No Comments Written by Anthony Truong on May 27, 2008 – 3:55 am

The following reader comment/question is in response to yesterday’s article, which itself was a response to a few Daily Reckoning and Money Morning articles.

Question: Daily Reckoning/Money Morning are only suggesting a possible decoupling event due to current world happenings, but are unsure of this themselves. Don’t worry, every other newsletter they have refers to what you’re saying and how there’s more to come. But what they are more concerned with is how damaged we are going to be coming out of this (as well as the rising developing/emerging nations), as compared to the US who everyone knows is going to be literally screwed. Sure, global equity markets are interconnected, but some are in a better position to recover, or at least not be as affected as opposed to the US and Britain. Don’t forget, China and India’s economies are mainly driven by domestic [I think the reader meant 'foreign'?] demand, and not exposed to dodgy credit markets as heavily as others (yes yes, they are a part of the global community and might feel some impact, but I really don’t subscribe to the belief that we are all heading towards a worldwide depression). Look up India, Germany and Brazil; these countries aren’t stupid with their credit.

Shoot me – I’m an optimist!

Answer: I’ll give you India, China and Brazil (BRIC, anyone?), but not Germany. Germany is going to be flushed down the same toilet as the rest of the “Western” world. It’s various banks (Deutsche Bank being the biggest, but others exist that I can’t name right now [through ignorance]) have revealed write downs in association with the subprime mess; sure, not as bad as some US, UK and Swiss banks, but substantial nonetheless. And Germany has been one of the countries that has boomed the most since the ‘dot com’ bubble burst, i.e. it has enjoyed the credit bubble just as much as other countries (such as the US). So it can’t help but fall in unison.

Funny how I was saying in yesterday’s article that all financial markets should be considered separate and distinct, and therefore analysed accordingly. Then I went into how the credit bubble has interlinked everything! You didn’t even pick up on that contradiction. BUT it still stands as true; you can’t say that one market moved BECAUSE of another market, but markets can be affected by this one phenomenon, namely credit deflation, i.e. credit/money being sucked out of all assets simultaneously.

I’m reading “When Genius Failed” by Roger Lowenstein which depicts the rise and fall of Long Term Capital Management, a hugely successful hedge fund for 4 years before it collapsed in style and almost took the US financial system with it (due to GARGANTUAN exposures/contracts in derivatives; estimated at about $1 trillion, even though they ONLY had around $4 billion to play with [NOTE: LEVERAGE]). What facinates me is that I’m reading this book, and what happened then (mid 90’s through to the financial crises of 1997-1998) is recurring now, yet no one really notices…? The same causes of those financial crises are the underlying factors in the markets at the moment, specifically huge derivative contracts/transactions that are outstanding; no one can really quantify exactly and no one knows what will happen when a big player in these derivatives decides to fall over and default on its obligations (in holding these contracts).

Anyway, I mention this book because the author describes very shrewdly how in times of crisis, seemingly distinct and separate markets suddenly correlate and move together. This is because a trader (or anything that represents a “trader”, i.e. a bank or mutual fund or hedge fund) takes up certain positions in various markets (probably to diversify), essentially using up all his cash for these contracts, and then adds leverage by borrowing to up the ante with his trades. If just one market moves against him, because he’s leveraged he will either 1) get a margin call (as discussed previously) or 2) want to close out his position to minimise loss before the margin call is issued. Now most traders will wait for no. 1, because most will want to hold on “just in case”, until they get that margin call.

What happens when they get the call? They have to front up cash to sustain their position, so they sell other assets for that cash, i.e. one market going down then “causes” a “sell off” in another market. This is a “liquidity” issue, mind you, not a causal relationship. But then, sometimes, during a crisis or panic, investors in a mutual fund or hedge fund (or any other type of pooling of cash) ask for redemptions, i.e. they want to pull out their money. The manager is obliged, but how does he find the money to pay them back? He sells his liquid assets; when more investors want their money back, he has to sell even more assets. Hence everything becomes interconnected in a panic; bonds, stocks, gold, treasuries, whatever – in a panic, everything will fall together as investors scramble to get back their money and fund managers scramble to return that money.

It’s what happened to Long Term, although they ignored the early warning signals. In one month in 1998 I think it was, they lost over 6% of their capital in that single month, yet they thought it was a “healthy correction” that they needed to have (up until then, they had a virtually untarnished trading record). What they didn’t see was why their fund had lost money; it was because traders around the globe were beginning to sell off assets en masse as a panic was spreading. And Long Term was over exposed because they took on huge risks with leverage and in “diversifying” in every known financial market they could get their hands on. They thought diversification would prevent their fund from losing everything in a panic; the most it could do would rip a whole in some of their trades, but not all of them, right? They were fatally wrong, as ALL their trades went against them simultaneously in ‘98 and they lost some $4 billion in 3/4 months.

Anyway, I digress. I agree that emerging markets may not be as affected as “Western” markets that have taken advantage of the credit bubble more, but as we’ve witnessed in the Shanghai index, they won’t come out unscathed. The Shanghai index is down around half since last October’s highs. That’s worse than US and European markets. The same is true with India, Russia, and other emerging markets (I can’t comment on Brazil, I don’t know where their Bovespa index is at the moment). The problem with emerging markets is that their financial markets are not as well developed, and so experience much more severe volatility as inexperienced “investors” jump at any signs, whether they jump to buy or jump to sell. And we’ve seen (since October 2007) that many are jumping real fast to sell. Same is true with the Vietnam index, right?

Keep in mind, I’m not talking about economies here, just financial markets. They are governed by different rules. You cannot apply economic theory to financial markets; it won’t ever work. Economists have known this for decades, but all they do is tweak old theories to make up for the bits that don’t make sense.

Having said that emerging markets’ financial markets are experiencing a faster downturn than “Western” financial markets, I believe this will result in them bottoming first (I’m still of the belief that Asia is leading globally). The advantage of this is that these emerging markets have significant industries related to hard, tangible assets and infrastructure and manufacturing. These are the industries that made the US such a powerful economy through the 19th and 20th centuries; they became richer as their financial markets developed and pioneered new financial products, but they’ve become weaker in a sense that they no longer have a manufacturing base to support the “real” economy. India, China and Russia will be burnt, but they will recover earlier (not necessarily “faster”) due to the fact that they are manufacturing economies, with basic industry driving wealth, as opposed to “paper” industries (i.e. financial assets).

But when will they begin taking over “Western” nations? After the depression that the world is due to experience, perhaps in a few years yet.