The Investment Risks are Building

For all the panic in September and early October, it turns out that stocks didn’t crash.

The Aussie S&P/ASX 200 index fell 7.8% from early September through to 13 October. The definition of a market ‘correction’ is when stocks fall by 10%.

If they had fallen 20%, that’s a full blown crash.

But that didn’t happen. Since 13 October, the Aussie index is up 4.9%. All the talk in the mainstream of an impending crash just goes to prove how bad the mainstream is at predicting major events.

Don’t get me wrong, the market will crash at some point. But the mainstream does the average investor a disservice by claiming that every small thing will be the event that causes the big crash.

When the crash happens it won’t be because of Ebola, a tiny failing Portuguese bank, or even Scottish independence elections. (Remember that? As recently as last month some analysts thought a Scots ‘yes’ vote could send stocks crashing.)

The event that will send stocks crashing will be the same as it always is — it will be a crisis of confidence in money.

Exactly when that will happen is anyone’s guess. James Grant, the publisher of Grant’s Interest Rate Observer believes it may not be for some time.

Grant agrees with my view that even the whiff of a potential stock market fall will see the US Federal Reserve launch another money printing program.

If that happens, and if the market believes that money printing will always be around, there’s no telling how high stock prices could go…in the short term.

Fortunately, if you’re looking for real analysis on when the actual crash will happen — and what will cause it — our old buddy Greg Canavan is putting together a report now.

But don’t expect to see it anytime soon. His type of in-depth analysis isn’t the kind of thing you can bash out in an hour or two to fit in with the 24-hour news cycle.
Stay tuned for more.

Meanwhile, don’t worry as much about a crash as the chance of another boom. If you think Wall Street has learned anything from the last boom and bust, I’m afraid you’re mistaken.

It’s all happening again

As the Financial Times reports:

‘“Bankruptcy? Repossession? Charge-offs? Buy the car YOU deserve,” says the banner at the top of the Washington Auto Credit website. A stock photo of a woman with a beaming smile is overlaid with the promise of “100% guaranteed credit approval”.

‘On Wall Street they are smiling too, salivating over the prospect of borrowers taking Washington Auto Credit up on its enticing offer of auto financing. Every car loan advanced to a high-risk, subprime borrower can be bundled into bonds that are then sold on to yield-hungry investors.’

Now, don’t fall into the trap of thinking this is something new. Wall Street has packaged up these loans for years.

So just because these ads appear today and are growing fast doesn’t mean an asset price bubble is about to burst.

The mistake that most people make about the 2008 crash is to think that the problems started with the Lehmann Brothers collapse. In reality, the problems started long before that.
American banks began bundling mortgages into securities in the mid-1980s.

And you could argue that the problems started earlier than that — all the way back to when US president Richard M Nixon closed the window on the gold standard back in 1971.

If you want to go further back, how about making the starting point the creation of the US Federal Reserve in 1914?

The point is that genuine crises take time to form, fester, and then explode on a largely unsuspecting public.

You can see how the US subprime auto loan securitisation has played out over the past 10 years:

Since the market crash in 2008, the market has grown again steadily. But it’s still only a relatively small market. Last year car loan securitisation amounted to around US$22 billion.
This year Wall Street is on track to beat that number.

It tells you that for all the talk of investors being risk averse, investors still love taking risks. It’s not surprising…they have to.

Buying junk

A good place to look for investor attitudes to risk is the junk bond market. ‘Junk’ bonds typically refer to a bond with a Standard & Poor’s rating of BB or lower.

They get this rating because, according to the ratings agencies, there is a higher probability that the bond issuer will default on interest payments or the principal.

But that doesn’t always happen. In some cases a company has just gone through a tough time. That can cause investors to sell the bonds simply because of the potential for default.

It’s the same as a stock investor selling a stock because they think it could fall further.

But while junk bonds may be risky, there’s no doubt they are super popular with investors. As this chart from the FT proves:

US junk bond issuance last year topped US$350 billion. This year it’s already nudging US$300 billion. With more than two months of the year to run it seems likely that junk bond issues will pass those of last year.
You can see more evidence of the popularity of junk bonds. The following is a chart of the SPDR Barclays Capital High Yield Bond ETF [NYSEARCA:JNK]. It shows that the ETF is trading near a six-year high:

Source: Google Finance
Why would anyone buy such a risky asset? Check out all those Ds along the bottom of the chart. Those are dividend payments. This particular junk bond ETF pays a yield of 5.83%.
That may not seem like a huge yield for an Aussie investor, but for a US investor who can normally expect to get an average yield of 2% from stocks, a yield almost three times higher is hard to ignore.

This is the consequence of low interest rates. When the Fed keeps interest rates at an all-time low, even relatively conservative investors have to find yield wherever they can.

If that means taking a bigger risk and buying junk bonds for a 5.83% yield, that’s what they’ll do. That’s fine as far as I’m concerned. But they should remember to check out the left hand side of the chart. The junk bond ETF fell from nearly US$50 in late 2007 to below US$30 one year later.

Speaking of risk, it’s all happening in Brazil…

Don’t make them angry

One of the big takeaways from the Grant’s Interest Rate Observer conference in New York last week was the investment opportunities in emerging markets.

One of the speakers, Cullen Thompson, said that he favoured Argentina. He figures that now is a great time to speculate on the country leading up to presidential elections next year.
With president Cristina Kirchner on the way out, the door is open for a more market friendly successor. Whether that will happen, and whether it will be good for Argentinian stocks, is another question.

But I like the trade.

Brazil was one emerging market not on any of the speakers’ buy lists. Things haven’t looked so good in recent months is Brazil. The iShares MSCI Brazil Index [NYSEARCA:EWZ] is down 27.2% since the start of September.

That, my friends, is a ‘crash’.

Things didn’t get better yesterday when Brazil’s president, Dilma Rousseff, won reelection.

Rousseff appeared to win power on a platform that promises to maintain high inflation! As any western central banker will tell you, inflation is good for the economy.

Rousseff said that if the opposition gained power they would raise interest rates in order to stamp out inflation. That would lead to lost jobs.

Like Australia, Brazil has relied heavily on resources for its economic growth. It took the proceeds of the China-led resource boom and chose to redistribute the wealth with welfare payments.

The trouble is, this hasn’t done much to diversify the economy away from resources. It now means Brazil’s government is trying to find a way to grow the economy while maintaining high welfare costs.

Estimates are that the government’s welfare program has lifted 40 million people out of poverty. It’s a fair bet that they won’t want to return to poverty.

Any unrest could create new problems for Brazil if its economy can’t grow of its own accord.

There’s always an investment opportunity somewhere

Due to lower commodity prices, Brazil’s stock market and currency have fallen. The Brazilian real is down 38% since 2011. That compares to a 24% drop for the Aussie dollar.

But just because commodity prices have gone down the toilet, it doesn’t mean there aren’t opportunities in the resources sector.

There are always ways to play the resources sector. That’s because even in a bad market, if an explorer strikes a new resource, the stock price will take off.

And regardless of the market conditions, there are two commodities in particular that investors should rightly associate with getting rich — oil and gold.]

One of those is the main feature in this report from resources analyst Jason Stevenson.

Kris Sayce+

for Markets and Money

This article originally appeared in the Port Phillip Insider.

Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Markets and Money e-newsletter in 2005. He is the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service, Markets & Money.

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