Reading a recent article on attempts to hot-air balloon around
the globe, I was fascinated by the problems that balloonists encounter because
of the changing effects of solar heating on balloons at high altitudes. To make
it around the globe, balloonists must fly at very high altitudes, in the hope of
maximizing the wind speed that will carry their craft. This exposes their
balloons to the full effects of solar radiation during daytime, which can cause
uncontrollable altitude increases, and dark, freezing nights which can cause
desperate plunges down in altitude. The investment markets have very similar
problems. In normal times, the steady heat of increasing earnings and cashflows
should move values on a steadily upwards altitude. The immense thermal action
of monetary policy, greed and fear very often overpower the modest output the
market burner of valuations. When the "sun of optimism" is warming
the big hot-air balloon of the markets, it is likely to shoot upwards in
altitude uncontrollably. In the "dark freezing night" of market fear
and turmoil, the market is likely to plunge uncontrollably downwards.
Investment managers have a lot in common with proctologists when it comes to
discussing their professions with outsiders. Both these professions are obscure
to the layperson, yet everyone is in some way involved with the object of their
attentions. Once the profession is identified, the small talk can take a
socially dangerous turn.
Frankly, I would prefer listening to a graphic description of my neighbour's
exhaust problems than being forced to explain the latest collapse of an Asian
currency or what the commentators have taken to calling the "Asian
Contagion" in the equity markets. Thanks to mindless mutual fund TV
advertising and glib ten second CNN summaries, everyone expects pat, confident
and reassuring sloganeering on what should be a considered and lengthy topic.
Lately, I have taken to comparing the frenzied activities in the world's
financial markets to the problems that hot-air balloonists encounter in
high-altitude flight.
Distance ballooning and investing have a lot of similarities. In both, one
takes risks. Investors and balloonists harness powers far beyond their own
puny resources in the hopes of getting more quickly to their goal. In both
pursuits, the vast forces they are dealing with can take far off their chosen
path with dangerous consequences. The investor left penniless by the collapse
of Bre-X shares failure with Richard Branson's terrifying night crash in the
Atlas mountains. Neither the investor nor Richard Branson had much control over
their eventual fate, both were along for ride.
Ballooning, like investing, seems quite simple to the outsider
Ballooning, like investing, seems quite simple to the outsider. You hop in
a balloon, fire up the propane burner which fills the balloon with hot air, and
soar into the heavens. The reality of ballooning, like investing, is quite
complicated and dangerous. The balloonist must steer his craft by using the
wind. How, you might ask, do you steer something that blows where the wind
takes it?
That's where the expertise is required. The balloon pilot is expertly
trained to recognize and utilize the difference in wind direction and speeds. At
lower altitudes, within 4,000 feet of the earth, the wind closer to the ground "backs"
to the north as friction from the earth slows and changes the wind direction.
Super fast "jetstreams" or rivers of winds exist at high altitudes
which can blow the balloonist at over 100 miles per hour. The balloonist can't
see the differences, but he knows they are there. This is how he finds the best
wind to carry his balloon in the right direction. Plotting his course and
changing with the wind conditions, the balloonist can manouevre his frail craft
with amazing skill.
Controlling altitude in a balloon is not easy although the principles again
are simple. Since the early balloonists of the middle ages, balloonist have
filled their balloons with hot air, which is lighter than the surrounding air,
and causes the balloon to rise. Today, balloonists use propane heaters which
they can adjust to achieve just the right amount of air for the altitude
desired. To ascend they increase the heat of the burner and the amount of hot
air going into the balloon's envelope. To descend, they turn down the burner and
even can vent hot air out of the balloon. They also carry heavy ballast in the
gondola which weighs the balloon down when they want to go descend. It all
sounds very easy, much like investing.
The stark terror of an uncontrolled descent
Now, picture yourself at 40,000 feet (8 miles up), cold, lonely and
insignificant in a cramped gondola somewhere over the Atlas mountains of Africa.
The sun has set and it is well below freezing. The balloon is cooling
rapidly, and the altimeter which shows the altitude is dropping rapidly. The
burner cannot pump out enough hot air to keep the balloon at a steady altitude.
The jet stream you are trying to ride is curving down over the far side of the
mountain range and is creating a dreaded "mountain wave" effect which
culminates in a "rotor cloud" which can tear a strongly built aircraft
apart with its fierce turbulence, let alone your frail balloon. It's dark and
forbidding and you have no idea what is below, except you know it is jagged
mountain peaks for the most part.
In fear for your life, you start dropping ballast. No change. The
altimeter shows you're still plunging rapidly down, towards the jagged mountain
peaks thrusting upwards at the flimsy gondola floor. You start throwing out
anything you can. The oxygen bottles which you need to breathe at high
altitudes. Charts, food, water.... anything you can rip from the gondola. Your
eyes are glued to the altimeter. Long gone are the visions of glory or the
happy picture of your balloon floating smoothly on a gentle breeze. The fear is
overpowering.
Floating happily on the winds of excess equity returns
Today, the investing public happily mouths platitudes about "investing
for the long term". When markets go down, its a "buying opportunity"
or a "correction". A lot of these so-called "long term"
investors don't even really know or care about the mechanics of what they are
doing. Like neophyte balloonists, they hop in the market and expect to float
away happily on the winds of excess equity returns to their happy retirement.
It's not really their fault. What else could one expect from an investing
public well-schooled by mutual fund advertisements that feature people sitting
on docks fishing or boatloads of racing oarsmen.
The fact is, they're not really wrong. The increasing cashflows in an
economy and good companies are the steady base on which equity appreciation is
built. Like the propane burner of our balloonists, they steadily push equity
prices higher over the longer term. The problem, like that of the balloonist,
is when other forces overpower this effect and cause the prices of equities to
no longer reflect the fundamental valuation reality of cashflows.
We are just finishing a period where the monetary authorities in the United
States, Canada and around the world have been pumping "liquidity" or
money supply into their economies. First they struggled to correct the
devastation caused by the real estate collapse of the early 1990s which caused
many of their major financial institutions to be technically bankrupt because of
real estate loans. Then they strived to correct for the deflationary forces
that were an immense drag on their economies. The problem was, and still is,
that this stimilus didn't cause a surge in spending and employment since the
public had been savaged by "downsizing" and "rightsizing"
and very high unemployment. It went directly into the financial markets which
have been in a frenzied orgy of specualtion, powered by the monetary
stimulation over the last 3 years since the last major tightening in 1994.
A high altitude market and Mr Greenspan's "irrational exuberance"
All this money sloshing around the major economies first found its way into
the bond markets which caused interest rates to plunge as investors raced to
lock in yields. The overwhelming mass of cash soon found its way into the equity
markets which raced ahead to new heights. Using our ballooning analogy, the
steady cashflow burner was trivial compared to the great force on monetary
stimulation and our market balloon soared ever highwards. A more powerful new
force emerged, the hot burning rays of the sun of market enthusiasm and greed
which made the market balloon soar uncontrollably ever higher. It was about at
this point that Mr Greenspan started musing publicly about "irrational
exuberance". He knew that all market bubbles and balloons had to
eventually burst. He simply could not maintain monetary stimulation at very low
levels of unemployment without risking much higher inflation.
The dark cold night is upon us
What does all this mean? We're now entering that dark, cold period when the
immense heat of monetary stimulation and market greed are no longer making the
market balloon surge ever higher. The Federal Reserve and The Bank of Canada
are now not in a stimulative mood. They're actually tightening monetary policy
which puts less cash into our market balloon. Market psychology has turned from
a "no-lose" and "get me in" greed to the deadening fear of
capital loss. Lower-quality and less-liquid investments like smaller foreign
stock markets and currencies are now plunging downwards in the freezing night at
high altitude. Even high quality domestic stock and bonds are being buffetted
and tossed about like leaves in the cruel fall wind. When bonds surge upwards
2% in a day because stocks are being hammered down 7% and then reverse exactly
the next day, all is not well with the fundamental value underpinnings of the
market.
Do I sell, jettisoning everything from my portfolio in the hopes of staying
financially aloft? Do I buy because "everyone knows you buy when the market
is down"?
This is when the skill is required
In the cold dark night of market turmoil, the fear from the jagged peaks of
capital loss below is overwhelming. Like ballooning, a high level of skill is
needed to keep investment portfolios aloft. You must have the confidence from
knowledge of the powerful heat of the steady cashflows keeping your portfolio
value aloft. You need to know what is in your portfolio and the valuations of
your holdings. They had some women from an investment club on the news the
other night in the middle of the crashing global equity markets. In the midst
of all the senseless dogma from the so-called "investment experts",
they explained that their portfolio had done very well because of attention to
the mundane detail of what they were buying. To paraphrase: "if we by good
companies cheaply, we really don't have to worry." On the other hand, one
member said she had been pretty badly beaten up on some personal mutual fund
positions that she hadn't really thought too much about when her financial
advisor suggested them. There's no substitute for doing your own homework.
If you have speculative or ill-considered positions with little cashflow
lift, you could be in for a bumpy landing. If you have an undervalued portfolio
and cash, you'll be able to buy steady cashflows at cheap prices in the
terrifying period when the plunge seems never to stop. When the warming rays of
monetary loosening and market optimism once again return, your cashflows will
power your portfolio ever higher in value as you soar to new heights. |