Sent: 05-02-2008 11:08:02
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Given that I wrote extensively on the Sub-Prime debacle last year, my determination to leave the subject alone has lasted well into 2008, i.e. the begining of February
Those who subscribe to the ATC Digest will note that I have written the feature for the latest edition about how markets are rollercoasters, always have been, always will be. Trouble is, most average investors, and many professionals as well, tend to forget this simple fact.
The following is a highly abridged version of that Digest article.
Once again markets are demonstrating their volatility. What many forget is that by their very nature, markets move in both directions, i.e. down as well as up. Back in 2001/2 I gave a number of presentations around the country called "Putting Market Crashes in Perspective". I also wrote a detailed report on the issue which a number of ATC subscribers ordered. It seems that it is time to dust off that document.
Back then I stated that stock markets are dynamic, constantly moving, sometimes up, sometimes down and sometimes susceptible to manias, panics and crashes. Such events are part of the normal investment cycle and have been going on for a very long time. The issue that is causing the current round of unrest is the credit crunch, caused in no small way by the sub-prime crisis. However, as I pointed out back in 2001/2, panic selling and buying in volatile times has been demonstrated to be one of the worst strategies a person can use.
Charles Kindleberger argues that there is a consistent pattern to financial manias and panics. He suggests that typically an upswing starts with new markets and/or new opportunities. The cycle then proceeds through the euphoria of rising prices often with the increased availability of credit fuelling the process. This happened during the crash of 1929 and has happened during subsequent boom periods and especially during the sub-prime expansion.
In the manic phase, investors find themselves scrambling to get in, changing their assets from cash to stock, commodities, tulips or whatever it is that is the current craze. In the latest debacle all sorts of organisations rushed headlong into this new and highly lucrative market. This phase is characterised by "overtrading", i.e. pure speculation (buying something with the aim of selling it a short time later at a higher price), overestimation of the true expected return and excessive gearing (low initial cash requirements when buying). The emergence and subsequent 'misuse' of mortgage-backed securities and credit default swaps are manifestations of this phase.
Ultimately the market stops rising and people who have borrowed heavily find themselves over stretched. The emergence of recent write-downs in the US and around the world is yet another example of the cycle Kindleberger talks about.
In sum, human psychology leads to market prices being volatile. The trouble is, it often leads to human misery with those who are the most vulnerable being the ones who usually pay the highest price.
The twist to the current situation is of course the so-called 'rogue trader' at Societe Generale. There is speculation the in their effort to unwind the massive positions he had established in excess of $50 billion it seems), the bank's traders may have triggered the most recent falls. Even if that was the case, it doest not alter the fact that the markets were merely waiting for someone to light the match as they were primed to fall. All part of the normal cycle.
The problem is how do you explain this to others. That will be the focus of my article next time.
For those who are interested, the next edition of Digest will contain the full article entitled "The Rollercoaster is Back - Again" and goes into much more detail about how markets are destined to go down as well as up.
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