Monthly Archives: August 2008

Living under a rock

I would like to start by saying that this is in no means a research piece on the markets, but a commentary that will hopefully shed light on the current frenzied global situation.

Deciding to spend more time with my family this weekend is the main reason I was inspired to write this piece. In fact, it was my father’s birthday and I got to spend a few hours discussing various topics, among which was the ‘Dead Cat Bouncing Theory’ – a theory he introduced me to. So before I begin, I just wanted to say ‘Thanks Dad’.

Trying to make sense of current capital markets is like trying to understand someone speak during a rave: the music is deafening and you are being shoved around to the point at which you feel that you are in a pinball machine. There is so much ‘noise’ that you lose track of the conversation’s crux and end up feeling very confused. Therefore, it is important that you remove yourself from the situation and quietly assess the events taking place. As I mentioned before, I am not here to predict the outcome of the global marketplace; I simply want to block out some of the noise and share my two sense.

For those of you who have not been following the financial news and have been living under a rock, the global markets have experienced a downturn over the past few months with an estimated $7.9 trillion of wealth just vanishing into thin air[1]. To put this into perspective, imagine the site of destroying 26 Airbus A380’s! The US Federal Reserve Bank Chairman, Mr. Ben Bernake, is taking drastic measures to try and quell the markets by slashing interest rates and rescuing financial institutions, and in the process coining the term the Bernanke Helicopter. The reason why so much attention is being given to the US market is simply because it represents roughly a quarter of the world’s GDP output equating to the largest share amongst all the other countries. The phobia has always been related to the notion that if the American economy sneezes then the rest of the world will catch a cold. Now although I believe in that statement, I am not sure it is completely true.

Today’s financial and economic markets are facing paradigm changes in the underlying fundamentals they were based on for the past half a century. China, currently the world’s third largest contributor to the global GPD, is estimated to overtake the United States’ 23% contribution to global GDP by the year 2020. In addition, the Middle East economies, benefiting from an insane $100 per barrel oil price have a combined reserve account relative to that of China’s currency reserve of $1.5 trillion[2]. Both regions are facing continuous inflation, which pressures the respective Central Banks to behave in a more hawkish manner, cubing their double digit GDP growth. The contagious effect from the US sneeze will also have a lagged effect on the rest of the world’s economies but nothing that a shot of fresh lemon juice and spoon full of honey won’t fix. So although the Asian and Middle East economies are slowing down, the strength of corporate balance sheets aided by strong government surpluses and spending will lessen the extent of the overall cold and will aid in a swift recovery, relatively speaking.

In other parts of the world – in places where there are more burger joints and hot dog carts than shawarma stands and noodle bars – the situation is quite different. In an economy driven by consumption, any hiccup to the average American’s ability to spend has a material effect on the overall growth of the economy. Just try to imagine a scene in which a woman who is out on a mission to find that perfect dress finally succeeds, only to realize that her husband’s VISA card was declined. Trust me, it is not a pretty sight. To give more color to the magnitude of the situation I should remind you that the 213 million middle class (those with annual income of $18,000 – $55,000) Americans, representing approximately 70% of the population, are already witnessing their savings plans – and, more importantly, their home values – dwindle away like the strong scent of a beautiful woman in a cool summer breeze. Additionally, in a flat to negative savings rate environment where the average American is no longer able to borrow in order to quench the never ending thirst of the US economy, the canvas is starting to look more like Edvard Munch’s The Scream rather than an exquisite Monet. I am not implying in any way that the sky is falling but simply want to prepare myself for the strong gales ahead.

From an economic standpoint, the current situation is being compared to the Great Depression in the 1930s, a tragic event that left the US economy crippled for many years. The reason for the resemblance is highlighted in the anticipated similarities to the extent of the damage. Although the current situation has also been compared to the late 1980’s market crash and Dot-com bubble crash in the earlier part of the 21st century, I do not agree that they are comparable.

During the mid 1980s, the scene on Wall Street was filled with high powered investment bankers driving around in exotic sports cars, buying up anything that tickled their fancy. The introduction of junk bonds enabled corporate to issue large amounts of debt at high interest rates which gave birth to the leveraged buyouts, merger and acquisition mania, and an era of hostile takeovers. I highly recommend watching Barbarians at the Gate and Wall Street to get a sense of what was going on during that time. On October 19, 1929 a day later know as Black Monday, the Dow Jones Industrial Average Index (DJIA) tumbled 22.6% translating into $500 billion of value evaporating like a puddle of water on a hot summer’s day in Kuwait. The Fed intervened and scrambled frantically to stabilize the situation and the market retraced back to post new historical highs.

As for the bursting of the Dot-com bubble, this is another example of an industry specific situation in which the actions of the Fed had managed to mitigate and contain the spillover effects that would affect the rest of the economy.

I will follow up with an article explaining how the Dead Cat Bouncing Theory conveys the resemblance between the current crisis and part of the Depression.

[1] World Federation of Exchanges. July 2008

[2] IMF