So the strategy now ? Inject more money in return for equity ownership. 

World Governments believe that by injecting a bucket load of cash into banks in return for equity and all sorts of guarantees – they are going to stop the market panic, at least in the short term. Credits markets have crystallized and each and every day, the markets are free falling – so it’s clear that something needs to be done. 

Will it work ?

Probably in the short term. But the biggest fear from my analysis on the situation is that inflation will start to rise. You cannot dump huge amounts of liquidity into the markets and not expect inflation to rise. Of course, on the flip side of this argument – analysts will suggest that with unemployment rising higher, oil prices falling and wage pressure hammering organisations – inflation may not be the problem – rather, deflation will be. 

Either way – what does it all mean ? Well, it definitely means, regardless of what anyone tells you, thats its a time to be risk adverse in the short term. Growth is definitely to going to slow, if not reverse, in most economic nations and this is going to hit underlying profitability of big organisations.

The 12-month All Ords Chart shows a very bleak picture – down from 6,200 to 4,631.30 as of today. With  consumer sentiment usually always being positively correlated to the overall stock market business cycle – one would suggest the RBA is still being far too cautionary with its reaction to the global economic woes. Retail sales have continued to slow and if you take out food sales, then retail sales actually fell by 0.5 per cent for August – a shocking result.

Glenn Stevens has consistently maintained the view that the RBA needs to proactive rather than reactive in reaction to the markets and I think the time has come to fully uphold that ideology. Australia is yearning for some economic indicator which will bring some relief to the overall pressures of the global economic meltdown and the best place to start is at the cost of borrowing. The dollar is falling, investors are pushing back to raw commodities such as gold and lending is drying up hurting not only the consumers pocket at the current interest rates – but also growth and sales.

Of course, the risk in all of this is that the Big Banks are not going to pass on any associated interest rate cut in order to sooth the pain of the huge losses from the USA market collapse, and the still very high funding costs. Unfortunately, this is not something that the market can directly control – other than to pressure the Federal Government to in turn, pressure the banks to fully pass on the cut. A 50 basis point decrease in the cash rate would take it down to 6.50 per cent and provide a lot of relief to not only many families and businesses doing it tough – but also to encourage many businesses to start borrowing again and expanding.

The Official Cash Interest Rate has not been cut by 50 basis points since the aftermath of the Dot Com implosion back in April 2001. Given the current market conditions however – you would have to think the Dot Com crash was only a blip on the radar.

If you reading Mr. Stevens – do something!

This is not about Wall St and its very rich, now only rich, investors.

This is about ordinary Americans and other citizens in countries around the world who rely on their small investments and superannuation and pension funds as a means of living and retiring. It has nothing to do with bailing out rich Wall St investors, rather the US Congress should be focusing on bailing out the world financial markets above and beyond any thought to rich Wall St investors – who are now, have no doubt, very much poorer. As soon as the bailout was rejected last night, the Dow Jones fell 777.68 points, the largest one-day point drop in blue-chip history. I have no question most of this was reactionary and that the Dow will post huge gains later in the week when congress reconvenes and attempts to modify the bailout bill and vote on it again.

But the point still remains – they may not pass the bill again, and they may continue to take on this stupid ideology that its Wall St that they are bailing out – it is not. In total, US $1 Trillion was wiped off the value of the entire US stock market yesterday, and the ASX is down more than 220 points at the time I wrote this article. Do you honestly think that Mum and Dad are going to understand why $1 Trillion was just lost in the US Markets ? Of course they won’t. But they certainly will understand when they look into their superannuation and pension funds that they have taken a massive hit – and then they will start to ask questions and get angry.

Congress needs to stop focusing on a stupid, self-indulgent – “we will make wall st pay” philosophy – and rather just fix the problem. If they don’t, I really honestly fear what the result will be.

Why should we (the USA) use public money to bail out rich investors who took too much risk without any sort of penalty ? They still drive their rich cars, live in their rich houses while 90% of America can’t even afford to stay in their homes. How is this fair ?

On the face of it – it seems like a fairly good argument to make and one that does hold some underlying truths. Wall St did take far too many risks primarily in order to push up salary bonuses and generate spectacular portfolio returns while also ‘returning shareholder value’. It did this with the full knowledge that more and more risks were being taken than what would have normally been permitted. Everyone pushed a little harder, and took a little more risk than they usually would which ultimately ended in the highly volatile and reactionary market conditions we have at the moment. The question is, who ultimately is responsible?

This is a two-fold argument and depending on which side of the coin you are coming from – it will differ. The key to apportioning any blame is to really focus on the downfall of the market and why the downfall occurred. Should the regulators have moved faster and questioned the huge profit gains more regularly and with greater scrutiny they did ? My response to this question is yes – but, in saying that I argue that realistically pre-emptive mechanisms should have been in place in the first instance to identify and question the risks investors were taking. This would have included a greater review of internal risk strategies by regulators of financial institutions, and a greater level of market disclosure on there open positions.

The failure of regulators to act, and to act quickly, has been perhaps the driving force behind the entire financial systems downfall. The reason ? I like to refer to an age old adage:

Give someone an inch, and they’ll take a mile.

The truth of the situation is that by the regulators failing to adequately manage, assess and hold each financial institution accountable for there increased risk taking strategies – they allowed the market to implode because investors felt they could take as much risk as they wanted. For the record, I am in no way implying that the management of these financial organisations shouldn’t be held just as accountable – they should be. They owe a duty of care to act in the best interests of their shareholders and to maximise shareholder value, and by increasing their appetite for risk they directly put shareholder interests in the firing line. But, if regulators had of forced investors to disclosure more and regulated more proactively – then perhaps this “huge” appetite for risk may have been reduced to a “mild” one.

A reoccurring theme in all the notes I have been sent is not that a USA bailout strategy shouldn’t go ahead, but rather, what taxpayers should get out it. I argue that USA taxpayers should get much more out of any sort of bailout plan than what they are currently getting (which is arguably nothing). The $700 Billion USD should allow the US Government to secure stocks in any banks that want to utilise the bailout and then when market conditions stabilize and improve – the government can sell these stocks for a profit. It really makes sense and it provides some net interest benefit to taxpayers for using almost $700 Billion USD on the financial markets instead of using it for infrastructure and health services in the USA. 

I think the USA Treasury has simply created a knee-jerk solution to a very complex situation – something that the USA is very good at doing. The Treasury should have proposed and tendered the plan for a 1 week period to achieve more commentary from industry professionals and government, than simply try and rush a bill through Congress which is now being stalled. I think an immediate reaction is necessary, but not one that is rushed and may have serious implications down the track if it is not thought out correctly. 

To conclude I ask you this:

Would you want government to spend $700 Billion of taxpayers money on a decision that was put together in 2 days?

I certainly wouldn’t.

So how to get through ?

1) In my opinion, the first way to get through is to start liquefying any relevant risky financial positions and cease entering ‘quick money’ arrangements which carry high risk. At the very least, a substantial reduction in these types of instruments will ensure that you are not hammered by adverse market movements. For the average portfolio holder – it’s all about reducing the risk and exposure. This may also mean closing down any positions where you have the thought that the stock ‘may go up, but will more than likely go down’. If the probability of ‘down’ is greater, in your opinion, than the probability of ‘up’ and the financial loss is not enormous – then it makes no sense to hold these so called ‘fence sitter’ positions in the current market. You are either going to lose massively, or gain a little – think sensibly and not greedily. A small loss is much better than a huge one.

2) Avoid any relevant exposure to the counter party risk that is reeking havoc to basically every major investment bank at the moment. You see this is where the biggest problem has been for all the US financials. Basically, all the major investment banks have engaged in credit default swaps which allow a buyer or ‘fixed rate’ party to make periodic payments to a ‘floating rate’ party in exchange for the ‘right’ to a payoff if there is a default or credit event in respect to a third party – called the reference entity. Simplistically, the lower the credit rating of a contracting party the greater the risk that the third party reference entity will default on its payments and this increases the cost of the credit swap.

Of course, because of the huge mortgage problem in the US at the moment – this has meant that the counterparty risk associated with these instruments has gone through the roof as contracting parties are defaulting on their obligations which has basically engulfed a lot of companies - American International Group (AIG) most prominently. The reason they have taken such a massive hit is because they offer insurance to the financial markets on so called ‘non-risky financial instruments’ such as ‘credit defaults swaps’. Of course, traditionally these instruments have never really been in the ‘high risk’ category – hence the reason AIG insured them – but in the current United States financial market where the securitisation industry is getting pummelled in every direction and the underlying price of houses are next to nothing – these instruments are now obviously, high risk. Do some research, don’t invest in companies who haven’t stated their entire position to the market yet or who ‘may be’ even the slightest bit exposed to credit swaps with contracting parties who are considered high risk.

3) Diversification should always be a part of any good portfolio position and if you portfolio isn’t diversified chances are you are either holidaying in Hawaii off your recent profits, or needing to buy another case of wine to calm the nerves from the losses you have sustained. In a market like this, it’s the turbulence that makes it very difficult to try and find good investments. I tend to argue that good performers over the last 2 years, will be good performers in the next 2 years assuming they can weather the financial storm. Most recent stock losses primarily relate to two things – the first being plan old market panic, and the second being a big sell off of any company remotely connected to ‘mortgages’ or ‘securities’. Does this make sense? Yes and no (I’m not going to go off down this road for this post). Most importantly, think sensibly and rationally – all the major financials in Australia will recover because regulators don’t give them a choice. More so, interest rates will fall – this is really inevitable otherwise the economy will come to a roaring halt which the RBA won’t let happen – so once again banks etc will be able to lock in profits from a reduction in funding costs and their share prices will rise in correlation with these interest rate reductions. Remember to look at any relevant dividend payments and focus on the underlying growth of businesses which you are analysing and/or looking to invest in.

4) For traders, please ensure that you ALWAYS use stop losses. No matter how ‘good’ you are – you are never better than a good stop loss. If you trade a lot you will already know this, if you are starting to trade – don’t bother in this market – and if you have never traded, don’t start yet. By all means practice with a Excel spreadsheet and “fake” money, but trying to pinpoint good investments in this market and trade them well with little experience is really something that I wouldn’t recommended to anyone at this current point in time. It’s best to learn in this market, but not best to use your own money. Practice, practice, practice using a real live trading program so you get a ‘realistic’ exposure to how difficult it is to trade in turbulent markets. If you find yourself ‘more up than down’ – let it stay that way until the market settles.

5) Keep rational, stay focused. This is probably the most important thing to do in a market such as this one. Don’t take risky CFD positions or Index options or even attempt to create complex trading systems which can ‘beat the market’. There’s a ‘high risk’ chance you will end up down and I recommend you re-read point 1 above if you are even thinking this. You can bet your bottom dollar that billions of dollars was lost in call options alone in the United States because many financial experts had suggested ‘the worst was over’. The worst is never over until the Regulators start shaking down the biggest companies and demanding they account for their risk and balance sheet exposure. Once you see this start happening publicly as it is slowly starting to happen in the US – then you will start to see the ‘true state of affairs’. This hasn’t happened to a great extent yet, and I think in the next few months there will be a few more issues in the pipe particularly around investor sentiment leading up to the next US president and their respective economic policy.

These are just a few tips in order to “weather the financial storm”. Feel free to contact me via the Contact Page above if you have any comment.

My standard and immediate answer is No.

The reason I say this is because no matter which way you spin it and no matter how bad things are at the moment – history has shown us that financial markets will always recover. I find it personally fascinating when things have been so good for so long, how people are all of a sudden “shocked” when there is a downturn. Don’t get me wrong, this downturn is much more serious than most others in history (but not all … are we so short sighted to have forgotten the great depression?) and is just a reflection of one person cutting corners and allowing 1000 other people to do the same thing. It’s most interesting to note that Regulators will now “all of sudden” become very active because times are tough, instead of being more proactive when times are rocking along. The Securities regulators in the US should have been much more stringent in their management of US financial system during the last seven years than perhaps taking the “times are good, we don’t need to do anything” strategy. This is, sadly, always the way it works when it should be “times are good, we should be freaking out why they are”. It’s the management of risk that was critical in the United States, and clearly most firms capital adequacy requirements went out the window and they were able to lend to anyone.

So what exactly is going to happen now ?

People will move to safer investments. You will see a large move into secure and risk adverse opportunities such as bonds, treasury notes and term deposits. I think there will also be a larger shift towards underlying commodities as people shed the risk on futures markets and invest in the underlying fundamentals which make up our markets. Whenever there is huge write downs - most people fall back to investments which are safer and allow them to more easily manage their risk. This just makes sense.

Equivalently, this means that there will be some very good buying opportunities. Spin the clock back on your charting programs 7 years and what will you see ? Most stocks (which still exist) are hugely higher than when they were 7 years ago. So what, you ask? Well this is just to point out that even after the Tech Bubble Burst and the tragedy that was September 11 occurred, the market has managed to recover hugely.

So don’t fret too much – the financial world is NOT going to end. The only way forward in anything in life is to get rid of the bad odors, and I think that we have still not seen the complete end of the bad smells yet. The standard business cycle is around 3 years and we have had 7 years of “up” – something had to falter and it had to falter in a huge way. You cannot expect the US economy to loose in excess of $1 Trillion dollars and think that things are “going to go back to the way they were”. It’s not economically possible for this to happen.

But as we more forward now and more and more people shed risk and invest in secure investments – asset bases will build back up which allows banks to borrow more and more – which consequently “frees up” their now risk adverse lending practices and the cycle begins again. People always want money and they always want it as cheaply as they can get it – this means that although we are going to see a severe “tightening of the belt” – sooner or later banks need something to eat.

Times will be tough for the next year or so and maybe even longer as risk policies are dusted off and shaken down – but the the funding squeeze will ease up, and interest rates will start to fall (because consumer sentiment will have taken a battering) which will make the liquidity markets start flowing again and the good times will return. The key for you, as a small investor – is to the rid the waves of highs and lows

Such is the game of the Financial Markets.

If we refer back to the scarcity concept – the more scarce a good or service is at any particular time, the more you have to be willing-to-pay to acquire it – that is the supply of the good or service is low which drives the demand for the goods or service high. Conversely, if a good or service is very common then you do not have to pay as much for it. This is because the good or service is frequently available meaning the supply of the good is high, which means that demand for the good is low because it is so freely available.

The supply and demand laws are continually moving back and forward freely within society and constantly recorrecting themselves in order to find the best supply and demand equilibrium – the point at which the amount of goods and services supplied is equal to the amount of goods demanded and vice-versa. Demand and supply will always attempt to allocate resources in the most economical way possible so that there is never an excess/shortage of goods and services demanded or an excess/shortage of goods and services supplied. This can be shown graphically by combining the previous two diagrams:

This is the Equilibrium Supply and Demand diagram. It indicates that at point (Pe. Qe) all resources have been allocated efficiency. It means that the quantity of goods demanded, is equal to the quantity of goods supplied for a given price.

It is important to remember that this is a theoretical model that assumes time has stopped. The quantity of goods and services demanded and quantity of goods supplied can only realistically be modeled in this fashion. In real life, measures of demand and supply are constantly changing so the equilibrium point is never truly reached.

When supply or demand change, they disrupt the supply and demand equilibrium which implies that there is an inefficient allocation of resources – this is termed disequilibrium. Since the market always wants to remain efficient, it attempts to recorrect itself whenever disequilibrium occurs by recorrecting itself.

At P1, the price has increased meaning that demand (A) has decreased and supply (B) is still in excess. To recorrect itself the market must either supply less of the G&S or decrease the price of the G&S to increase demand and return to (Pe. Qe) once more.

At P2, the price has decreased meaning that demand (Z) is now in excess of supply (Y). To recorrect itself the market must either supply more of the G&S or increase the price of the G&S to increase demand and reach (Pe. Qe) once more.

Conclusion

You now have a basic understanding of market forces that influence the economic process. In applying this information to the investment process, you want to research companies that are producing goods in excess demand, or in limiting supply so that their stock price is generally increasing. While this is a vast generalization, it shows you that the stem of all economic reasoning lies behind the study of this model, and its application is important when choosing the right investment in your investment strategy.

The more important difference – apart from the obvious – between supply and demand is that supply contains an extra variable that demand does not – time. Time is fundamental to suppliers because they need to ensure that they can both:

1. Supply an increase or decrease in goods and services in response to changes for those that demand them and
2. Establish whether the changes in demand are seasonal (change with the seasons) or permanent.

Demand does not need to account for these changes and this is why time is a critical feature to the nature of supply.

The law of supply states that – ceteris parabus (all things equal) – if demand is held constant – an increase in supply leads to a decrease in price while a decrease in supply leads to an increased price. This can be illustrated graphically which is shown below:

Points X,Y and Z represent different goods and services available (G&S) at a particular time.

1. At X (P1,Q1)- the price of the G&S is low, so the quantity of G&S supplied is low.
2. At Y (P2,Q2)- the price of the G&S is intermediate, so the quantity of G&S supplied is intermediate.
3. At Z (P3,Q3)- the price of the G&S is high, so the quantity of G&S demanded is high.

Movements (change along the curve) in supply will only occur when there is a change in the price or quantity supplied of a particular good or services compared to original price/demand relationship for that good. For example, assume the current supply of Soft Drink was at point Y:

1. If the price decreased, the quantity supplied would decrease to point Z.
2. If the price increased, the quantity supplied would increase and move to point X.

Shifts (movements of the line) in supply will occur when something other than price has affected it. Continuing the soft drink example, if the current supply of Soft Drink was at point Y and:

1. The price remained at P2 but the quantity demanded decreases – the line would move from S1 to S2 and
2. An entirely new supply line would be established in response to this change.

Shifts like this would occur if a sugar cane disaster occurred and no sugar was available to produce soft drink. Suppliers would be required to supply less soft drink for the same price if there no other substitute (a good used in place of another good) available.

Remember that the supply of goods and services is driven by changes in price levels which is influenced by the amount of demand for it – suppliers only want to increase or decrease their supply if there is a demand for it. This allows them to supply more goods and services in order to make a profit.

The law of demand states that – cetris parabus (all things equal) – the higher the price, the less people will demand a good or service. This can be illustrated graphically which is shown below:

Points X,Y and Z represent different goods and services available (G&S) at a particular time.

1. At X (P1,Q1)- the price of the G&S is high, so the quantity of G&S demanded is low.
2. At Y (P2,Q2)- the price of the G&S is intermediate, so the quantity of G&S demanded is intermediate.
3. At Z (P3,Q3)- the price of the G&S is low, so the quantity of G&S demanded is high.

Movements (change along the line) in demand will only occur when there is either a change in the price or quantity demanded of a particular good or service compared to original price/demand relationship. For example, assume the current demand of Soft Drink was at point Y:

1. If the price decreased, the quantity demanded would increase to point Z.
2. If the price increased, the quantity demanded would decrease and move to point X.

This relationship also holds if the quantity demanded of soft drink increased or decreased – with the price moving accordingly.

Shifts (movements of the line) in demand will occur when something other than price has affected it. Continuing the soft drink example, if the current demand of Soft Drink was at point Y and:

1. The price remained at P2 but the quantity demanded increases – the line would move to from D1 to D2 and
2. An entirely new demand line would be established in response to this change.

Shifts like this would occur if soft drink became the only type of drink available and there was no other substitute (a good used in place of another good) existing.