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Learning from the Meltdown

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By TMFRoZany
December 16, 2008

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Teachable Moments: Is there something to be learned with this financial meltdown?
"In our age... men seem more than ever prone to confuse wisdom with knowledge, and knowledge with information, and to try to solve problems of life in terms of engineering." - T. S. Eliot

To this I add the axiom, a cause can never be less than its effect.

Two recent articles caught my attention, both siting ‘Teachable Moments' in some fashion related to the economy and the financial crisis. Delving into this financial crisis we find T. S. Eliot quite prescient. The crisis we are experiencing was engineered by the financial system itself with assistance from dysfunctional parties. The subprime crisis was not isolated, eventually we had a financial meltdown.

In all the din of markets, there is something that should gain our attention. With the dearth of headlines intoning that the the FTSE falls, commodities retreat, Big Three automakers grovel for loans - Senate puts brakes on, shares soar on US stimulus - then sink, crude below $44 now curving up, stocks shake off jobless claims to end with big gains - whoops, not so on the latest report, and the dollar falls on upturn risk, with gyrations of various magnitude. John Mauldin writes about the velocity of money again, and algorithmic trades heighten volatility.

We are admonished to remember that borrowing money was easy, but it eventually has to be paid back even by those finessing with financial engineering. Somehow the banking industry failed to ‘get this' with their enabling trickery from various sources.

Our culture of corruption unfolds new misdeeds with frequency. Like this Madoff character and his firm's purportedly $50B fraud Ponzi scheme.

BenGrahamMan posted on the Liquid Lounge board, "What can we learn?" Notes from 1929-1937 chapters of '101 Years on Wall Street' by John Dennis Brown
"We learn that things can always get worse." (Link to this post in Selected References below)

True, but the sense of purpose in this post is that regardless of the cloud cover, we are blessed as a nation even as many struggle in this economic downturn. We should try to understand and learn from the impact of this financial crisis, remember a cause is no less than its effect or you might say for every action there is a reaction. The Financial Times reports that the world's largest credit insurer forecasts that a record number of companies will go bankrupt next year with 200,000 insolvencies in Europe alone and "an explosion" of failed businesses in the US. (December 7)

To put this into some sort of perspective in human terms, not Wall Street terms, more jobs are being lost at the same time as the world's hungry increase to the 1 billion mark reminding us of a food crisis as mass starvation rises. The action on commodities takes it's toll on the weak.

The loss of money is painful but it is not the end to life. A change in lifestyle for many of us is in order. Teachable moments surround us if we take note.

Observing encouraged - Grant
From the eminent James Grant, editor of the newly published sixth edition of Security Analysis, by Benjamin Graham and David L. Dodd, writing in the Financial Times:

"US Treasuries are the investment asset of the year. The less they yield, the more their fans adore them. Then, again, these fearful days, yield seems to have nothing to do with investment calculation. Purported safety is all.

"Super-safe Treasuries", the papers call these emissions of a government that, this year, will take in $2,500bn but spend $3,500bn. "Toxic assets" is how the same papers characterise orphaned mortgage-backed securities-or, for that matter, secured bank loans, convertible bonds, junk bonds or almost any other kind of debt obligation not bearing the US imprimatur...

"The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price...

"Yes, Treasuries might conceivably redeem the hopes of their besotted admirers. Maybe a deflationary chasm is about to swallow us all. Never before has the US been so leveraged. And-just possibly-never before were lending standards so reckless as the ones that brought joy to so many astonished mortgage applicants in 2005 and 2006...

"[But] what I observe is a monumental push to reflate. The Federal Reserve is creating more credit in less time than it has ever done before - in the past three months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise no inflationary sweat?

"Evidently, they are-at least, forward swap rates betray no such concern. The market's best guess as to what the 10-year Treasury will yield in 10 years' time is 2.78 per cent, never mind the famous (and now, as it seems, prophetic) remark of Fed Chairman Ben Bernanke that the Fed could drop dollars out of a helicopter in a deflationary pinch...

""Risk-free return" is the standard tag attached to the government's solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description - "return-free risk".
None of which, of course, will stop long Treasury yields from dropping to 1%, at least temporarily. It happened in Japan. It's about time we stopped saying "it can't happen here."

So get used to it, those icky low rates are here to stay for while, even had the T-Bill bounce negative.

"Two urgent questions present themselves. One: does something far worse than recession loom? Two: does that certain something definitely spell much lower interest rates?

"We can't know, but we can at least observe. What I observe is a monumental push to reflate. The Federal Reserve is creating more credit in less time than it has ever done before - in the past three months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise no inflationary sweat?"

Lots of tweaking of the system going on in the world of money. All this leads us to mind the advice to OBSERVE and to find the teachable moments as reality strikes.

Teachable Moment #1 -
"All of life is the management of risk, not its elimination." - Walter Wriston
Points to Ponder
1. What goes up, must come down, the U.S. economy is cyclical.
2. The government provides a safety net but you still need those life preservers for such things as layoffs, inflation, and economic forces.
3. Identify the government driven inputs and sort them out from the market driven inputs in the economy.
4. Change forces can be painful and messy. When you see the word ‘transformation' that is one version of change, so are job losses, Chapter 11, and rescue plans to banking institutions and to automakers.

Change is upon us, whether we like it or not, from within or without our boundries. We find instability in the current financial system because the the mechanisms of self-correction and price discovery have been broken.

We have had over twelve months of a credit crisis that seems to metastasize. Beware of ponzi -like schemes enhanced by the media hyping the good times and ignoring the action between dirty financial sheets of the convoluted processes in the banking investment community. It has happened before.

Nobody wants to hear "bad news", nobody wants to face the horror of truth and reality. But reality strikes and is with us.

Government inputs - Mauldin
A political economy will be driving stocks says John Maldin quoting from Statfor. Stratfor's focus is on geopolitics. That means that it focuses on the behavior of human societies organized into complex, geographically defined systems.

Mauldin writes (bold mine), "Exhale for a moment, forget your losses for the time being, and try to appreciate the fact that you're living through the single most important development in global finance since Bretton Woods.[bold mine] This is a "tell the grandkids about it" moment, when governments all around the world have essentially decided in unison that it's time to rewrite the rules, the very framework, in which financial transactions take place. Stock trading, interbank lending, commercial paper, the very concept of private sector ownership are all up in the air right now.

"The only thing I can tell you with certainty is that if you try to evaluate your investments using the same metrics you've always relied on - P/E ratios, market share, interest rates, etc. - you're going to be as successful as a football-turned-baseball coach evaluating a pitcher by the number of touchdowns he throws. The rules are changing, gentle reader, changing at least for awhile from market-driven inputs to government-driven inputs. If you try to apply what you know from the "old game" without understanding that you're playing a "new game," the rules might not make sense."
(Frontline, 10/16/08

The Stratfor concluded that the U.S. economy was moving into a recession but that the recession would not break the framework of the postwar economy, although clearly the degree of government intervention will reshape the financial markets. This was written well before the recent acknowledgment of a recession.

The latest week from John Mauldin, "What we're witnessing isn't finance or investment as usual. We're watching a shift to a managed economic structure, where government officials determine who will live and who will die. It's a shift from investments to agreements, where having access to large pools of ready cash is the ultimately persuasive argument. And lacking access means doing whatever you're told." The Stratfor letter is about the shortage of capital around the world and those who retained access to capital have became increasingly risk-averse and are hoarding capital.
(Outside the box, December 4, 2008)

False signals - Gross
Bill Gross of Pimco is saying that stocks might be pricier than they seem saying the new economic reality means traditional techniques are sending false signals. "My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to - that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner." (from Pimco's newsletter)

Credit crunch - Inside Value
And from the December newsletter, "With so much going on, we decided to take a hard look at our past recommendations in light of the very real credit crunch and the possibility that a recession could be deeper and longer than we originally thought. The credit crunch affects all companies, but some a lot less than others."

"Now back to my newfound optimism. I've decided to view these difficult times as an opportunity. . . . I've been buying stocks over the past few weeks at fantastic valuations"
- Ron Gross Inside Value newsletter

Input requested
I hope that our analysts will give us their take on the comments from Grant, Mauldin, and Gross. Others are encouraged to comment also, the more the merrier.

It is helpful to have the input from our analysts and others. Each of us should point out the risks of investing for ourselves, as our newsletter does. Know that there are no surefire get-rich-quick formulas and know the dangers of not understanding what you're investing in (invest in what you know). You are encouraged to ask questions here.

"Living below your means" happens to be board at the Motley Fool. Many consumers need to go back to the financial basics of making sure there is more cash inflow than outflow in the family budget. In other words, keep spending under control.

Who will guard the guardian?
It has been said that the guardians do not need guarding. To which Glaucon, Socrates' interlocutor, replies: "Yes, it would be absurd that a guardian should need a guard." Plato-through Glaucon-expresses the optimistic view that one should be able to trust the city's guardians and rulers to behave properly." My, how times have changed.

Where was the government, the so called guardian of the populace, in the buildup to our current crisis that has rocked our very foundations? The oversight issue by government has been a hot button in political circles similar to the story of Goldilocks, too much, too little, but in this case, never just right.

One event that sticks in my mind was the encouragement to spend and borrow against the equity of our homes. And if you didn't have a home, President Bush said we want everybody in America to own their own home in effort to stimulate the economy.

And the enablers came forth from many corners, especially those with the means to funny money. I think it not necessary to list out the financial system, the mortgage folks, the Legislative assistance with various activities.

All this sets the stage for something that could rock generations.

A few posts back jlyer brought up ‘generational dynamics' considering different age classes mentioned in TMFInept's post ‘wondering whether stock market crashes might be some implicit reaction to the varied lifestyle demands of varying age classes.'

This is not your father's recession, so what does that mean? Great minds are not sure and are still searching for answers. Some arguments center around the "D"s, depression and deflation. Financial capitalism is an offshoot of free market capitalism just as managed capitalism is and the tinkering continues.

For the time being, I see cash as very good place to be analyzing my Portfolio and my age horizon in retirement. Go ahead and take risks but only use a small amount of your portfolio would be my thinking right now. In my take, price discovery mechanisms are broken and assessing risk is like shooting fish in the barrel.

This is backdrop to identifying what has been labeled a "Significant Emotional Event" and relating it to our current financial crisis and economic downturn for Part 2 with identification of what I consider "Teachable Moments".

Part 2 looks at generations, what was going on as we were growing up, and the influence on our values. We need companions such as those found at Inside Value as we continue on in our investing journey. On the one hand we need support, on the other hand we need to challenge some of our thinking, but most of all, we need to encourage each other when we become discouraged.

I have found it very important to let go of my wishes and to live in hope.

Comments welcome.


Selected References:
Use today's economic crisis to teach important lessons

"Lessons From This Downturn" - Barron's

Seven lessons to learn from today's economy

Long Term Investors: Opportunities Like These Don't Come Around Very Often

BenGrahamMan,"What can we learn?"

Stock market crashes and participant age...
TMFInept and jlyer post.

The International Economic Crisis and Stratfor's Methodology

The Six Lessons from Last Week's Action

"Insight: Return-free risk" Subscription required.
Insight: Return-Free Risk - METR board

"The International Economic Crisis and Stratfor's Methodology"

"Bill Gross Says Stocks Aren't as Cheap as They Appear "
Investment Outlook - Bill Gross

Bush seeks to increase minority home ownership
You Tube, President Bush and Home ownership

"What is to be Done? The End of the Washington Consensus,"
Somewhat controversial for some, global thinking, written by one American Econ Professor, the other from a visiting Fullbright Prof from Sweden.
Wall Street's financial meltdown marks the end of an era. What has ended is the credibility of the Washington Consensus - open markets to foreign investors and tight money austerity programs (high interest rates and credit cutbacks) to "cure" balance-of-payments deficits, domestic budget deficits and price inflation. . . Austerity and "fiscal responsibility" are for other countries. America acts ruthlessly in its own economic interest at any given moment of time. It freely spends more than it earns, flooding the global economy with what has now risen to $4 trillion in U.S. government debt to foreign central banks.

If G.M. Was a Canadian Company It Wouldn't Be Asking for Help

Inside Value January.