The Higher the Market, the Harder the Fall

Legendary investor Jeremy Grantham, of Boston based fund manager GMO, recently said:

The investment business has taught me – increasingly as the years have passed – that people, especially investors (and, I believe, Americans) prefer good news and wishful thinking to bad news; and that there are always vested interests to offer facile, optimistic alternatives to the bad news. The good news is obviously an easier sell.

After 26 years in the financial planning industry, Grantham’s observation resonates loud and clear with me.

We repeatedly hear that ‘every cloud has a silver lining’ — so this saying is the perfect platform for industry marketing efforts to promote the positive in every situation.

Markets rise to record levels — they’re set to go even higher.

Markets fall to records lows — they’re cheap and destined to turn and go higher.

The industry view is ‘there’s never a bad time to invest in markets’.

Even a cursory study of market charts shows this isn’t true. The Australian share market is still some 25% below its late 2007 high. So selling or not buying at that stage would have been an excellent call.

The reality is there are some times when there just isn’t any good news out there. Sometimes you have to be patient and wait for the reward to outweigh the risk.

This view is a curse to both the investment industry and anxious investors searching for a pre-determined rate of return on their capital.

In my opinion the world we find ourselves in today is vastly different to the one that shaped the investment community’s generally optimistic views on markets.

For the best part of three decades (1980 to 2007) the greatest credit bubble in history powered the global economy, and by extension investment (share and property) markets. We developed an addiction to continuous growth.

From 1982 to 2007, the Australian share market grew by a staggering 1,500% (460 points to 6850 points). In the 130-year history of the Australian share market, there has never been (and most likely never will be) a 25-year period of performance that comes close to this one.

Surely it’s no coincidence this occurred at the same time as the greatest credit expansion.

What is less well known is that from 1968 to 1982 the Australian share market managed to eke out a paltry 10% gain over the entire 14-year period (420 points to 460 points). That’s less than 1% per annum growth.

But the great credit expansion came to an abrupt end with the subprime implosion. Subprime lending was the bottom of the credit pyramid. Like all Ponzi schemes, the pyramid collapsed when they could no longer expand the base.

The great credit contraction began in 2008 and five years later all corners of the globe are feeling the effects of this ‘cooling’ process.

Central bankers and politicians (the world over) are desperately trying to re-ignite the rampant consumerism that was so prevalent in those heady pre-GFC days.

Initially, policymakers responded with relatively modest and measured ‘strategies’. The fleeting success of these ‘strategies’ has gradually led to the situation we have today — unlimited and indefinite money printing combined with zero bound interest rates — any pretense of caution has been thrown to the wind.

The US share market has been the major beneficiary of Bernanke’s firm stance to rebuff the effects of the great credit contraction.

From its lows in 2009, the US share market has recovered to record highs. The investment industry trumpets this as proof the worst is over.

If the global economy was genuinely recovering why are the money printing efforts intensifying?

Why are central banks keeping interest rates so low with no prospect of an increase even remotely visible on the horizon?

Why has the commodities index fallen 20% over the past two years?

Why has the Baltic Dry (shipping) Index fallen 75% over the past two years?

Why is there a currency war?

The latest Daily Sentiment Index of traders (published by registered an overwhelming 90% of bulls on the S&P. Only 10% of traders aren’t convinced of Bernanke’s Ponzi scheme. When pretty much everyone is on one side of the boat, the boat tips.

Remembering Stein’s Law

In the rush to participate in Ben’s party, it appears investors have forgotten or ignored Stein’s Law: ‘if something cannot go on forever, it will stop’.

Excessive money printing and artificially inflated markets won’t cure the ills created by the great credit contraction. Debt needs to expunged from the system. This will be a long and painful process — the exact opposite of the euphoria created by credit expansion.

Eventually economic reality and markets will collide — unfortunately the higher the market, the harder the fall.

The ‘silver lining’ in this dour outlook is that patient investors will be rewarded handsomely.

It’s ironic the massive damage to be inflicted by Bernanke’s Ponzi scheme will see him rewarded with a lifetime pension, whereas Madoff was punished with a lifetime in prison.


Vern Gowdie
for The Daily Reckoning Australia


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[Ed Note: Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top 5 financial planning firms in Australia. Vern has been writing his ‘Big Picture’ column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. In his leisure time Vern remains active with triathlons and pilates.]

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