Apocalypse Dow

By Tim Price | October 10, 2008 | 9:30 AM | 0 Comments

"This notion that great misadventures are the work of great and devious adventurers, and the latter can and must be found if we are to be saved, is a popular one of our time. Since the search for the architect of the Wall Street debacle, we have had a hue and cry for the man who let the Russians into Western Europe, the man who lost China, and the man who thwarted MacArthur in Korea. While this may be a harmless avocation, it does not suggest an especially good view of historical processes. No one was responsible for the great Wall Street Crash. No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of thousands of individuals. The latter were not led to the slaughter. They were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich. There were many Wall Streeters who helped foster this insanity, and some of them will appear among the heroes of these pages. There was none who caused it."

-       From ‘The Great Crash: 1929' by John Kenneth Galbraith.

 

"Senator Couzens: "Did Goldman Sachs organize the Goldman Sachs Trading Corp. ?"

 Mr. Sachs: "Yes, sir."

 Senator Couzens: "And sold its stock to the public ?"

 Mr. Sachs: "Yes, sir."

 Senator Couzens: "At what price ?"

 Mr. Sachs: "At $104. The stock was split 2-for-1."

 Senator Couzens: "And what is the price of the stock now ?"

 Mr. Sachs: "Approximately $1 ¾.""

 

-       From Senate hearings in 1932, and cited in ‘The Great Crash'.

Perhaps the biggest mistake Goldman Sachs ever made - other than launching its eponymous investment trust in 1929 - was its decision to go public in 1999. That enabled the former partnership to retain employees otherwise then being enticed by the prospect of dotcom riches, by means of share options and restricted stock. But it also turned a tightly focused private partnership into a public company. That involves a loss of independence. And as Chris Dillow recently suggested in a Times article ("Why aren't hedge funds failing as fast as banks ?"), the current crisis is as much one of ownership as of finance:

"It is not markets that have failed, but a peculiar form of ownership that we have taken for granted for decades - stock market-listed companies with dispersed shareholders."

As Chris points out, the succession of hammer blows to the market this year have come from stock market-quoted companies, not from hedge funds - which, despite the misplaced mudslinging from the more wilfully ignorant members of the financial press, are largely blameless bystanders in this colossal drive-by shooting. That is not to say that hedge funds will be immune to the ferocious deleveraging gale blowing wildly round the world, not least as the implosion of investment banks and reining in of credit provision may prove terminal to more highly leveraged strategies and funds. But in Chris' opinion (which I very much share), the principal-agent problem is at the heart of the crisis:

"Big, quoted companies have been unable to solve this problem. Shareholders - often, ordinary people with pensions - have little control over fund managers. Fund managers have little control over chief executives. And chief executives have had little control over trading desks, partly because they just didn't understand the complexities of mortgage derivatives.. In hedge funds [for example] things have been very different. Very often hedge fund managers invest their own money and take key decisions themselves, or at least closely watch those who do. Their incentives to take huge risks have been smaller. So these have at least survived [in general].. What we're seeing, then, is the cost of separating ownership and control. In private firms, or partnerships - even limited liability ones - the two are closely aligned. In stock market-quoted firms, they are not."

Maybe Goldman Sachs (which by now seems to have become a placement agency for the US administration) and Morgan Stanley survive as the last remaining former investment banks. Maybe they don't. But if they don't make it through this crisis, expect an orchestra of the world's smallest violins to play to their demise. The taxpayers of the world are in no mood to indulge the whims of (what's left of) Wall Street any further.

But the search for scapegoats has to be relegated behind the urgency of shoring up confidence in the financial system. By all accounts the UK's bailout plan, revealed this week, takes the right tack. It seems increasingly likely that other countries will follow a similar interventionist model. But what is needed is coordinated action as opposed to piecemeal band-aid flinging. This weekend's G7 meeting is an opportunity to prepare such action.

As Redburn Partners point out, the Dow Jones has now racked up the worst 12 month performance since 1932. The MSCI World Index has recorded its worst weekly fall since records began. When does it end ? There have been plenty of false dawns throughout the crisis but the UK rescue plan has ignited a glimmering of light at the end of the tunnel. But it needs bold and international follow-through. We will know that the low is in when the market stops going down after being hit by new bad news. For investors with some semblance of a balanced portfolio, it seems late in the day to be capitulating now and fleeing the stock market. Die-hard contrarians would be selectively buying (pharmaceuticals; consumer staples; the more solvent banks; telecoms; utilities). Gold still makes sense. Gilts still make sense in a big way as inflationary pressure subsides and the likelihood of slashed interest rates builds. Taking the longer view, the ‘BRIC' countries - notwithstanding the likely hit to the global economy over the next few years - are still better positioned to deliver growth ; G7 economies will be close to exhaustion for some while yet. "The only thing we have to fear," says ‘The Onion's re-imagined 1933 US President in his inaugural address, "is a crippling, decade-long depression". By all means have the witch-hunt. But do the triage first.

 

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