The Crash Of 2008

October 10, 2008


Government interference is intensifying the problems markets face and the likely length of the recession. If Paulson, Brown and others stopped throwing good money after bad and committing taxpayers to enormous new liabilities, markets would hit bottom sooner and stabilise. We have had endless "new" rescue programmes since the credit crunch started last year—none of which have worked—and all of which have involved replacing old debt with new and covering over institutions' and people's inability to pay rather than facing it. Defaults are inevitable, healthy and long overdue. Let failing firms—including banks—fail, let deposit insurance schemes work as they were intended to do and a new landscape will emerge. I am not optimistic that this will occur, but at the same time, I sense a strengthening public support for such an outcome.

The focus remains on debt. The credit bubble has resulted in chronic overborrowing, on a scale never seen in modern history (in the Anglo-Saxon economies at least—for evidence, see here). The credit markets have led equities all the way for the last year, hinting at trouble ahead and giving advance warning of all the major collapses (from Bear Stearns to Lehman, Fannie Mae, MBIA, Ambac, AIG, to name just a few). For all its faults (opaqueness and lack of a safe exchange to trade on), the credit derivatives market has largely worked. Pay attention to government debt markets as the next potential flashpoint. Can the world's governments really service their massive debt piles in an environment of recession, huge social expenditure demands and plunging tax revenues?

Yet at the same time, there are many companies in a strong competitive position, without balance sheet problems. They are the likely winners in future markets. I wrote recently about Shari'ah funds, which screen out overleveraged companies, and which have performed relatively well over the last year. This and similar equity screens can reveal plenty of attractively priced investments.

Counterparty risk remains acute. With further bank collapses highly likely, investors should stick to funds where they know what they will receive in the case of a bankruptcy. This means—unfortunately—lots of digging around in prospectuses and examining managers' policies on counterparty exposure. We will be writing more on this at shortly. The outlook is bleak, maybe terminal, for ETNs and large parts of the structured product industry, which has been such a money-spinner for banks over the last decade.

There are still plenty of areas of the ETF market where investors have been able to protect their assets over the last year. The physically backed gold ETCs continue to shine, inverse ETFs have done their job and there have been other standouts like inverse credit funds, money market funds and government bond funds. ETF investing is, as always, an asset allocation puzzle, and investors have at least had all the tools they needed available (despite the regulators' attempts to prevent short-selling).

Other, newer areas covered by ETFs have fared less well. The large number of emerging market equity ETFs launched late last year and early this year now looks, with hindsight, very much a top-of-the-market phenomenon. ETF issuers are not immune to the same trend-chasing as has always characterised the mutual fund industry. In issuers' defence, they can argue that they are only meeting client demand when launching new funds. But retail investors should always be sceptical of any new theme of the day.

And if banks' own risk models have proved suicidal, there is no reason for us as individual investors to follow them over the cliff. Diversification remains the key, and an excellent article from 2005 reminds us that we need to be more diversified than we think.

Finally, as always, someone's crisis is another person's opportunity, the sun came up again this morning in London and money is not the most important thing in life! Until next week ...



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