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A “Hot-Air” Approach to the Markets

Editor’s Note: This article makes reference to events up until 1998. How the housing collapse of early 1990s and Hot-Air ballooning can teach us about irrational exuberance. Surprising how history tends to repeat itself.

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. Compare 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, but ultimately both were just along for the rides

It’s harder than it looks

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 “jet streams” 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 maneuver 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 butt” 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. Good companies along with increasing cashflows in an economy 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 stimulus 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 speculation, 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 higher. 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 the risk of 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 buffeted 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 values underpinning 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.