The Dow Jones Industrial Average (DJIA) gains 936 points on a spectacular Monday. And then, like the proverbial monkey on the oily pole, drops 733 points on Wednesday, making it the second worst single day drop in Wall Street history.
The stock market has now entered a most dangerous period—-a time of high price volatility. As an investor, you say to yourself—“The market has gone the lowest it can go, equities are as cheap than they have ever been for a long time and I can start buying stocks now.” And the moment you think its safe to go into the water, the market goes into a free fall once again. Naturally, you panic even more and keep holding onto whatever investments you have. Unsure as to which direction the market will go and fearing for the worst, you start having a fire-sale of your holdings. Other people do the same thing. The market drops further. Then perhaps some little gains are made, market sentiment perks up and you again wade in. The shark however sneaks up once again and before you know it, you are holding a bloody stump where once your investment portfolio was.
Welcome to 2008. What the pundits are now saying is as close to the Great Depression as we have ever been. The very worst of times. The last time they used the word “depression” was in the context of the 1929 economic cataclysm. Markets then took decades to recover—-General Electric, one of the leading corporations of the day, took almost twenty five years to recoup its losses in value.
Which means that if we accept the assessment that we are inside a depression (or something close to it), then what we are seeing is much more severe than just a “market correction”, a “bear market” or a “recession”.
And the most disquieting thing of all.
Evidently, as the big brains tell us, matters are even now nowhere near the worst.
The only silver lining. The big financial gurus have been proven very wrong in the past. Maybe, after a spell of irrational over-exuberance in the last few years, they are now compensating for it by being over-pessimistic. Or perhaps, by the law of “a broken clock is right twice a day”, they are finally “on the money”.
The kind of disquiet and apprehension for the future that exists in the US today is almost unprecedented in recent memory. National debt is so high that the debt clock in New York city had to be taken down as it had run out of digits ! Unemployment figures are at historic highs, consumer confidence (very critical to the economy for the Christmas shopping season) low and real estate prices keep falling every month (Recently, a house sold on Ebay for $1.76)
People are angry. And angry people obsess about identifying the “guilty party”. Not that the act of identification serves any purpose other than to provide the mental satisfaction that the apportion of blame, even if it be as effective as shouting in a dark room, brings about .The verdict is unanimous —–“Wall Street” is the culprit but since there is no single person who can be lynched, all America’s anger has focused on the Republican administration, that is widely perceived to have let investment banks run loose. And the man who has suffered most as a result of this has been John McCain, who has seen his election lead being wiped out to be replaced with a significant lag behind Obama (Gallup) on the back of the economic collapse. So concentrated has the tide of public opinion been against him that he was found to be pleading with the nation in the third presidential debate— “I am not George Bush”.
This post is not about who is to blame for the credit crisis—I think that has been discussed in the previous posts on the subject. However I cannot go to the main course without telling you about something that has fascinated me—-in the same sense that Shibu Soren “fascinates” me, in the same sense that two cockroaches making love hold me enthralled.
And that is greed. Vulgarly arrogant displays of it. The kind that brings the world’s strongest economy at the doorstep of collapse.
Story 1: After the Paulson plan became law, many financial institutions (who had lobbied extensively for a government bail-out) were reported to be no longer as keen to avail of the provisions of the plan because the politicians, in an acknowledgment of popular anger, had put a ceiling on executive compensation for any institute that wished to avail of the plan’s benefits. Instead, these financial fatcats were preparing to go it alone, at least for now, to see if they could solve the problem without taking a pay-cut. And if they can’t, they can always extend the begging bowl later on. For now, let’s empty out whatever we can.
Story 2: 70 of AIG executives, after (and I repeat after) they had been bailed out by the government, went on a pleasure trip to an exclusive resort and spent many thousands of dollars on spa treatments and the other corporeal pleasures of the Wall Street life. If that was not outrageous enough, what send me into fits of maniacal laughter was when I saw one of the AIG bosses on TV justifying it by saying that perhaps the executives were stressed out by recent developments—-of course later on the story was changed to be: this trip had been planned “in advance” and surely once you tell kids about a planned excursion, it would be most unfair to “cancel it”.
Story 3: By the high standards of Wall Street compensation, 50 per cent of the total revenue of a financial institution is spent on executive salary, when times are “good”. In the first nine months of 2008, when times were undisputedly bad, Merrill Lynch (now bankrupt) paid their execs 13 times their total revenue as salary —yes that means 1,300 per cent. So next time, one of your Wall Street friends tell you that that they earn more because of their astounding “performance” (and so jealous outsiders should “get over it”), kindly throw this figure in his/her face. And you do have the right to be a bit arrogant here. After all, its your tax dollars that’s providing the downpayment for his Porsche.
But greed is not what this post is about. Its about trying to answer whether the crash of 2008 is really as big as it is being made out to be or is all the hullabaloo just an extreme knee-jerk reaction to the inevitable bad times that follow periods of high Wall Street numbers?
After all, the Depression was more than 70 years ago. The science of managing economic crises has changed since then. Surely the same follies in 1929 that drove the US deeper into Depression will not be repeated. Steep declines in stock values and wiping out of investments have happened many times since, from single day bloodbaths like Black Monday to a period of free-fall like from 2000 to 2002 when the Dow Jones lost more than 50% of its value with $7.4 trillion dollars “vanishing”. Some would say that after prolonged periods of increase in stock prices (“`overheating”‘) [about a year ago, on October 9 2007 the Dow Jones Index had reached its highest ever number] such a crash is inevitable.
In passing, isn’t the state of the investor today, after the highs of 2007, somewhat like the hedonist party-goer who after a deliriously debauched night on town wakes up in a bathtub with a “You have one kidney left”‘ message scribbled on the mirror in red lipstick?
As to big and perceived-to-be-solid corporations, they have failed before. Penn Central Transportation Company, the biggest railroad in the United States, declared bankruptcy in 1970, shaking up the system and sending people into panic. This is also not the first time that major banks have gone bust—the 80s had quite a few major catastrophes in the banking sector. Inflation? Today’s inflation in the US is still nothing compared to the early 80s.
So what is it that has changed over the years? What is it that is so special about this economic downturn that has necessitated the biggest government intervention in modern history? Needless panic? Or is there something unprecedentedly wrong with the US economy?
First let us look at what has not changed. That is what has remained constant over the last 100 years.
The follies of the common investor.
People still make the same mistakes while investing their money in the stock market that their grandfathers did years ago. After all what is the stock market except a composite measure of a nation’s economic sentiments, reflecting both the fundamental irrationality as well as the capriciousness of the homo sapien ? It is these emotion-driven swings between hopeless optimism to debilitating pessimism in the blink of an eye, that has historically driven markets to heights unheard of and then brought it to the ground with earth-shaking violence.
So what are these follies, so eternal that they bind together the monocoled banker of the 30s to the rimless framed soccer mom of the 2000s?
Error Number 1: This is the big one. And by far the most common. Whereas in every business transaction, people believe in buying low and selling high, when it comes to the stock market, they end up doing exactly the opposite.
How many times have you heard something on these lines:” Did you hear how much money Rajesh has made on the stock market. He used to ride a bicycle. Now he has a Bajaj scooter. Everyone is making money on the market. Let’s take money out from your provident fund and buy some shares.”
I have. And this is, on the face of it, a rather persuasive argument for buying stocks. After all if Rajesh and Rukmini are making money playing stocks and riding a bicycle or buying a new fridge, why the hell should not I?
The problem is that if indeed Rajesh and Rukmini are making money off stocks and so is Riaz and Rahim, then the chances are that just like you, everyone else is making a beeline to buy stocks, pushing their values up way above their true worth as investments. Hence if you “jump in” as soon as you hear Rajesh’s scooter vroom, the chances are that you are buying “high”. It stands to cold-hearted logic that the more the market does “good”, the greater is the risk that tomorrow it will do “bad”. And once that happens, you shall be forced to sell your stock “low” (the same stock you bought “high” in the hope of buying a scooter) in order to minimize your loss.
Smarter than that? Perhaps you are. But this error sneaks upon you, often in a very insidious, indirect way.
Consider Tandiya Bhai, who after capturing Gol Basti decides to do some investment. Having learnt a lesson from his old boss, Lukka who put all his money in risky investment and then lost it all (as Lukka said about his investments: the share certificates he holds are like cinema tickets for a show that has already taken place) Tandiya creates a portfolio where he puts 50% of his savings of $200 i.e. $100 in a company bond (paying 5% simple interest) and the remaining $100 in a high growth stock. Namely in Lucky Chikna’s Latakta Circus Limited (ticker symbol: LCLC).
A year later, based on bumper earnings of LCLC and a huge Bull(ah) market, Tandiya’s $100 stocks are now worth $150 netting him a 50% return on his stock investment. His $100 in the company bond gave him $5. Tandiya’s total worth is, at the end of 1st year, $255 ($105 of his original bond investment and $150 in stock).
Note that the 1:1 balance from the previous year is now tilted in favor of stocks. In other words, Tandiya’s exposure to the stock market (i.e. the chance that something “bad” in the stock market will affect him adversely) has increased because he has almost 60% of his assets in stock. As a result, the insurance against risk (the $105 holding in the bond account) is not as strong as it was before. This lack of “insurance” is even greater a problem than it appears because since the market is now higher than the level at which it was a year ago, the chance that the stock markets will subsequently fall and reduce the values of his investments has increased. In short, Tandiya has a bad risk management policy in place.
And as luck would have it, the stock markets do go south. Lucky Chikna and business partner Haseena Tantan (duplicate of Raveena Tandon) fall out publicly and this adversely affects investor confidence in LCLC. Result: LCLC stock falls by 50% i.e. Tandiya’s $150 in stocks now becomes $75. So now in comparison to two years ago, his total portfolio is now down to ($100 [bond principal from 1st year] + $5[ bond interest from 1st year] + $ 5[bond interest from 2nd year] + $75 [new value of stock portion of his portfolio])=$185 i.e. he has lost 7.5% of his principal in 2 years.
So how could Tandiya have done better risk management? By taking $25 (half of $50 profit from 1st year) out of his stock account at the end of the first year and putting it into the low-yield but safe savings account. If he had done that (that is maintained the 1:1 ratio between his stocks and bond account) his total portfolio would have now been: ($100 [principal from 1st year] + $5[ interest from 1st year] + $25 [added principal to the bond in the 2nd year] + $6.25[interest from 2nd year] + $62.50 [new value of stock portion of his portfolio]= $198.75 i.e. he would have almost recovered his principal.
Looking at it another way, if at the end of the 1st year, he had sold some of his stock (i.e. cashed in) when the market was high, he could have reduced his loss to a large extent. However Tandiya did not. He told himself “The stock markets are doing so awesome. It would be a sin to take money out of it when the going is good” and did not balance his portfolio. However as pointed out, just because the market was doing well, the risk of it going down had become higher and Tandiya would have been better advised to take out a larger “insurance” to cover the increased risk (technically speaking, he should have made a better hedge).
Taking away money from a stock fund when things are doing well in a smart manner, as means of managing risk, is one of the toughest things to do. Which is why this is a folly that is made not only by small investors and tyros but also by the big boys and the market gurus.If one looks closely, one would see that the major losses on Wall Street sustained by the big players have come because of similarly improper risk management strategies where the potential of higher returns have made fund managers take more and more risk till the camel has buckled down and rolled over under the weight of one straw too many.
Error Number 2: The Nostradamus syndrome. When you hear people saying “Biotech is going to be the future. I am putting $10,000 on Toxic Pharma”, you know that they are making Error Number 2.
While you may definitely get lucky and choose a winner among companies perceived to have potential, putting an inordinate amount of your investments in so-called “growth stocks” (i.e. those companies that have shown healthy per share earnings in the past one or two years or are tipped to grow) has historically been extremely risky. As well as extremely popular.
It is indeed because of this popularity, that growth stocks are almost always “over-valued” and that is because everyone wants to buy them. It is worth remembering that an investment, even in a company that is “great” or may become “great”, may be bad if you paid too much for it.
Also the potential for growth of a sector does not necessarily mean that their share prices appreciate as much as expected. The classical example of this are “air-transport-stocks” which were considered to be the growth industry of choice in the early 50s. Mutual funds that invested in the airline industry (like Aeronautical Securities) have proven to be disastrous and despite the popularity of air-travel today, the airline industry has never performed as impressively as was believed.
In addition, just because a sector looks good to grow, does not mean that you will be lucky enough to separate the wheat from the chaff. For every IBM, there are hundreds of tech companies that have been brought to their knees. Amerindo Technnology Fund, a mutual fund that concentrated on dot coms, rose 249% in 1999–however if you had invested $10,000 in it, you would have about $1,200 left at the end of 2002.
Error Number 3: The stock tip. Whether it be your paanwala, the guy who sits in your cubicle, or the market expert on TV giving you a stock tip, people should treat such advise with more than a healthy dose of skepticism. Not surprisingly, they do not.
Unless the information is of the type that is not by nature publicly available (i.e. reliable “insider” information from a direct trusted source), stock tips are almost always misleading. If the stock tip is “good” (which is rarely the case), everyone knows it, and then acts upon it. This pushes the price of the tipped security up making it not as attractive an investment as it originally was.
In most cases however such insights into the future are misguided.
Remember that the most intelligent men of our times with great heads for figures have suffered humiliation in the stock market. Case in point: a certain Isaac Newton who lost a lot of money thus.
And as to the so-called experts on TV and on the Internet, the lesser said about them the better. James Cramer, a stock evangelist and expert, who comes on CNBC and is known for his animated sports-casterish way of analyzing markets, gave ten “hot tips” for the future in 2000 (read them here). Most of these companies have now gone bust and according to the “Intelligent Investor”, a $10,000 investment spread equally across Cramer’s picks would have lost 94% of their value by 2002, leaving the hapless investor with a total of $597.44.
Coming back to the original question. So given that people still make the same mistakes and will continue to do so, what is it that makes the situation so bad in 2008?
First of all, and this is perhaps because stock investments have done fairly well over the years, they are considered much less risky than they were considered to be in the 50s and into the 70s. Which is why many people in the US think nothing of putting almost their entire life savings in the stock market.
Even more important has been the democratization of the investment landscape brought on by low-cost online brokerages. Traditionally, investment in the stock market was an opportunity reserved for a privileged few, that is those who had a significant corpus of assets that would make it economically feasible for them to hire a money manager and to shell out large broker commissions (the money a broker takes from you as his payment for doing a stock transaction) and engage in sufficient volume of transactions that would make it worthwhile for the broker to service the customer.
However the last decade or so has seen the proliferation of online brokerages whose low fees and low limits on volume of transactions has removed the entry barriers to the stock market in a way that is nothing less than revolutionary. Housewives, truck drivers, college students, grandpas—are now all “in the game” , connected by their cellphones and laptops at all times to the market, having real-time access to market data and an always available corpus of financial knowledge, things that even a few years ago were the prerogative of the professionals.
This increased involvement of all sections of the society in the market has increased, in general, society’s exposure to the vicissitudes of the stock market. Which means any slight perturbation in the markets affects people’s wealth to a far greater extent than they would two decades ago. This also works the other way—-people’s emotions (of panic as well as of optimism and of course collective follies) affect the market more significantly than they used to.
Add to it the fact that instantaneous online trades, automated trading and the availability of real-time quotes make shock waves propagate through the market faster than before, and one begins to understand why share markets are much more volatile and exert a greater, almost instant impact on the common man than ever before in their history.
The second reason why the crash of 2008 is different from previous collapses is that for the past few years, both individual investors as well as financial institutions have exposed themselves to almost obscene levels of risk through high leverage. This means that they have not been investing with just their own money but also with money borrowed from others, with this borrowing many many times greater than their own assets.
This borrowing of money to increase your returns is called investing on margin.
And why is it so attractive?
Consider aggressive investor Inderjit Chadda, the lawyer from “Damini”. He has $20,000 in assets and borrows another $180,00 from a lender, promising to pay him back the principal along with $10,000 as interest at the end of one year. Seeing that the housing market is booming, he then buys a $200,000 house. In a year the price of the house becomes $230,000. Chadda sells the house, returns the money to the bank ($180,000) and pays them the interest ($10,00) and has $40,000 left for himself. Since his initial share was $20,000 he has now obtained $20,000 as return on his investment—in effect doubling his money in a year.
Consider passive investor Alok Nath. He waits for many years till he himself has saved $200,000 and in the process misses many opportunities for profiting from rising housing markets. Ultimately, he times his house buying at a time the housing market is going up and like Chadda manages to sell the house for $230,000. His profit is $30,000 but on an initial investment of $200,000 making it only a 15% gain per year. Good but nothing like Chadda’s returns however. Expect Chadda to do an exaggerated toss of his head,as a sign of victory, every time he sees Alok Nath
But what if Chadda made a miscalculation, like the time he dared to cross paths with Sunny Deol. What if instead, the market went down while he held the house. That is, at the end of the year, the house’s value had become $170,000. Now Chadda would still have to pay the bank their $180,000 + $10,000= $190,000. Which means he would need to get $20,000 ($190,000 – $170,000) from somewhere in order to prevent being in default of the bank. And his own investment of $20,000? That would have been wiped out. Chadda would now effectively have lost $40,000 in a year, $20,000 of which he himself never had.
In a similar situation, Alok Nath’s loss would be only down 15% i.e. he would still have 85% of his original investment. And he would not have to sell his kidney. At least for now.
If you think that Chadda was being excessively cavalier in his investments, you are mistaken. At $190,000 debt for $20,000 of assets, he was well within the leverage (i.e. debt to assets) ratio of 12:1, traditionally what has been considered, by US law, to be the upper limit to the amount of leverage a bank can carry. In 2004, under pressure from the sharks at Wall Street and from their greasy lobbyists, the federal government entity SEC (Securities and Exchange Commission) allowed 5 investment banks to carry leverages of, hold your breath, 30 and even 40 to 1.Which not only opened the doors to the potential of mind-boggling returns (mind you ‘potential’) but also unleashed the dogs of absolute financial ruin on five of the strongest pillars of the US economy.
And who indeed were the chosen 5?
Lehman Brothers, Bears and Sterns, Merril Lynch, Goldman Sachs and Morgan Stanley.
And we wonder why a firm like Lehman Brothers that survived a Great Depression and two World Wars could not survive 2008 !
Operating under dangerously high leverage ratios is not a prerogative of the Big Boys, even ordinary investors, seduced like Inderjit Chadda, have fallen prey to it like never before. Not only are they carrying higher risks by operating “on margin” (i.e. investing borrowed money), many Joe the plumbers and Jane the programmers are using the borrowed money to venture away from stocks into riskier, but higher pay-off financial instruments like options and futures(which are bets placed on the price of a financial commodity in the future).
In short, ordinary investors are not only more plugged into the markets than ever before, they are also carrying higher levels of risk. Which means that while billions will be made when the going is good, in times like 2008, the impact of a weak market on the country is like a rifle shot through the brain whereas in past decades it was perhaps like a slash with a long knife on the thigh.
And finally what makes 2008 so hellish, in comparison to the past, is that the main fuel for a vibrant economy—corporate growth has come to a standstill in the US. The cumulative effect of years of steady flight of manufacturing jobs and investment capital away from the US, high oil prices that not only have led to the biggest transfer of wealth in human history but brought to its knees many of America’s most venerable automotive corporations and the three trillion cost of a needless war have all detrimentally affected the foundations of the market. So while money can still be made on Wall Street through well-placed bets and the markets will go up (and down) based on trading, the fundamental supply of oxygen that keeps earnings growing, the dividends coming and leads to overall economic prosperity have been severely constricted.
Which is perhaps the most worrying aspect of this whole affair.