Market Melange

It´s time to remind some market participants of the fact that this is not the first time in market history when bubbles are bursting. This is a message to an investor generation that is facing such a crisis for the first time and to investors that are too driven by adrenalin for thinking rationally.

First of all. Read Charles Kindleberger´s classic “Maniacs, Panics, and Crashes” as a start. Quoting smartmoney.com “It will tell you what it was like to live through a mania and what inevitably happens when the market comes back to earth.” 

As investors we should be aware that “rise and fall” fluctuation is inherent to any system the homo sapiens is involved with. Expressed in the language of finance it sounds like Hyman P. Minsky (in “Stablizing an Unstable Economy”): “turbulence, especially financial instability, is normal in a capitalist economy. […} There is no possibility that we can ever set things right once and for all; instability, put to rest by one set of reforms will, after time, emerge in a new guise.”, or like John Kenneth Galbraith (in “A Short History of Financial Euphoria“): “Yet clearly the speculative episode, with increases provoking increases, is within the market itself. And so is the culminating crash.”

If rise & fall, J-curve effect, economic cycle, boom & bust or however you name it, is just the normal way of how trends are developed, we should stop thinking of them as situations to be avoided. Once we accept them, we can start to think about how to manage up & downswing exaggerations.

Let´s have a closer look at the current situation. Right now we are facing two bubbles that are nearly overlapping in their bursts. 

The housing/credit crisis bubble

Between Jan´91 and Jan´06 the number of annualized housing starts increased from 800k to 2300k - a multiple of 3. This annual increase of 7,2% was significantly higher than the increase in household starts. Between 1996 and 2001 the real estate prices soared by 42%, in the following four years by 64%. More and more households were lending money on their property, assuming that the value increase of the underlying will exceed the mortage costs … we know the result.  

The oil bubble

Between Dec´85 and Dec´01 the barrel was priced at an average of USD 19,95. Volatility around this niveau was moderate. Today the barrel is priced at USD 145. In the previous 6,5 years the price appreciation was on avg more than 30% p.a. The nominal national product of the world increased during the same period “only” by 7.9% (IMF). Oil prices increased faster by a multiple of 4!

Two complementary scenarios of how to handle the current situation without meeting trouble halfway but choosing the constructive approach:

REGULATORY CHANGE

I don´t need to re-invent the wheel after having read Larry Summers´ ideas to this topic that deserves to be endorsed. He published them on Jun 1st in the FT  Six principles for a new regulatory order (below a short summary):

1. no regulatory arbitrage
2. no self-regulation of financial institutions
3. Rather than judging where and when the next crisis will occur (inability to predict), regulators need to try to assure the resilience of the system with respect to economic shocks or problems in any one sector or institution.
4. the focus of regulation must shift from the prudential practices of individual institutions to the health of the financial system.
5. any regulatory regime must address the risks arising from “parallel banking activities” in a realistic way.
6. regulatory policy must to the maximum extent possible create a situation in which the failure of an individual institution is not itself a source of systemic risk.

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STRUCTURAL CHANGE

For me it seems as if we have reached global capacity constraints. Consequently inflation is caused by a lack of productivity reserves. In other words: a part of the production capacity has to be mothballed as it could be only used under the old input-cost-relation between energy, capital and wages.  Under the current crcumstances we do not need productions plants for vehicles with hillarious gasoline consumption, for houses with lacking heat insulation or carriers with business models that are depending on cheap kerosene. Given these contraints, the productivity potential might be lower as we have thought.

The solution is to understand the situation as an opportunity for modern structural policy. This new policy bets on a permanent renunciation of energy-intense production processes. The high energy prices extort anyway a reaction from us. Let`s seize the opportunity and follow a pro-active than re-active approach. We have to restructure the supply and demand side of the energy market. Apart from lower / more stable prices, we can benefit by

• - freeing our dependency from states we would not like to see too powerful
• - slowing global warming
• - becoming more independent from non-renewable energy sources
• - fuelling global community thinking (political effect)
• - … many more

Increasing interest rates is not the only answer to a rising inflation rate. In my view it is the least effective answer at the moment.  

MY ADVICE TO ALL DOOMSAYERS.

STOP WHINING. START WORKING ON THE IMPLEMENTATION OF THE TWO CHANGES. THE NEXT UPSWING IS AHEAD. THE LONGER WE WAIT, THE DEEPER THE PERIOD OF CONSOLIDATION WILL BE.