Posted by: Dr Pano Kroko | October 22, 2012

Capital Markets Memory from Black Monday 87 to day – What goes up must come down – Gong Xi Fa Ca

In China the great depression of 1929 is called simply “The Loss.”

More specifically “The Loss of ’29.”

And with good reason because much like Life – Loss – gets repeated every so often.

In a fecund manner, Markets imitate Life. After all it’s the Tango of Life – a few steps in each direction, always moving forward – eventually.

Yet the losses scare people and scar the memory synapses indelibly.

Still worth remembering; losses never follow losses. For more recent examples we have the loss of “87 or the loss of 2007 etc. A “Loss” therefore is just as much a realistic descriptor as it is a prerogative and an artifice of the Geography of Markets. And it’s Mandarin rendering of “The Loss” makes for a much more reasonable naming system of commemorating checks and balances in the Capital Markets. And it doesn’t confuse anyone, because it carries no racial overtones, or socially bewitching dark & sinister shadowy undertones and obscure meanings of black death, either. “The Loss” simply states the facts in a rational manner. We have gains and we have losses. We make money and we lose money. That’s the nature of the game. And its a game that involves all of us, as the Capital Markets always do…

And the Chinese are famously involved in game playing. They love simple games but their Masters love games of complexity too. Have you ever tried your hand at Go? Chess is simple and benign by comparison. Complexity is an Art at the game of Go. And Go is complex at it’s best in that it has an infinite number of moves, variances and therefore potential outcomes. Add to it the personality traits and level of skill of the players and you get something resembling the Capital Markets in complexity. Something like 10 in the power of 190 for the game of Go has been calculated to be the vast number of moves. And this is even more complexity than chess can carry in it’s infinite variety of moves. To understand how vast this number of moves in complexity is, consider that 10 on the power of 190 is more nanoseconds than existed since the time of the Big Bang. There are no computers today or in the foreseeable future strong or complex enough to be able to examine this many potential moves. And this is the level of complexity with just two players and board of Go. That in my mind mirrors the Capital Markets with it’s many “rational” agents acting in synch. And with each one of us trading we are doubling the level of potential moves, thus adding that much level of complexity again and again with each additional player in the Markets out there. Go ahead, do the math … and enjoy, because it will reveal some perpetual novelty. A complex adaptive system is all what Markets are… and the operating word here is still — complex. A mathematical approximation of 10 in the power of 190 and multiplied by the number of players – rational sophisticated agents that each day are trade as part of it, along with the machine intelligent agents – software trading – and the economic agents at large that make up society’s functional entities. Now you do the math…

Is that complex enough for you?

Rational expectations be damned, only the concept of increasing returns and emergence can explain some of this big phenomena. And giant losses are a big phenomenon worthy of investigation and thoughtful awareness in order to be able to broadly perceive the next ones… if not to outright forecast. Because these “Losses” are such  global reality and they spread so much faster than our economies are geared to defend against them — that we can’t built breaker circuits or switches fast enough, to slow them down or stop their catastrophic path of spreading the virus. Simply put, there is no platform or system informed enough — to contain them today.

And even way back in ’29  “The Loss”  was a global phenomenon.

Imagine now with computerized trading holding in thrall the markets by controlling upwards of 90% of transactions and you can see how systemic crashes are much easier. Even though they are limited by the circuit breakers to a molecular level. Limited to a specific equity, a sector, or a single company share. Or a simple currency. Or a single sovereign. Or a bond. Limited to one equity in many instances, iterating over and over agin in the course of the trading hours, second by second. One micro victim at a time. It all adds up. It also hurts, because we are not having institutional “switches” or circuit breakers, smart enough to detect the undetectable and tiniest of crashes that happen all the time – all around us. Blink and you missed it sort of thing. Yet for real people, real companies, real economies this is serious business and puts their livelihood at stake. From global to molecular and back again complex systems are not necessarily rational. Nor is there an optimal equilibrium, unless they are dead and buried…

Still the Black Monday plunge of October 19, 1987, was unique because it replicated worldwide and lit many fires across the globe without burning the forest…

This capital markets fell by 25% the following day, and lost almost as much again (27%) before they stabilised. Of course as it always happens, it took more than seven years to shift perspective fully and recover the lost ground. The confidence of the rational irrational agents takes about this long to reboot and memory to slacken. Good to remember when you have Presidents, Prime Ministers or Chancellors, looking for quick fixes. And even though the 1987 crash’s place in history has been revised many times since the global financial crisis began in 2007 in order to fit hindsight better — one thing remains constant. It was complexity at work…

The busted banks and busted nations era or the sovereign debt crisis era as is a more politically correct way of calling the mess we are in , has announced itself as the Global Financial Crisis. This GFC, has been with us now for a few long years and all losses appear personal yet the systemic nature of the Loss proves the fallibility of the Markets, the fact that no Holy Spirit guides the “invisible hand” and that the rational agents are all a bit irrational. And GFC it is such a big loser for us all, as it comes loaded with giant repercussions and wave effects, that the overall loss is so much bigger than Black Monday 1987 ever was. And that has relegated the ’87 event, to the status of a simple ”flash crash”  unlike today’s disaster, which is a continuous crash with intensity, ferocity and longevity to whip us all so that we collectively cry Uncle and seek shelter behind Uncle Sam and his relations worldwide. Yes, the ’87 event clearly wasn’t a Flash Crash but in retrospect it wasn’t such a big deal either, only a harbinger of things to come. It was more like a flash mob, a mass market move that caused a giant market shock and yet it didn’t mean much for the global economy in the end. So today in revising history, the Black Monday, is remembered  primarily as the first example of machine mad algorithmic trading gone bad. Serious Market Scientists simply say that they had put early model computerised stop loss selling orders which kicked in on Black Monday simultaneously, thus creating sell side pressure that was overwhelming for the system — much like when everyone at Superbowl’s half-time goes to the crapper and floods the system.

Yet even though it blackened everyone’s portfolio, it served us well. Served us because the first stock market exchange “floor jumpers” AKA  price circuit-breakers, were introduced as a result and all software and hardware had to be innovated all over again. As an example, the computerized trading systems moved a quantum leap forward in their capacity to think and mirror Artificial Intelligence as well as monitor and learn from their behaviour. Game theory advances were introduced into the complexity enabled systems and black box trading without risk analysis, brought us the latest round of Lehman, Banking and Sovereign Debt style collapses, and the related Global Financial Crisis into which we are all treading water… And the irrationality of our adherence to the evidently false belief that all economic agents and market participants are rational and that Markets operate for the well being of all and that there is no dishonesty and corruption in the marketplace comes back to haunt us again and again. And this is where Black Monday served us the best, because it opened the door to see this particular opaque light shining through.

Yet that’s all history now and the progress of the game is evolving. Situations, change, data streams change and so do the icons of our economic philosophy. It all changes and so do political opinions and then economic doctrine changes along. Yet the orthodox view remains firmly rooted in it’s errant past. But I differ and say clearly that we learn and gain much more from losses – at least in advances to knowledge and innovative development  of scientific thought – than in periods of calm and stability moving prosperity along. And it is axiomatic that for wise Leadership both losses and gains need to be factored in the economic outlook of a great economy. Rich and poor alike. Big and small too. Look at the giant centralized economy that China manages and learn. Arguably the Chinese technocrats learned far more fro Black Monday and curbed markets excesses far more deftly than their western Economic leadership counterparts. And the bit about centralized Economy, doesn’t mean all controlling but simply a benevolent pressure and direction stemming “from up above” like the FED could do in it’s glory days or the Office of White House Economic Advisors and the Secretary of Treasury if allowed to “meddle” somewhat “beatifically”…

Because if China has anything to teach the world as the second largest economy scheduled to become the First in a few short years, is that their unparalleled three decades long economic growth and compound expansion of an average of ten per cent 10% per year, is a victory of the centrally planned or overviewed economy.  And I say “overview” because you can’t really claim to be able to plan an economy with such a degree of complexity as discussed earlier… Yet you can nudge the ecosystem in the right direction and the great steersmen of today are doing this happily. As Wen Jiabao is evidently doing along with the tope tier leadership. They understand physical science better than their European and American brethren and that serves them well. At least the ones I spoke with had some idea of Complexity, whereas their Western counterparts are all asleep on that matter. And the long term consciousness of the Chinese being, steeped in Confucianism, gives them a grounding in smart ways of managing this vast economy without resorting to fiat decisions and thereby avoiding collapse. All the while deftly deflating bubbles and encouraging entrepreneurship and laissez-faire market led economic growth speak loudly to my ears as success breeds success and the law of increasing returns now favours CHINA OVER THE UNITED STATES OR WESTERN EUROPE… as the investment growth destination counted to flourish long term. Long term value investors have been heeding this gospel for a long time now ever since my early days as the first foreign investor in China Mobile.  History is magnificently rewarding sometimes.

China’s leadership is aware of their shortcomings too. And they do act solemnly and swiftly, to curtail the losses and minimize threats to economic expansion. And of course in a typical Politburo discussion, only the inexorable movement forward is broadcast. And in the time of the fat cows or more aptly in the years of the fat pigs — the Chinese economy has slowed to its lowest growth rate since the Global Financial Crisis began for the rest of the world, with GDP growth coming in at 7.4% in the September quarter of this year. This was the seventh-consecutive quarterly growth decline — slower than the 7.6 per cent posted in the July quarter and well down from the 10% average annual growth rate that China has posted over the past three decades. But positive signs, including comments from Premier Wen Jiabao that ”economic growth has started to stabilise” — suggest growth may soon be picking up.

And this is the greatest legacy of the last three decades of China’s economic expansion: China has deftly navigated the shoals of crash and boom economic cycles the West has been mired into during the last thirty years. A singularly significant feat if there ever was one way, to validate the unorthodox economic theory of state oversight and intervention in running our economies. And as am sure all the Neoclassical economists out there will convolute in delirious tremens but facts remain. China rules in expansion and prospects for continued prosperity and uplifting people out of poverty more than any nation on Earth. Simple…

But the harpies out there remain harpies and as some naysayers in the West suggest, all this economic growth will surely lead to a Black Monday. Or a Black Friday. Or some other Black and ominous day is awaiting…

In truth, however, the ’87 loss of Black Monday didn’t affect China. Nor was it an occurrence of a freak storm in the cloudless summer sky. Although global in reach – China was insulated. Or insular. Either way this fast resounding flash crash didn’t enter the PRC. But then again it neither was a flash crash due to the vast blink of the eye nanosecond trading frenzy, resulting from machine artificial intelligence actions. It wasn’t computers trading while imitating neural network and in turn imitating complexity adaptation – blindly synching up. It wasn’t that simply because the market had been unravelling for more than two months prior.  Computerized trading did play a rather minor role during that one-day, record-breaking plunge, but as the Friday before the Black Monday, saw the Dow Jones Industrial Average falling by 108 points, its first 100-point loss, the computers weren’t doing the talking over the weekend gossip and black mood swings… And even by the “falling” Friday, and the mood setting weekend, the Dow Jones was 17.5% below its August 25th 2007 high. Capital Markets savvy investors who really woke up on Black Monday — they already knew that a serious Capital & Equity share market correction was well under way and sought shelter from the storm. Naturally the herd mentality caused a major loss of shelter, but that is another foible of human nature.

Yet the reason the 1987 sell-off is worth remembering, is because it sheds some light, and some hope, on the situation that investors face today as the markets climb a formidable “Great Wall of China” to be up about 5% in three months in Wall Street, 12% over the same period in Europe, and 18% here in China. Beware of unlimited expansion and drastic growth fed by exuberant sentiments of positivism or unrealistic optimism. They are bubble forming and as always they tend to burst with nasty side effects. And maybe that is the best reason why we need economic oversight…

Yet in relation to Black Monday, today the parallels are clear, because the boom that the October 1987 crash ended, was a takeover boom, funded by junk bonds, or rather corporate bonds that did not have an investment grade rating and therefore required no due diligence whatsoever except a blind adherence to the Milken algorithm of increasing returns…

Developed almost single-handedly by one US investment bank, Drexel Burnham Lambert, and within Drexel by one brilliant man, my friend Michael Milken, whose junk bonds transformed the financing world in the Capital Markets forever. This of  course changed the world of M&A and from then on the whole of Corporate world and Capital Markets. And this change happened swiftly like a seismic phenomenon, because takeovers suddenly became the norm of growing the Business and with many other lenders – wannabes – rushing in to imitate Michael and his brilliant algorithm, without the basics – they flooded the system and spoiled it for everyone. Too much of a good thing perhaps? Yes, but all the other lenders who offered easy money on similar terms, did so without even the cursory due diligence and thus the healthy basis in future increasing returns. So, they screwed it up. This mass engagement similarly crapped the Markets at half time and the apocalyptic effect took place, resulting in Black Monday.

That’s my theory at least, BUT IT MIGHT NOT BE AS SIMPLE AS THAT.

Because it was not just that takeover funding was easier to locate, source and apply for M&A activity. Maybe it was that capital was supplied according to the simplified and perhaps misunderstood “Milken formula” of cash flow financing, which assumed that asset prices would continue to rise, as they had been doing for several years. And this exuberant optimism led the proverbial “fat cows” to the abattoir.

The slaughter that followed was mainly because earnings multiples were completely ignored and the only big question was how much cash a takeover target could produce. And maybe, how much debt its cash flow could service. The formula produced highly leveraged acquisitions, but if the debt could be serviced by cash flow, the payoff came when asset values rose, and the acquisition was resold at a price that covered the debt and created a profit for the acquirer.

From early 1986 the US market rose from a multiple of about 10 times expected earnings to 15 times, and dividend and earnings yields fell. At the peak of Wall Street’s boom in August 1987 the companies in the S&P 500 index were producing earnings that against their share prices represented a yield that was 24 per cent or almost a quarter of a percentage point below the yield that could be locked in by buying risk-free US government bonds.

That only made sense if share price gains – capital gains – were going to continue to offset the yield discount that had been created, but confidence that share prices would continue to rise cracked in August 1987. Something had to give, and share prices began to fall… precipitously.

Now let’s consider the situation today.

The US Federal Reserve has been battling for four years to push interest rates lower to stimulate the US economy. Central banks in Britain and Europe have been doing the same thing. US 10-year government bonds are yielding just 1.8 per cent – and the companies that comprise Wall Street’s S&P 500 share index are expected to deliver earnings this year that equate to a yield on their shares of 7.7 per cent.

On that measure, US shares are tremendously cheap, despite the gains that have been made this year. The maths is similar here, too. The S&P/ASX 200 index is also trading at a prospective earnings yield of 7.7 per cent, and the 10-year Commonwealth bond is yielding 3.2 per cent.

It is not as simple as that, of course. The yawning gap between government bond yields and share market earnings yields in the major markets is mainly a product of record low interest rates and yields in the wake of the global crisis: bond rates will become more competitive with shares as the financial crisis that began in 2007 eases.

Yours,

Pano

PS:

Walking the lantern lit paths of the Forbidden City at night one thinks big and takes the long view, or at least in the many centuries and thousands of years perspective. And in the last five thousand years of Chinese  history and another fifteen of mythology – we come to know plenty of progress, interrupted by crashes, war related booms, serenity and collapse.

Still today we all wish “Gong Xi Fa Ca” for all the Capital Markets in China and beyond, even though that’s just pure heart wishing.

Because we all expect China’s growth to rebound late this year or early next year, but her recovery is likely to be too weak to drive global growth without a significant improvement in the US and Europe.

The slowing economy in China is due largely to government lending and investment controls imposed to cool an overheated economy and inflation. But the downturn worsened sharply last year after global demand for Chinese goods fell unexpectedly.

The government has cut interest rates twice since June and is injecting money into the economy through high investment by state companies and spending on building airports, subways and other public works. But authorities have avoided launching a massive stimulus after big spending in response to the 2008 global crisis fuelled inflation and a wasteful building boom.

PRC premier, Mr Wen Jiabao expressed confidence that the country could meet its official targets for the year, but he gave no growth forecast or a possible time frame for a recovery. ”Economic growth is stabilising and we are confident through our efforts we can achieve the full-year targets for economic and social development.”

Still for those of you who ever had the Chinese flu, the bird’s flu, the pig’s flu, or it’s many variants, you know how devastating these viruses can be once unleashed by China’s feverish attempts at controlling this vastly complex mood swinging player’s market. Not much one can do, except to pray to not catch the virus, and engage in frequent hand washing [portfolio purging] which helps by maintaining a certain level of health.

Back in the US, the Wall Street is buoyed amid hopes of recovery and the good – better than expected — employment, business and consumer confidence indicators have helped shares grow in value.

It’s worth noting that the share price rally has combined with softer earnings predictions this year to push the earnings multiple on Wall Street’s S&P 500 index up to 13 times prospective earnings – about two percentage points below its 1987 peak, but no longer in bargain basement territory.

And where is China in all this?

Well, in the elliptical memory of capital markets, traders and equity investors alike, today’s Shanghai Composite Index is hitting what seems like an all time high…

Therefore the good news is already behind us.

How You feeling?

Ready for a jump or ready for a fall?

As always we put our money where our mouth is.

Where is that?

Now that you’ve been briefed…

It’s your Call.

Gong Xi Fa Ca…

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