Learning to live with market volatility

Stock market indices

Alasdair Macleod – 20 June 2013

It is approximately a month since Japanese monetary policy makers destabilised their financial markets, and triggered instability everywhere else. Emerging-market currencies have been hammered, as have European and US bond and equity markets. It has not helped that the debate has now turned to how the Fed will exit its strategy of buying $85bn of Treasury and mortgage-backed securities every month, leading to the gradual realisation that there is no plan, and worse, no exit.

This is very worrying, but has been obvious from the start. The surprise is that the investing crowd has been in denial of the facts, which we can only put down to the human desire to be blind to negative outcomes. Instead, investors everywhere have been happy to believe that Mr Bernanke knows best.

While statistics such as brokers’ loans show that equity markets have become overbought, there is not a bubble mentality in equity and bond markets: by this I mean that the wider public is not scrambling to buy in the sure-fire belief that prices are going up. It is more a case of markets being mispriced on zero interest rates and investors being complacent.

Shifts in sentiment can be very sudden under these circumstances. A good example was the 1987 October crash, when markets were over-bought and investors were enjoying the ride, rather than going mad for equities. In that case equity markets lost between 30% and 50% in a matter of days, with New Zealand falling 60%. The reasons for the October crash are disputed, but it was the first time that global equity markets were linked together by financial institutions operating in multiple markets and investment diversification across a range of these markets had become the norm.

It was for this reason that all markets crashed together. Today, we have a similar set-up, but with far greater levels of inter-dependency between markets. No financial institution recommends an investment in one country, without comparing the alternatives in others. Nor will an investment manager contemplate an investment in, say, Spanish bonds without comparing them to Germany’s or perhaps Italy’s.

While this makes eminent sense in today’s investment world, it does mean that if one market weakens it is bound to affect others. When Japanese equities began their fall not only did it undermine other markets, but hitherto bullish investors began to consider issues that hadn’t worried them before.

There is no knowing how far the increase in bond yields and the slide in equities will go. But with all the printed currency that has ended up in financial markets, the rush for the exit could be spectacular.

This leaves gold and silver in an interesting position. Short term instability in other markets usually has unpredictable effects. Holders of physical bullion should look through these and think about the end result of a bond and equity market crash. They should ask themselves, will it be more destabilising for gold, or for paper currencies?

And here we must think about the central banks’ response. Their immediate problem is the consequences of losses on securities held in the banking system and being used as off-balance sheet collateral in the shadow banking system. Systemically-important banks particularly in Europe are still highly geared, and falling bond prices will likely wipe some of them out. There can only be one central bank response, and that is to accelerate the provision of liquidity to the banks to avert a crisis. Furthermore, central bankers firmly believe that healthy equity markets are necessary to bolster and maintain consumer confidence, so they will also wish to intervene for this reason.

When financial markets wake up to this inevitability they will seek safe havens; and the only ones that exist are in basic commodities and precious metals. While the ride in gold has been very uncomfortable for the last 21 months, gold bugs might reflect that it has taken less than one month in other markets to produce losses on a similar scale.

As to the future, I leave you with my favourite chart, which shows that the US dollar is already experiencing monetary hyper-inflation, and that is before we consider the extra money supply needed to rescue the banks and to stop market falls become self-feeding.

True Money Supply plus excess reserves $bn

And that is the real reason to have some gold and silver: currencies are on the path to self-destruction.

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FinanceAndEconomics

Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

3 thoughts on “Learning to live with market volatility”

  1. Is there any scenario in which we can have today’s currency wars, rampant money-printing via POMO, massive deficits, without accompanying price inflation, and STILL have gold rising versus paper currencies?

    Or need we wait, through deflation, for a ‘stagflationary’ period?

    I’m posing these questions because the myopia of the markets, their heedlessness of risk and their steadfast focus on paper currency YIELD and the SHORT-TERM should, somehow, somewhere, in some alternate universe, be punished…because you can’t hide from RISK.

  2. Do not look at investing in the stock market as a hobby.
    It is something that has a lot of risk involved and it should be
    taken very seriously. If you do not have enough time, effort and patience to take it seriously, then you should
    not get yourself involved with it.

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