October 4, 2010

We are in a tricky spot right now in the global economy. This is not one person’s, one group of people’s or one institution’s fault. It is the fault of all of us. Enough of us believed that the good times would last forever, that prices would continue to go up because they had, that we could have whatever we wanted, immediately. The damage happened when enough people assumed that the good times would continue, and made choices that relied on that judgment. But too much money spoils even the best trade. We forgot to put away something for a rainy day. We forgot that unexpected events happen. A heck of a lot of people, no dummies either, bought into this mentality. Hook, line, and sinker.

This current economic backdrop has been building for a generation, fanned by positive feedback loops, backed by a desire on all of our parts that it be true, that it not go wrong, that the music keep playing and we keep dancing.
Another way of looking at our current situation is that we forgot one of the classic investment and economic concepts: what is good for one individual isn’t good for the whole population. Let’s consider an example. If every company wants to pay their CEO above average, the average will inevitably increase dramatically. Rational decisions carried too far led to an unsustainable outcome. This type of excess happened in all parts of the economy and markets. A good idea was taken too far. Again and again.

The Big Risk

The ever-stimulating Economist magazine recently compared finance to plumbing. Most of the time, you barely notice it’s there. Until there’s a problem, and then it stinks. It is inconceivable to think that modern society could exist without a functioning financial system. So the governments of the world have a fundamental problem. They know we need to unblock the financial system, even if that bails out the most visible culprits who got us into this mess in the first place (remember, we are all partly to blame, as mentioned above).

The difficulty is that the financial system is based on confidence. We cannot all get our deposits back at the same time; banks just don’t work like that. We cannot all be bailed out by the government. They can bail out a few, make the rest feel safe, but they can’t do it for everyone. Government is an offshoot of the people, not the other way around, as there are many more people and much more wealth in the private sector. We are now realising that there are problems, serious problems, and cracks are starting to appear in the wall of confidence. As we said in an earlier paper, “Confidence will survive a battering, but once lost, it is very difficult to recover” (see December 2007 Thinking Aloud Paper – Why Hold Gold ). This puts the governments, and all of us, in a very tough spot. What can we do to restore confidence when everyone has an incentive to try to take their money out of the bank first.

The US has been especially active in trying to do everything possible to help restore confidence. Hyper-active it has been said. They think that confidence might not be completely shredded and that they can find enough fingers to plug the leaking water dykes. What worries us most at Kennox is that this may be impossible at this time. Maybe the expansion went on for too long, stretched too far. Maybe it is similar to Napoleon or Hitler marching on Russia –they both gained a lot of ground but, once they started retreating, it was inevitable that they had to collapse back an enormous distance. Too far from Rome, the legions lost the strength of their proximity to each other and to fortified positions. Sometimes there is a point of no return.

We applaud Misters Paulson and Bernanke for their actions. These steps are necessary and desirable to restore confidence. At the same time, we observe the greatest risk they face –that they are trying to defend over-extended borders; that they are trying to protect asset prices that are over-inflated. The banks’ balance sheets rely on the underlying asset values. If these asset values are too stretched, then protecting the balance sheets now is using up fire power very early in the battle.

Bubbles don’t often slowly deflate, they tend to pop. If we witnessed one or many bubbles recently in the economy, then drawing this line in the confidence sand, saying this is where the US government will not allow its enemies to cross, is a risky proposition. This is protecting an undefendable border. The Irish government’s recent actions are a helpful example. In guaranteeing all deposits and loans for the countries biggest banks, they are attempting an audacious bluff: the €500bn+ that they have guaranteed dwarfs the €165bn GDP of Ireland. The biggest risk of all is that those calling the shots miscalculate where the battles should be fought.

The Cycle

Boom and bust are a part of human psyche. People get comfort from the actions of their neighbours and companies from the actions of their competitors. How much easier is it for the Board of Directors to go into a new business segment when others have been doing so for ages, and making huge profits  Then there’s the famous saying: Nothing is harder than watching your neighbour get rich. And so people gave up their jobs and became day traders in the late 1990s in the tech bubble. The better the shares do, so more people buy them, so the shares do better, etc.

That positive feedback comes from the tendency for people to do what everyone else is doing. Which works, so long as everyone else keeps doing it. “Debt has been increasing in the US for 20 years and it hasn’t hurt us yet, why should it now “; “You could have made that argument last year, or the year before, and you’d have been wrong both times”–these lines of reasoning go on and on. This mindset leads to the behaviour that makes unsustainable booms. And at some point, the boom runs out of “greater fools”to buy the expensive assets. At some point, everyone who has been investing and buying sees that everyone else is cutting back and saving, and does the same. What follows is a contraction, as sure as night follows day.

There is discussion (especially now) as to whether recessions are a necessary evil. We believe they are, as they put a check on the excesses and mistakes of the last expansion. And “what doesn’t kill you makes you stronger”. Those that survive recessions emerge more productive and go on to help fuel the next expansion.

We at Kennox are firm believers in the cycle, and we have been bearish for a long time now. But we don’t believe the world will end (it could get nasty along the way though). The outlook will be uncertain as fear takes hold, but, at some point, the downturn will right itself due to forces of economics and human psychology. Excess capacity will be shut down, asset prices will fall back to the point where investment is profitable again, entrepreneurs will see opportunities and have the guts and financing to take advantage of them and the economy will flourish again. We are as comfortable making this prediction as we were that the good times were not here to stay.

So we at Kennox will continue to look for companies that we feel will be in business in 5 and in 10 years and look to buy them at a discount to a conservative view of their assets or of their future earnings. We’ll keep a margin for error, on both the valuations and on the speed at which we use up our liquid resources. This tricky spot too will pass, as others have before it, but we have as much confidence in our ability to predict the timing as ever –not much.

Authorised and regulated by the Financial Conduct Authority (FRN: 475658)
The Company is based in Scotland, UK with the above registered address (Registered Number: SC302037).

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