Intermission

The FTSE has just closed at 5,414.40, about 1,150 points down from a recent high (10 December 2007) of 6,565.40.

But the gyrations have gone on for much longer. The FTSE bust UPwards through 5,438 on 29 October 1998, heading for nearly 7,000 by the end of 1999; popped and went through 5,417.60 in a DOWNwards direction on 29 August 2001; hit bottom (3,287) on 12 March 2003; rose back UP through 5,358.60 on 2 November 2005 - and here we are again.

Except we haven't factored-in inflation, so each later revisiting of the 5,400 level represents a further loss in real terms.

Meanwhile, let's take a look at what we might do to preserve what little wealth we have.

Residential property: costs about double its long term trend (3x income). But Mrs S isn't keen on a caravan, not even, as I suggested, "if we get a nice horse".

Stocks: the S&P's long-term trend p/e ratio is a little under 15, so to get back to that it should fall by 25 - 30%. Looks like we're partway there. Emerging markets have boomed, but as that sage Christopher Fildes said many years ago, the definition of an emerging market is that is is a market from which it may be difficult to emerge.

Bonds: a painful subject, with CDOs and the like. Hard to tell quality from rubbish at the moment, and if the credit contraction forces interest rates up, the capital value of bonds will have to fall to match the yield available on other kinds of loaned money.

Commodities: some markets such as gold are small enough to be manipulated by speculators (and sales from stock) - and much of the investment in them may be leveraged, which brings in extra uncertainty because the credit crunch could force sales to cover cash calls. Others, such as oil, may be affected by reduced demand in a recession. So commodities are not a no-brainer for the amateur investor. How many will know when they've reached the top of the price spike? Agriculture might be interesting, though, as I reported a while ago and as Jimmy Rogers says now, according to Contrarian Investor.

No wonder Marc Faber said last year that he saw bubbles everywhere. He has since gotten into gold, among other things, but he is a very smart, quick-moving trader. If I had any serious money, I'd rather use him (and others like him) than try to compete with him.

What else?

Some governments offer their own instruments for matching inflation - Index Linked Savings Certificates in the UK, TIPS in the USA, for example.

I suppose that if you expect food and fuel to rise in price, you might stock up - though a John Denver-type petrol store is probably unwise, if not illegal. And even tinned food, rice and dried pasta will only stay in good condition for so long.

And not everything is likely to go up. We look as though we're in for an odd combination of inflation and deflation. Houses, stocks, maybe bonds, maybe some commodities, may present buying opportunities sometime. And how about those consumer durables - the cars, computers etc you may want to renew or upgrade sometime? So cash really doesn't seem that bad to me, so long as you make sure you're maximising your rights under local depositor protection laws.

And then there's the bigger picture. Douglas Adams, author of The Hitchhiker's Guide To The Galaxy, observed of unhappiness: "Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which is odd because on the whole it wasn't the small green pieces of paper which were unhappy." My point is not that money is unimportant, but that it won't be enough to see ourselves all right - we still have to live with our neighbours. It's important to get the economy straightened-out, because when others are unhappy and insecure, we shan't be safe, either. Perhaps there's a selfish element in altruism.

It's pretty clear how things are now, and there's no need to keep the sirens going when you can see the fire. All I hope is that concerted, imaginative action will minimise the damage. A wilder hope is that we might reform the system - especially our rotten currencies and remote, self-centred politicians. I've learned much from joining in the debate, but don't think I have much more to contribute at this stage, so I think I'll be better off giving my ego a rest and reading you, instead.

My final guess, for now: it'll be time to get back into the swim in the Spring of 2010.

Wise after the event

I'm stung into a rant by an article I've just read. A classic example of mainstream journalist wisdom here - and only one of very many similar now available, I'm sure.

I'm don't know what the economics editor of one of the UK's most successful papers earns, but I'd be happy for him to earn double if he could tell us all this "it was so obvious" stuff BEFORE the crisis.

Not that it couldn't have been foreseen. In the late 90s, I was so concerned at US debts and the massive zoom in tech stocks driving the FTSE and Dow into the stratosphere, and so apprehensive of what I thought would be the inevitable aftermath, that I warned clients not to get into the frenzy, reminded them they had an option to switch into cash, moved my wife's pension savings into cash, and (despite the awfulness of modern British schools) resumed teaching as well as holding onto the financial advice business.

Am I wise? No, I listened to what many others were saying, and wasn't blinded by greed. But I wouldn't have learned it from the papers.

And the smugness! "Above all, the current crisis will force us to relearn one of the oldest lessons of all, one from neither the Seventies nor the Thirties but the wisdom of the centuries: that what you owe, you must one day repay." The credit bubble was created by banks, permitted by regulators and governments, and exploited by financial engineers and intermediaries - yet it is the private debtor and the taxpayer that will pay. Don't hold your breath waiting to see unemployed bankers selling the Big Issue.

Back to 2003

Karl Denninger thinks we're on course to lose all the gains of the last 5 years:

I am updating expectations for this Bear Market; I no longer believe 1070 on the SPX will hold, and have now moved to the camp that sees the potential for the S&P to retrace all of the 2003-2007 Bull Market's gains, taking us back to around 800 on the SPX.

In the UK, the FTSE closed at 3,287.00 on 12 March 2003.

Forgive us our debts, Part 2

A very stimulating response from "Caronte" to the earlier post on debt reduction, so I've taken the liberty to bring the argument out front here.

Caronte, you say:

Suppose it is believed with absolute certainty that every 50 years, say every year divisible by 50, all debts are forgiven. There would follow a bunching of loan demand as the forgiveness date nears, while willing lenders would simultaneously vanish. The market would no longer match credit demand and supply, total welfare would suffer. Debt forgiveness would only avoid this problem if it was done by stealth, unpredictably, once and for all and never again. Like forgiveness of tax evasion or illegal buildings. Difficult to persuade debtors, (or builders, or taxpayers), that forgiveness would not occur again. Lots of people would be encouraged to borrow beyond what they can afford (or evade tax) – the moral hazard implication. Unsustainable indebtedness would multiply rather than disappear. Moreover, a defaulting borrower does not need forgiveness if she genuinely cannot pay: can’t pay, won’t pay, period. If the defaulting borrower has some residual wealth, though less than the outstanding loan, who is to deprive the creditor of that? What legal or moral right would support state action without creditor compensation?

Would “debt cancellation (or rather, reduction) … be a suitable punishment for the principal offender”? True: “the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.” No more than the relationship between employer and worker. There are various way to reduce this inequality, workers can form Trades Unions and cooperatives, and borrowers can found building societies – until New Labour wickedly de-mutualised i.e. privatised this form of social property which was not theirs to privatise. But the main reduction of the inequality comes from competition among lenders (and among employers).

“By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply”. True, there is a credit multiplier at work when banks re-lend their deposits and get some new deposits as a result. If they were prevented from re-lending – by law or by contract – they would act solely as custodians (as in the early days of gold-money) and would charge depositors for the service instead of paying interest. And any act of individual saving would instantly reduce total demand by the same amount and cause unemployment. Besides, the ratio of deposits to loans is regulated by law and is variable at will only when it is higher than a prudential limit. And banks face the consequences of their bad loans, they can go bankrupt and their shareholders can lose all their capital. That’s punishment enough. As long as they are competitive, there is not much of a reason to “punish” them by forcing them to remit those bad loans that still have a residual market value.

“Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden?” Absolutely right. “Pay off the depositors” – if the bank can, or if there is a state guarantee. But why “shrink the lending book” by debt remission? If mistakes are always to be automatically corrected ex-post when they are revealed as such, the market disappears and with it all the conceivable advantages that it brings.

An Australian economist whose name now escapes me once wrote an article mocking the theory of general economic equilibrium – with its complete system of futures markets – by imagining a system of “past” markets in which economic agents could undo their past transactions that with the benefit of hindsight turned out to be a mistake. Just imagine. Debt remission would have some of the same effects.

I say:

Caronte, welcome, and many thanks for the length and thoughtfulness of your response. I don't pretend to have your economic expertise, but I still think there's a debate to be had. I'll try to tackle some of your points, not necessarily in strict order.

I suppose that in ancient Israel, the economy was not so monetised as today, so the advent of the year of Jubilee may not have been so disruptive as it would today. I don't really advocate a periodic debt cancellation - though I'm beginning to wonder about the necessity of charging interest. (Isn't it the case that some Swiss banks do in fact charge you for looking after your money securely, instead of making investments with it or lending it out to others?)

Competition between lenders may help keep down interest rates, but it's the ballooning of asset prices - and the consequent increase in the size of mortgage required - that causes the damage. So many are now locked into monster mortgages that a significant rise in interest rates - which otherwise might be appropriate for tackling inflation - is politically very unfeasible.

I argue that the price of houses is pretty much beyond the buyer's control, except that there's a point where a purchase is either not affordable (we seem to have reached that stage) or, as with subprime, fudged at the outset with disastrous consequences later. So I suggest the expansion of credit (for which, as you say, regulators also share responsibility), and the terms set by fee-hungry lenders and intermediaries, are more to blame than the family that wants a roof over its head it can call its own. Finance for cars and consumer goods is something else; a house is a necessity, and surely, owning one is not an unreasonable aspiration.

Banks should be, but are not being made to face the consequences - look how governments are propping-up Northern Rock and Bear Stearns.

Debt reduction does not seem unreasonable to me. If a life insurance company fails, the book of life business can be passed on to another provider, who is only required to underwrite 90% of the outstanding life cover. So why not for lenders who (through greed and stupidity) have gotten their sums wrong? A 10% reduction in the capital only represents a couple of years' interest. Better a borrower who repays a reasonable proportion of the loan, plus interest, than simply mail back the keys and leave the bank with illiquid stock it doesn't know how to manage.

This is not a problem limited to a single bank -and anyway, there are far fewer these days, and they are much larger, so one failure could really rock the boat. At worst, we could now be facing the prospect of mass bankruptcy, the crash of the credit system and general economic carnage. It's worth coming up with some fudge to keep borrowers and lenders going.

Here in the UK, you can enter an agreement with creditors and as long as you keep up the scheduled payments, interest charging stops altogether. Maybe that would be another way forward - the monthly repayment would be lower and the borrower would see his equity in the house increase over time.

We've been watching enslavement by money-owners who have been licensed to print almost unlimited amounts of their own money, but the poor man only feels it going past and can save none, so remains in debt-bondage. Better any reasonable rearrangement, than "I owe my soul to the company store".

Market timing

A very useful piece by John Mauldin considers long-term returns. He quotes findings by Ed Easterling at Crestmont Research, about what would have happened had you retired and invested $1 million to take $50,000 a year, rising annually with inflation. He looks at 78 different 30-year periods since 1900 and works out whether your money would last as long as you:



The forecast price-earnings ratios of the S&P 500 for 2008 range from 18.69 to 22.20. This does not bode well for long-term retirement investments made now. If the p/e ratio from the current c. 20 to 16, this would imply a share price decline of 20%, and even then you'd outlive your income in 30% of cases. A p/e of 12 requires shares to drop now by 40%, and that still means a one-in-five chance of running out of cash.

It looks as though, rather than fear a major crash, we should hope for one - as long as we're in cash or something else that's relatively safe and liquid.

Forgive us our debts

In one version of the Lord's Prayer, the word "debts" replaces "trespasses", and this is in keeping with the etymology of "redemption". The ancient Jewish law forbade perpetual debt-slavery for fellow-believers, and even provided for ceremonial debt forgiveness every 50 years (which, I imagine, had a feedback effect on the terms and length of loan agreements).

"Hatfield Girl" gives a very vivid picture of our slow slide into dingy, shabby poverty, and it has to be every sane person's earnest wish that we (or our fellow citizens) don't return to the conditions so many suffered before the Second World War. Yet what is causing all this but the heavy chains of debt?

A disclaimer: I often feel that I not only know nothing, but never shall know anything, despite much effort. Then I see how the world is going, and wonder who knows better.

Having said that, I'm trying to work out why, as Karl Denninger says, we don't make the banks eat some of the debt they laid on us. In the comments to the Hatfield Girl piece linked above, "Caronte" refers to "moral hazard", a point I entirely accept. But I say that debt cancellation (or rather, reduction) would be a suitable punishment for the principal offender.

In our society, the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.

So what determines the price of houses? Supply and demand. And a major element of demand is how much money is available. By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply, as everyone knows (I say everyone, but actually I don't think the public is fully aware of the simplicity and enormity of this scam). Since 2000 or so, the money in the economy doubled, and so, un-oddly I think, did the price of houses.

The lender can decide how much to lend into the market generally, and consequently influence it; the buyer cannot decide, on an individual basis, to halve the value of the type of house he wants in the area where he needs to live.

So by what right should lenders inflate asset prices, fix on them loans of money they created virtually ex nihilo, then deflate asset prices by reducing lending in difficult times, and expect the borrower to bear the full weight of the consequences?

The borrower may have colluded with the lender to take on an unsustainable debt (or one that exposed the borrower to excessive deflation risk), but for reasons already given I suggest it was a shotgun marriage (or a mass marriage, like those Moonie wedding rallies) with the lender handling the Purdey. For subprime borrowers, I think it's fair to argue that the class of people involved means that the lenders had far better knowledge of the implications, and so are far more culpable.

Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden? Pay off the depositors, but shrink the lending book - which is mostly funny money, less substantial in its origins than candy floss - a drop of ink on 80-gram paper.

To quote the inscription on the statue of Justice above the Central Criminal Court, "Defend the children of the poor and punish the wrongdoer." The trespasses of the mighty are less to be forgiven.

The silent watchdog

Yet another important post from that heroic toiler (an oxymoron for classical Greeks), "Tyler". He looks at the economic implications of our ageing population and demonstrates that public expenditure cannot continue as projected.

The long-serving Comptroller Generals, both in the USA and here the UK, have recently retired. The difference between them is that the American, David Walker, has spent two years on an increasingly well-publicised Cassandra mission to warn the public of future dire financial dislocation, because of unfunded liabilities such as medical care and pensions. I may be doing a disservice to Sir John Bourn, but I can't remember any media fuss about him going on such a tour here.

Looking at the website for the National Audit Office, I see that in the FAQs, the spelling of "comptroller" comes second, after a dry summary of the NAO's role. However, the "find" option on my Windows toolbar can find no occurrence of the following words in that web page:

disaster
bankruptcy
poverty
IMF
inflation

Some barking from its kennel would now be most welcome.