Everyone had a teacher who could see through the nonsense and zero in on behavior that was “just not acceptable”. Miss Tottenham (who later became an Anglican Bishop) did not have time for excuses and, perhaps because she was Canadian, she did not particularly care if our young egos were bruised by her corrective nostrums. The bruises healed but the lessons stuck.

Amongst her many admonishments was the old saying: “What’s good for the goose is good for the gander”. The term is meant as a reminder that the two sexes should not be subjected to different standards and it was often used in that context. However, she was fond of extending the saying to other areas (comparative religious studies in particular).

How does this apply to the markets today?

As the mainstream financial media beat the drums for the next round of quantitative easing, one can’t help but notice that policy makers in the US have one set of recommendations for developing countries going through a financial crisis and another set for G-7 countries.

Like my old teacher, the markets do not suffer fools lightly. The question is: who are the fools today? And why are they acting foolishly?

Let’s start with the mainstream financial media, which was born and raised in New York and London.

The reason I pick on the media and not Treasury Secretary Geithner is because I do not have regular access to the latter whereas it is hard to avoid the former. Whatever Mr. Geithner, Mr. Bernanke, Mr. King, Mr. Trichet and Mr. Shirakawa are thinking, saying and doing, I am confident that the Financial MSM will be there to parse each datapoint for the rest of us.

But all of that analysis and commentary, which have tremendous impact on intraday trading, is largely irrelevant given the direction in which these esteemed gentlemen and their institutions are heading. Instead of learning lessons from the recent crises that have plagued the world outside of the mainstream media’s immediate focus, the leading economies in general and the US in particular have decided to validate Santayana’s famous quote: “Those who cannot remember the past are condemned to repeat it.”

What past am I referring to? How about the Asian Financial Crisis? The Swedish Banking Crisis? The Japanese Stagnation? Or even the S&L Crisis?

Rather than detail the lessons missed, let’s start with why they were missed. The primary reason is an extension of the NIMBY attitude which ensures for example that the US perennially lacks adequate refining capacity (haven’t heard about that one lately? Just wait until the US unemployment rate heads back to 6% and all those new workers drive to work). These crisis events did not take place in the backyard of the policy makers who are tasked with designing a recovery. Therefore, until now, no one was building a policy response. And, after years of doling out harsh advice through the IMF, no one is seriously proposing the same draconian measures for developed economies.

Not everyone failed to learn from the recent slew of crises. Let’s start with the Asian Crisis. Who learned what lessons? All the countries involved, including China, recognized that a banking system run amok could torpedo decades’ worth of economic growth in very short order. China, Korea, Taiwan, Hong Kong, Singapore, Malaysia and Indonesia faced severe challenges. So did Thailand (patient zero of the Asian Financial Pandemic) but that country has been too busy with internal politics over the past decade to worry much about economic development.

What was the response? They learned that keeping banks on a tight leash, stacking up piles of foreign exchange at the Central Bank, keeping currencies stable and current account/budgetary balances under control were all needed to stave off the next crisis. What assistance did the countries receive from the G-7? Not much. As a result, banks failed or were merged, property markets took hits and some of the cowboy financing was curtailed.

Therefore, one shouldn’t really be surprised when China doesn’t respond to every US Treasury lecture or Congressional resolution. Chinese officials know that a revaluation of the RMB is not going to change the structural nature of trade between China and the US anytime soon. Furthermore, while it will not instantly transform China into a modern service and consumption based economy, a revaluation will hand the Chinese an “instant loss” on the pile of US dollar denominated assets which backstop the RMB. With the Asian Crisis experience fresh in their minds, is there any wonder that we are hearing “What’s good for the goose is good for the gander” statements from Chinese officials.

What can Japan teach us?

If you look through a second hand book store, you are bound to find copies of books declaring “Japan as #1”. These books all date from the peak of the Japanese property bubble in the late 1980’s. In the intervening two decades, Japan’s economy has stagnated while its government has accumulated a peacetime pile of debt that is staggering. How did this happen? Two words: gullible stooges.

Who were the “gullible stooges”?

In Japan, they were the middle class who were happy to plow a significant amount of their savings into government bonds or institutions which primarily bought government bonds. With such a bountiful supply of willing buyers, the government was able to funnel that savings into zombie companies, zombie banks and infrastructure projects that make the famous “Bridge to Nowhere” look like a sensible project. The whole process was contained largely within the borders of Japan because the Japanese had the resources to squander that allowed them to overlook the consequences. The only outsiders who might have noticed were academics and a few foreign bond traders. The price and yield of JGBs were largely uncorrelated to the rest of the world. The only outside effect was the “carry trade” (borrowing cheaply in Yen to invest dearly in other currencies) which drove massive fund flows to high yielding currencies and helped to drive down rates globally. So, what did the rest of the world learn about the Japanese situation? Almost nothing. After all, the problem was contained in a stable democracy and all those Quantitative Easing Yen were flowing into Australia, New Zealand, Canada and the US, lowering interest rates, easing lending conditions (by boosting wholesale funding supply) and indirectly boosting consumption and property prices.

Now, with 20/20 hindsight, we can see that there were important lessons in the Japanese experience that no one was willing or perhaps even able to comprehend at the time.

When it comes to the US property bubble triggered Financial Crisis, most learned observers point out that conditions are very different in the US than they were in Japan in 1989. Oh really? Property prices and lending standards that had lost touch with reality? Government funding for zombie companies (AIG, GM, Chrysler)? Government support for zombie banks (Citibank, Goldman Sachs, Bank of America, Morgan Stanley…)? Massive stimulus packages funded by public debt? A peacetime record level of public debt? Raising taxes? Ah, but you might say, there is a difference. The American Middle Class did not have the savings to become “gullible stooges” like the Japanese Middle Class. And that is correct. The “gullible stooges” were governments and banks around the world which used US Treasuries and Agency paper as well as more exotic derivatives as their asset base. That’s how Japan’s lost decades have remained largely a domestic issue while the US Subprime disaster morphed so quickly into the Global Financial Crisis. So, while Japan has tried to squander the wealth of its middle class, the US is busy trying to squander the reserve status of the US dollar.

How does that help us as investors?

When we look forward over the next two years, we need to build investment scenarios that accommodate reality the way it is unfolding rather than clinging to historical relationships that may no longer be valid. The economic balance of power is shifting as China overtakes Japan to become the second largest economy (it earlier overtook Germany’s top export position).

With the US largely in denial (the political mood is heading towards “Carter malaise” levels), the profitable investment opportunities are probably not going to come by buying and holding a wide slice of “blue chip” companies with the S&P500 trading on a high teens forward P/Es. Unless something changes dramatically, the US will stay in a bear market (which can be defined as a secular fall in P/E ratings). Asia and Latin America’s painful financial crisis experiences appear to have served both regions well. Africa is growing economically for the first time in decades (with South Africa leading). The Middle East has opportunities that a country like Turkey is trying to capture. And Europe, led by Germany, is starting to deslot from the fiscal and monetary policies advocated by Japan, the US and the UK. Resource rich and legally/politically stable Canada and Australia are also areas that deserve a closer look.

The world survived the stagnation of its previous world beater, Japan, in the 1990’s and it will no doubt forge ahead while the US spends the next few years putting its affairs back in order. Even a crisis in China will have to be put in the context of improving fundamentals in Brazil, India, South Africa, Indonesia and Turkey.

This is not idle speculation. The IMF is forecasting global growth in excess of the 4% as the rest of the world recovers from the effects of the Global Financial Crisis. But that number hides big gaps between the developed and developing worlds. Companies that are poised to take advantage of the growth will benefit while companies that are depending on the US consumer are not likely to grow as quickly.

That doesn’t mean that there won’t be opportunities along the way in the US Equities Markets. It does however mean that a Buy and Hold approach to the markets is probably not the right method.
As a result, the Fund King System is starting to show growing momentum in equities, particularly in emerging markets. The previous leaders, US Governments and Precious Metals, are still holding up with Silver playing some catch up to Gold.


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