Delusion, Debt and Defence

debt and deficits
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The US market gave up some ground last night. The Dow was down 110 points…neither here nor there. Gold and oil were both steady.

The big news in recent days has been the surge in the ore price. China, as reported in the Financial Review, has fallen off the structural reform wagon:

…the [Chinese] government indicated it stands ready to roll out other stimulus measures to meet targeted growth of 6.5 per cent between 2016 and 2020.

The markets — initially — loved this hairy chested pronouncement. But what will be the cost of relentless drive for growth?

According to Michael Pettis (Professor of finance at Guanghua School of Management at Peking University in Beijing) in his excellent blog post of 25 January 2016 (emphasis is mine):

Chinas most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt. In fact it doesnt really matter if China is able to report growth rates for another year or two of 7%, or 6%, or even 8%. If the only way it can do so is by allowing debt to grow two or three times as fast, there will have been no improvement at all, the economy will not have adjusted, and Chinas longer-term outlook will be worse than ever.

Going deeper into debt to provide the illusion of growth is a failed strategy. Exhibit A — Japan.

We (as in the major global economies) are all on the same debt-funded economic growth staircase to hell…it’s just that some are leading and some are lagging.

Resorting to the ‘tried and failed’ is China’s easy option. It buys time. Procrastination feels good. Nowadays, ‘don’t do today what you can put off until tomorrow’ passes for responsible economic management.

From Beijing to Brisbane and Shanghai to Sydney we’re all participants — willing, unwilling and blissfully unaware — in this global Ponzi scheme.

Creating the illusion of growth stabilises markets — for a time. In recent weeks we’ve witnessed markets recover some lost ground. The ‘buy the dip’ crowd are out there saying ‘I told you so’.

Last night the local news channel ran a segment on how to get more out of your superannuation. The in-depth (2 minute) report left the viewer with the impression the preferred option was to switch into an aggressive fund — one with 80% plus exposure to shares.

The standard financial planner sound bites — shares for the long term — were inserted to give some level of authority.

Because the world is going deeper into debt and delving into negative interest rates to support a flawed growth model, it is less safe to invest in shares.

As Pettis rightly points out, going further into debt to create a headline number means the ‘longer-term outlook will be worse than ever’.

Macro Business reported on29 August 2012, ‘Pettis: Hard commodity prices will halve in 2 years.’Based on his analysis, Pettis warned Australian mining executives they should prepare for a significant fall in commodity prices.

His warning was ignored. Mining companies have paid a huge price for their ignorance.

Investors should heed Pettis’s latest warning.

Now is not the time to buy the dip. Now is the time to be selling into any market ‘recovery’.

We are on a stairway to economic hell and no one — least of all our so-called leaders and financial experts — is showing any signs of changing direction. China’s announcement is the equivalent of bounding the staircase three steps at a time.

In the last 30 years the share market has incurred three corrections of 50% or more. The next correction promises to be far worse because of the delusion over the debt malaise. To think you can grow debt indefinitely without serious consequence is the grandest of all delusions.

When reality hits it’ll be the ‘mother of all corrections’. China may have bought some time, but they have not made the world a safer place to invest.

Last night’s news segment on superannuation sent me searching for the counter argument to the one they reported.

On 13 August 2014, I wrote an article for The Daily Reckoning titled How to prepare for a possible 90% market correction

Here’s an extract that I hope provides you with some balance on how best to allocate your precious capital in the coming years:

Besides the usual ‘cant happen; ‘youre nutsand ‘what rubbish responses, not one person has been able to refute the historical facts and mathematical calculations [that a 90% correction is possible].

The prevailing mentality is one of ‘it simply wont happen because…(pick your reason: its too preposterous to even contemplate; the Fed wont let it happen; the Fed will start QE again; markets are different today; theres too much money on the sidelines waiting to buy; companies will never be that cheap.)

Thats the sum total of the naysayers argument against a catastrophic fall. These are statements of hope and absolute belief in the Fed. Now which one of us is nuts?

Your investment strategy must be well reasoned, suit your tolerance for risk and reflect what stage of life you are at.

My investment motto is “winning by not losing. Sounds simple, but it took years to figure this out.

The ferocity of a historic bear market can wipe out years, even decades, of gains in the blink of an eye.

For me, successful long-term investing is more to do with avoiding catastrophic losses than it is do with capturing unrealised gains.

Heres the maths to support the “winning by not losing” premise:

% LOSS % GAIN REQUIREDTO OFFSET LOSS
50% 100%
60% 150%
70% 233%
80% 400%
90% 900%

Every 10% of losses requires an exponential level of gain to recover. It can reach the point where the losses become so great, recovery will never happen in your lifetime.

In the space of 18 months the GFC wiped over 50% from the Aussie share market. The All Ords is still languishing some 20% below its 2007 peak. Seven years and still not back to break even. You have to wonder how many more years it will be before the 50% loss is finally recouped?

If you think thats a tough question to answer, then try contemplating how long it would take to recover from a 90% fall? My guess is several decades.

Therefore the preferred strategy is to sidestep the majority of the losses and participate in the majority of the recoveries. This is easier said than done. Which is why having well defined investment guidelines is imperative to assist in achieving this objective.

When formulating my long-term investment strategy the wisdom of Ray Dalio has been invaluable.

Ray Dalio is the founder of Bridgewater Associates (the worlds largest hedge fund managing US$150 billion). He is a seriously successful businessman and investor. Forbes estimates his net worth at US$15 billion.

In 2011 Dalio released a 123 page paper titled: Principles— which outlined the principles that have guided his tremendously successful life.

The Introduction begins:

“Principles are concepts that can be applied over and over again in similar circumstances as distinct from narrow answers to specific questions. Every game has principles that successful players master to achieve winning results. So does life. Principles are ways of successfully dealing with the laws of nature or the laws of life.

“The five critical steps in the process for success are:

  1. Have clear goals.
  2. Identify and don’t tolerate the problems that stand in the way of achieving your goals.
  3. Accurately diagnose these problems.
  4. Design plans that explicitly lay out tasks that will get you around your problems and on to your goals.
  5. Implement these plans—i.e., do these tasks.

 

“Here’s a brief summary of how these five steps have aided the development of my strategy to successfully deal with the laws of the market.

“Have clear goals – Avoid capital destroying losses. Investments must satisfy the low risk/high reward test. Any investment must be transparent without any hidden surprises – know exactly what you are investing in. Do not chase a specific rate of return.

“Identify and don’t tolerate the problems that stand in the way of achieving your goals – The major impediment to long term investment success is self discipline – losing patience with your strategy; not sticking with what you said you were going to do; not doing sufficient research; ignoring the asset allocation suitable to your risk profile. The likes of Buffett and Dalio are successful because they adopt a highly disciplined approach to investing and stick to their ‘knitting’.

“Accurately diagnose these problems – Nearly thirty years in the investment business has provided me with plenty of time to analyse where people have gone right and gone wrong. Over-confidence, lack of self discipline, investing in opaque investments and following the herd pretty much constitute the major problems that lead to investment failure.

“Design plans that explicitly lay out tasks that will get you around your problems and on to your goals – Continually question your assumptions. Read a variety of opinions from independent sources with sufficient experience to make insightful and constructive commentary. Regularly review the premise of your strategy and the investment selections. Remain humble and realise your place in the world. Evaluate the market against time honoured valuation measures – Tobin Q, Shiller PE 10, Market Cap/GDP ratio etc. Remind myself that markets are going to do what they are going to do in their own sweet time.

Implement these plans—i.e., do these tasks. Every single day is committed to assessing the progress towards my investment goals.

“Any investor who identifies with the philosophy of ‘winning by not losing’ needs to ask themselves: ‘what level of loss can I handle before my lifestyle and/or retirement dreams are affected?’

“Here’s a table to assist you in determining the range of exposure to shares depending upon how tolerant you are to losses. Naturally if you cannot afford to lose anything – cash up now.

LEVEL OF LOSS EXPOSURE TO SHARES
10+% 15% to 20%
20+% 30% to 40%
30+% 40% to 60%
40+% 60% to 80%
50+% 70% to 100%

“If you suspect the next market downturn could be a real doozy, then go with the bottom end of the exposure range for the level of loss you are comfortable with i.e. a 30% exposure for a 20+% loss.

“If the market continues to rise, take profits (pay the taxes) and re-balance your portfolio back within the exposure level you are comfortable with.

“This disciplined approach is how you sidestep the majority of the capital destroying losses and leaves you with sufficient capital to bring to the bargain basement asset sale.”

Now is the time to work out your defence against a possible market rout zero the likes of which we have never personally experienced.

The fact that most people say it can’t or won’t happen, is precisely the reason why it’s a very real possibility.

There are times to be aggressive and times to be defensive.

For me, defence is the best strategy at present.

Vern Gowdie,

For The Daily Reckoning

Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.
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