole system crashes.
In a similar vein, if a story line is so good in a financial market that anyone who might ever be tempted to open a position does so, the only way a market can go, realistically, is the other way. Simply put, if everyone is long, there is no one left to sell it on to. Should the desire or, as in this case, "the need" arise to sell, a trickle can easily become a flood. In a market where everyone is facing in the same direction, this can trigger a stampede and a terrifying price implosion. The only winners are those who were in early and out before it was all over.
Despite the foreign exchange market's massive liquidity, daily volumes and its 24 hour trading ability, the $/¥ implosion on 5h3 7th and 8th of October, as forex desks around the world played pass the parcel was as close to a "no bid scenario" as any major currency pair has ever seen. Many lessons, no doubt, will and should be learned from those harrowing tow days, whether one was a winner or a loser.
Combat refusal
The one thing about human nature is that it does not matter how often one is told how to react in a certain crisis, human beings all behave in very different ways when it's for real. Its not so much they do not know how they should react, they do. Its just hat genuine fear in times of a crisis can trigger a form of overriding mental block which can lead to all sorts of unpredictable behaviour, breaking all the usual rules an disciplines.
In the context of the financial markets, the simple truth is that the human nature side within all of us makes us naturally slow to admit that we might be wrong, even slower still to do anything about it once we have accepted that we are wrong.
Often, as evidenced by numerous spectacular falls from grace by "star performers", the better and more reputable a trader or fund manager, the more hostile and entrenched in their directional view their minds become when faced with their "sure bet" directional play going pear shaped and fast. The faster the market, the bigger the loss and the bigger the loss, the greater the defiance.
There is no single or rational explanation for this dereliction of duty and abandonment of clearly defined rules and disciplines. What is certain, however, is that the investment road continues to be littered with bodies of, hitherto, extremely able and responsible traders or fund managers who have bitten off that little bit more than they can chew, been caught on the hop and, despite all the golden rules that are hammered home in the nursery school of investment, have sat like frightened rabbits in the spotlights of and oncoming car as their positions go from bad to worse.
Degeneration game
Another of life's certainties is that when it rains, it pours. If tax controls permit it, the next stage of this condition can be a snap divorce from reality and a degenerative spiral into frantic gambling together with a total loss of any sense of proportion and the value of money.
This surprisingly common human defect is a danger to us all and it highlights the necessity for banks and investment houses to be much more appreciative of Mother Nature's less desirable, yet surprisingly natural human instincts. Barings et al have shown us quite how spectacularly things can go wrong when a cocktail of star performer status, pressure to perform, adverse market conditions and poor risk assessment/monitoring are all thrown together in a quest for superior returns.
Theory versus practice
In hindsight, it is easy to say that with so much economic growth in Asia relying 100% on each country's ability to export, it was only a matter of time - with so many currencies pegged to the US$ - before the time-bomb in south east Asia finally exploded, Insofar that there was any surprise at all, as far as events in south-east Asia were concerned, it should only have been in that it did not happen sooner.
Many have commented on the folly and the inevitably disastrous economic consequences of pegging one's currency to another in complete defiance of acutely differing underlying economic market trends. History is punctuated by example after example of how singly unsuccessful this theoretically perfect ideology has proved to be in practice. Sadly, life is not that simple.
Speculators: evil forces or shining knights?
Neither the likes of Dr Mahathir (the Malaysian Prime Minister) nor the Bundesbank should curse what they might regard as evil speculators, if the changes going on are the unavoidable result of economic forces. The speculators are only performing their correct function, which -according to Lord Keynes - was to make the market more efficient. Speculators are usually simply the catalytic force behind the inevitable and can frequently save the day (case in point the UK in 1992) before the damage caused by an obsessive political dream, becomes irreparable.
However, this argument goes only so far. None of the Asian currencies crashed because the countries concerned had high inflation rates. Many of them did, however have large current account deficits. This was not least because huge amounts of capital goods were imported to equip new productions units. Before the Asian crisis, the financing of these current account deficits was not a major problem. On the contrary, the capital inflow from abroad has usually exceeded the deficit, thus affording a large build up of foreign exchange reserves.
However, after the crisis in Thailand, the capital flow to south-east Asia dried up. More and more investors came to the conclusion that these current account deficits were unsustainable. Again, not because of inflationary pressures, but because of the huge scale of overproduction.
This time, the economist's traditional rule of thumb that a devaluation would soon enhance a country's competitiveness and lead to an export boom was to be proved to be wrong. The sheer scale of these currency and stock market slides, together with defensive hikes in interest rates, rendered equity finance for many a corporation impossible and sparked a region wide liquidity crunch. Banks, as banks do, move themselves into "its pay-back time" mode and began to cast their wary eyes over their loan portfolios.
Moral hazard
In analysing the events of the past year in slow motion, it is clear that the subject of unrestricted capital flows will rise to the surface as will the uncontrolled and non-quantifiable aspects of the hedge fund industry.
Whilst it is inappropriate to generalise about the hedge fund industry, since there are so many funds with entirely differing objectives, the terrifying insight into what actually went on within Long-Term Capital Management and the unbelievable scales of leveraging that were involved should serve as a persistent source of concern to global leaders.
The past year will not go down in history as one of capitalism's best. In the good names of free market economies and unrestricted capital flows the very existence of whole countries has been threatened by panic withdrawals of funds. Worse still and, no doubt, of unfathomable unfairness to the very people whose whole lives and social infrastructure is affected by such arbitrary decisions, these rushes to the exit - which can leave a country stripped bare - can (and have) come about by a wholly unrelated incident affecting another country in another continent. This was clearly not what Keynes had in mind at all.
Happy endings
If the LTCM affair acts as a catalyst in bringing about some evidently much needed refinement to the global financial system then we will all be able to sleep better at night. In such a scenario, the losses incurred at LTCM may well be seen by some as a price worth paying. Many, no doubt, may also see it as a price paid for by the appropriate people, for a change.
For the rest of us, the exhausting events of recent months will serve as a sharp reminder that licking honey off thorns never was a particularly clever idea. Perhaps the biggest lesson of 1998 will be not to bite off more than one can chew.
1999 New Year's resolution should include never saying never (1998 showed us if it can , it probably will) and a firm commitment to take the technical analysts viewpoint a little more seriously in future since within the charts lie what is happening, not what people tell you should be happening.
