For Every Boom There is a Bust

— There are two ways you can look at a financial crisis. You can despair at the wealth destruction, uncertainty, fear and changes it brings about; or rejoice in the fact it will (slowly but surely) upset the existing power structure and force accountability on those previously held unaccountable.

— Here at the Markets and Money, we are cheerful types, always looking on the bright side. If there’s a positive to glean from any situation, we’ll find it.

— One of the positives we see unfolding over the next few years – as this debacle of a global economy stumbles from one crisis to the next, until the whole thing blows up – is the analyst community being held to greater account for their opinions and recommendations.

— You might think that is wishful thinking. But the whole model of investment banks employing overpaid analysts to guess earnings and set price targets that are different to optimistic and flawed valuation models is a product of a bull market.

— This bull market kicked off in the early 1980s and ended in 2007. That’s around 25 years, long enough to infiltrate a whole generation with a bull market mentality. And because the bull market is so good to the finance industry’s hip pocket, old habits certainly die hard.

— But the reality is we have been in a bear market since 2007 and will be in one for many more years to come. I remember reading somewhere – no source, sorry – that bear markets tend to be about half as long as the bull market that preceded it. So on that basis, you’ll be looking at around 12 years of going nowhere in aggregate. Excellent.

— Don’t expect to hear this from the mainstream investment community though. Telling it how it is in tough times is not good for business. Unless they’re in front of a courtroom for whatever reason and their PR person tells them to play the honesty and contrition card…

— No, the overwhelming tendency is to buy buy buy because that is how they make their bonuses and generate short-term profits for shareholders. The customer is of secondary concern. Investment banks make their money from selling you things.

— But in a bear market there is less to sell. The market shrinks. In the years to come, this will result in thousands of lay-offs in the finance world. The overpaid and mediocre will realise they only had a job because there was excess money to shuffle around and advise on.

— This process has already started in the UK and Europe where around 60,000 redundancies from the major banks have been announced in recent weeks. And it probably won’t take long for such cost cutting to hit Australia.

— If you understand how the system of selling works you won’t become a victim. But it’s not always so easy. Sometimes you want to believe.

— Take China for example. More than anything, Australia (collectively) wants to believe that China will continue with its industrialisation process and underwrite our standard of living for years to come.

— But China just experienced an epic credit boom. Can economic growth be sustained after such a positive shock? Bloomberg reports:

‘Chinese banks expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan ($2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. About a third of local government financing vehicles, used to get around laws prohibiting direct borrowing, don’t have cash flow to service their debt, according to China’s banking regulator.’

— One of New York’s top emerging market money managers thinks China’s banking sector is toxic. According to the Bloomberg story:

‘Bad loans at Chinese banks will rise to “shockingly high” levels, eroding profits and slowing growth in the world’s second-biggest economy, said Vontobel Asset Management Inc.’s Rajiv Jain, who runs some of this year’s best-performing mutual funds.

“We have not owned a Chinese bank, and I don’t see owning one any time soon,” said Jain, who oversees about $15 billion, including three funds that beat 99 percent of peers this year, data compiled by Bloomberg show. “If you look at the accounting, I don’t see how anyone could put a penny there.”’

— And here’s the kicker:

‘The New York-based money manager’s outlook is at odds with equity analysts, who predict gains of about 40 percent in Chinese bank shares during the next 12 months, according to the average of more than 900 estimates compiled by Bloomberg…’

— Now, whose advice would you rather take? A money manager intent on preserving and growing his clients’ wealth, or an analyst intent on making bonuses by keeping the buy rec’s and high price targets coming? It doesn’t require an answer.

— The problem for China – and Australia – is that it’s credit system is severely strained from too much growth. Whenever money is available at zero cost the end result is always bad debt – lots of it. These bad debts may lay dormant for another year or so…no one really knows. But the harsh reality is an economic system will always flush them out. Some sector of the economy will pay. The piper is waiting…patiently.

— Dan Denning made the point in his recent issue of Australian Wealth Gameplan:

‘But here is the unavoidable truth: China’s growth machine is built on a mountain of debt. And while that debt financed different economic activity than similar debt in America (houses) and Europe (houses, government spending), it’s just as large a misallocation of capital. It is a bubble of epic proportions. And it must burst.’

— If your standard of living and bonus structure is tied to the ongoing China boom you will probably argue that point. China is different; it has central planners that can ‘tweak’ the economy; there is such a thing as a free lunch; China’s trains are the best in the world…

— But the vast coordination of human interaction that we call economics doesn’t work like that. There is a yin for every yang. And for every boom there is a bust.

— We just don’t know when it will be.


Grag Canavan
Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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