Phuket Post :: Article :: Money Matters

Headline: Biting the Bust

FTSE100 - 6432.50

�My right is falling back, My left is caving in. My centre is under pressure - Situation excellent. I Attack.�

These were the words of the least bad commander in the first World War (Marshall Foch) in the middle of a battle which he subsequently won.

Investors might have been feeling the same recently:

Banks and associated financials were crumbling worldwide. Property and house building shares have been collapsing on both sides of the Atlantic, and the �Centre� � i.e. the American Economy - is on the �wobble�.

Over the very long period stock markets tend to have followed a fairly consistent 40/60 year cycle of behaviour (and the same applies to individual stocks or stock market sectors) which roughly equates to four phases; their lengths vary but the natures of the phases seems to have been one of the rare predictabilities of equity markets;

These are:

Revulsion � Caution � Enthusiasm � Euphoria - (BUST)

BUST is not a phase because it happens suddenly and unexpectedly and so quickly. It can be as little as one day in the case of an individual stock, or as little as six months in the case of an entire market - or as in 1987 � five and a half hours (that was actually the length of the Bear market on Wall Street in 1987).

Anyway the generality is that 90% of those in the Euphoria phase who don�t leave the party in time, lose possibly five or ten years of hard won gains, or the late comers never see their money back.

This is what happened in 1929, 1973, and in 2000 (with the Dot com collapse). Whilst the BUST usually takes a lot else down with it at the time, when the Euphoria of whatever it was implodes, historically the parts of the market not in euphoria soon make a strong and rapid recovery, and there is no need to lose any money unless you sell in the panic.

This is what happened in the 2003 general fall out after the 2001 tech bust. Markets worldwide are back to where they were in early 2000 and in the Far East and Emerging markets they are way higher and in new high ground, respectively.

It must be said however that the recovery from the 2003 low back up to the 2000 high has been the fastest in stock market history and may to some extent explain why markets have been falling in the more vulnerable areas recently.

Over the cycle, the enduringly successful fund mangers are the small handful - like Warren Buffet, Neil Woodford of Invesco Perpetual and Anthony Bolton of Fidelity Special Situations, who always try to buy their shares in the REVULSION or CAUTION stage of the cycle and sell mostly in the Enthusiasm stage, or early in the Euphoria stage.

Euphoria are by definition incredibly fickle and almost completely random in their length or extent. The Dot com being about the craziest of all time, though there are no anecdotal people around to tell us about the South Sea Bubble, which wiped out Sir Isaac Newton - discovering gravity did not stop him falling off the tree along with the apple.

So these savvy people tend to sell too soon, and the bigger the boom the worse short term their sale may look. BUT they know that to be caught out by a BUST is horrendously costly.

Warren Buffet has just completed what looks like a masterly sale of his huge Petro China holdings in the midst of the current China stock market Euphoria, having bought 5 years ago at about one sixth of his selling price.

The classic reaction to the BUST is a flight in following years to ALTERNATIVE investments as investors suffer Revulsion from the losses they have made in equities.

But effectively whilst this brings large profits to the purveyors of these "enticing at the time" products, generally all investors are doing is leaping from the fat into the fire - invariably jumping on an investment class that is in the "Enthusiasm" stage already and close to Euphoria and BUST.

So it�s: stamps, gold, rare coins, private equity, buy to let property - you name it - any damn thing that wasn�t involved in the equity BUST. But these cycles tend to be much shorter and quickly ruined by the old adage of Byron Wein, the very astute long term equity strategist at Morgan Stanley:

�There is no asset class that cannot be destroyed by too much money�

This is exactly what has happened both in property and private equity. Everybody last year was plunging into Property Investment, and then came the usual sign of a "top" - the mutual funds launched their PROPERTY FUNDS - and the bubble has already burst less than a year later. Property shares have more or less halved. M&G suspended redemptions for three months, and the experts are predicting that next year actual commercial property could fall by up to 20%.

However, the stock market has now probably over-discounted the problem with a much larger fall in the quoted share prices.

The lure of the quality and security of London West End and City property for international commodity-rich countries� individuals to place money long term may in fact mean that values do not fall as much. But in the short term this is scant comfort for those pushed into "alternative investments in property� in the last 18 months, now nursing uncomfortable losses.

Private equity has probably been saved by the banking crisis which has cut off the cheap flow of credit, so no more over-priced deals like the MBO of BOOTS/ALLIANCE at an inflated price will occur. So, much of the $340bn raised this year by private equity is still uninvested and could find now some much better bargains.

But the 2006 series funds will in general have overpaid and show nothing like the 15%+ returns that private equity had been making.

It remains nevertheless a very credible long term asset class, unlike the majority of the other �Alternative Investments� sold - like those hedge funds sold on the �Heads you win Tails somebody else loses� ticket.

Mann Group, the leading hedge fund manager, has now predicted that at least 10% of the HEDGE fund industry will disappear this year - some quietly - others collapsing worthless like AMARANTH and the two big Bear Sterns funds.

Mann Group itself remains an impressive operator in what has now become an overcrowded market, and will stay the course and reap the benefits after the industry thins out.

Returning to the stock market, unless I am wrong in calling the 2001/2003 the BUST at the end of a 25 year run which started in 1975 � it went through all the phases: Revulsion, Caution, Enthusiasm etc. We are still early on in the longer term equity.

Full cycle, but by June 2006 the cycle seemed to have jumped from 2003 Revulsion to 2006 Enthusiasm rather too quickly, probably resulting from somewhat too lax FED monetary policy, and elsewhere under Greenspan. It is easy with hindsight to say this, but at the time the sharp Federal Reserve increase in money supply staved off what looked at the time in 2003 as the onset of a nasty deflation.

Now there are a number of problems that have got to be worked through before markets can resume a longer term upward trend. But both the European Central Bank and the Fed appear utterly determined to avoid world deflation, either through forced or accidental monetary contraction. We are all Keynesians now (except Mervyn King).

Can this continue indefinitely? The trick seems to be the slow robbery by inflation of cash and bondholders. Provided inflation keeps somewhere below 5%, it seems they will wear it as it is not quite too obvious. But if it ever got to a situation like the late 1970�s when inflation rose above 10% and long bond yields soared, then no amount of credit creation could help. In the late 1970�s inflation had to be addressed and a sharp recession ensued.

It does not look as if the world economy is near that situation now.