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Paradigm Shift – Part 2

The major fall out of the paradigm shift discussed in last week’s blog has been that individuals, companies and governments have lived beyond their means fuelled by easy credit which lead to massive financial leveraging and excessive debt. Expectations have continued to get higher and higher in many facets of life including material possessions, entitlements, growth of company profits, growth of personal financial assets etc., creating a massive merry-go-round that just keeps spinning faster and faster. This human merry-go-round has been ridden many times before and has been fallen off many times before. When will we learn?

Since 2008 we have seen individuals in most ‘western’ countries curtailing spending, increasing saving and paying off debt. We have also witnessed many decade old companies going under through excessive leverage (Bear Sterns & Lehman Bros) or through waning demand. Governments are being hauled in through austerity programs. This will continue for some time to come across individuals, businesses and governments that have lived beyond their means and simply leveraged too much or not adapted to changing demand.

This process is called deleveraging. The process has occurred in varying degrees many times in the past most notably Australia in the early 1890’s, the USA in the 1870’s and most of the world in the 1930’s, all three being termed Depressions. Other minor occurrences have occurred in various countries such as Russia, Brazil, Argentina, Asia (1997) throughout the 20th century and before, as well as in the USA in the 1970’s and around the world in 1987, although quick action by the US Federal reserve stemmed fallout on this occasion. Indeed, the deleveraging process that we are in right now is by no means over. Debt to GDP ratios in many countries are still too high and some are still growing their debt (Australia). The economic woes of European countries have been almost a daily saga in our media for the last 2 – 3 years.

In the three big occurrences of deleveraging since the late 1890’s the process has taken between 9 and 17 years to play out. How long it will take on this occasion is an unknown. There are too many variables involved in each situation, some common and some totally different, to be able to use the past as an exact predictor of what may happen this time around.

On a totally separate and more technical but very necessary tangent, we need to look at secular bull and secular bear periods over the last 100 years in equity markets.

Secular bear markets are intertwined with the discussion thus far as the fundamentals of the human paradigm shift (discussed last week) back and forth over long term cycles creates the financial fundamentals that plays itself out in price movement in the financial markets.

It could be stated that there have been three secular bull markets and three secular bear markets over the last 100 years and that we are in the middle of the fourth secular bear market at the moment.

The last major secular bear market lasted two months shy of 17 years from January 1966 to November 1982. Then there was the March 1937 to January 1950 (nearly 13 years) and January 1906 to November 1924 (nearly 19 years) occurrences. The current secular bear in the USA started in January 2000.

Much research has been put forward about cycles and their cause that you can research in your own time, one cycle being the 17 – 18 year cycle. It may be that we are around 12.5 years through one of these cycles remembering that such analysis is not an exact science.

Whilst secular bear markets may not necessarily coincide with a period of deleveraging they typically are caused by falling company profits relative to company share prices (i.e. falling PE Ratio) which may be caused by any number of variables, including deleveraging.

You may wish to review cycles on the CPI adjusted S&P500 PE Ratio, more commonly known as the Shiller PE Ratio: – again the 17 – 18 year cycle plays out here too indicating a similar picture to the secular bear market picture painted above.

As an investor all this big picture stuff is important because it can help us understand what is happening but more importantly helps us determine what investment strategies we might be able to deploy for the different cycles. Ideally you want to use strategies that work in secular bull and bear markets without needing to chop and change strategies. This is so because:

  1. Secular bull markets do not rise in a straight line. The 1987 crash occurred right in the middle of a secular bull market!
  2. Secular bear markets do not necessarily fall, they track sideways in a very wide range to revert to the ultra-long term trend (unless there is total system failure) while potentially having index moves of -60% to over +100%.

In trying to determine what the future may hold, economists the world over are divided between whether the world economy will experience an inflationary or a deflationary period in the coming years.

In using past hyperinflationary and inflationary periods such the Germany post WW1, the Great Depression in the USA in the 1930 and the high inflation of 1970’s, economists can be very convincing that the massive printing of money that is taking place in the USA and Europe will lead to hyperinflation. However, there are also economic arguments based on massive falling in demand that can be equally convincing that we will enter a period of deflation. Which will it be?

Do we really need to know? As investors are we in the game of predicting? In my view we do not need to know and we are not in the game of predicting. What will be, will be. There is a far more liberating way of facing your investing future without the worry of what may happen and needing to take a side. “You do not need to know what will happen next in order to make money.” (Mark Douglas)

The most objective way of determining what is happening in the now and how humans collectively react to the fundamentals discussed above is to closely watch the movement of price on financial markets as it unfolds and to react to that. Many try to get ahead of the markets and predict what may happen based on the fundamental variables that are at play. The problem with this is twofold:

  1. There are just too many variables, fundamentals and otherwise, at play most of which will be unknown to any given player at any level in the game to predict with sufficient certainty, and
  2. Even if one did know it is an unknown as to how collectively human beings will react and, more importantly, to what extent and when.

For these reasons beware of getting influenced by ‘stories’ written in emotive language by quality copy writers about what may happen and what you must do with your money. If the arguments are too compelling for you to resist ensure that you only bet with small percentages of your capital. Some stories will be winners and some losers but nobody knows in advance with any certainty which will be winners and even more importantly, when.

Next week we will get into strategies.


One Comment

  • owen johnston says:

    as an 84 year old, I can remember the 1930’s depression. I can still see ” swaggies” coming onto our farm near Casino NSW. My mother a Welsh migrant from the coalfields never refused a meal & a bed in the barn. She or my Irish father never expected any work in return but never refused, if it was offered as we had a dairy of some 120 cows that needed to be milked by hand twice daily & 1200 acres to be farmed. That farm educated 3 sons to University standard- we left the LAND NEVER TO RETURN – I hope & pray that our governments are wise enough & have sound sdvisers, NEVER to let such a set of circumstances ever occur again. y/s Dr Owen Johnston B.V.Sc

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