Thursday 2 October 2008

Understanding the Boom and Bust Cycle

This is now the third economic crash I’ve lived through in the past 11 years. My first one was the 1997-1998 emerging debt default, which as people may recall led to a total collapse of some currencies, including the Russian Rouble. At the time, my company was advising on a number of investments in Russia and the former Soviet Union, and I remember well the difficulties my clients had: their debt and raw material purchases were usually denominated in US$; most of their sales were in local currencies. The fact that capital dried up overnight and their local currencies devalued against the dollar was a double strike of major proportions.

My second crash was the crash in 2000-2001. Nearly every week in 1999, a business plan would land on my desk, with yet another idea to revolutionise some aspect of the economy by migrating it online. The problem was that everyone wanted to buy a Ferrari with someone else’s money, but couldn’t figure out how they would pay that money back.

I remember teaching a ecommerce course to executives in Cyprus. I made the comment that if you are going to go online, make sure you know how you will make money, because most online ventures are losing it. The disbelief and reprobation at my comment was nearly universal, and it was most pronounced by one insurance executive who stormed out of the room in protest.

The third crash, real estate, has been a long time coming, and so many people have warned against it. It was Robert Schiller who coined the term “irrational exuberance,” later used by Alan Greenspan in his 1996 speech at the American Enterprise Institute. Any objective price analysis in major urban areas in the United States, London, Paris, or other major cities in the past 3-5 years has usually shown that the price-value relationship is overvalued, particularly when total costs of ownership are taken into account.

I’ve been warning my clients since 2006 to guard their capital, scale back, watch out for leading indicators in their source markets (mostly US and UK) for higher inflation and higher interest rates: these are the advance signs of a crash. Most of them did not listen.

What have I learned from the boom-bust cycle? They tend to follow five phases:

1. Early Innovation
There are good profits to be made through innovation. Whether this innovation is sparked by a company like, which pioneered online book sales, or the Cypriot farmer who sold his land outside Paphos and bought a Porsche, it's clear that at the first stage of the cycle the economic returns are far in excess of any capital invested or any risks involved.

2. Mainstream Acceptance (Jumping on the Bandwagon)
In this stage, the sector and business model in question enters the mainstream. Time, Fortune and The Economist all run features on it as an exciting new field. Coverage branches into hagiography: Jeff Bezos, Captain of Industry.

3. Institutionalisation
In this stage, the boom has become institutionalised. Goldman Sachs develops a separate unit with offices in New York, San Francisco, London, Tokyo and, yes, Moscow, to manage the money they are making. Harvard Business School launches classes on the subject; INSEAD develops a new department. Everyone and their uncle is involved, starting a hedge fund or selling lingerie online. When your taxi driver is giving you tips on what shares to buy, you know a crash is imminent.

In this stage, economic returns are created by economies of scale and sophisticated trading and asset management techniques: much value is generated by foreign capital and late investors who don’t really understand what they are signing onto. The institutionalisation phase is also characterised by the gaudiest and most ostentatious consumption possible: think of Dennis Kozlowski’s $ 6,000 shower curtain, or Enron’s strip club lunch breaks.

This is also typically where you have near-constant references to "a new paradigm," "a revolution in ____ (fill in the blank)," "new horizons," "emerging opportunities in the growth markets of the future," etc. This is often hyperbole cheerleading a trend who's main potential is behind it, rather than ahead of it.

4. Desperation and the First Panic
By this stage, so much money is chasing so few investment opportunities, that the potential for producing an economic return to cover cost of capital and risk is difficult or impossible. Corners are cut: high valuations are justified through improbably forecasts; returns are made through high-risk bets. This is the stage where the risk of an illegal or unethical trade is the greatest. This is where companies advance-book their income, move debt to off-balance sheet vehicles, or take high risk positions. This is also where you will see the first valuation crashes: a share will lost 15-20% overnight; within a week it will have regained its value as investor see “an exciting investment opportunity at a historically low valuation.” Right.

5. Crash
The crash is when the shares of an entire sector drop, dragging the rest of the index or the economy with it. The main emotions of a crash are desperation, panic and ignorance. An observer never knows why the market is dropping; he only knows it’s dropping, and he’d better cash out as well.

The crash is when you have all the natural pessimists (about 75% of the population, in my opinion), come out of the woodwork and start the “I told you so,” and also when you have the craziest ideas surfacing: it’s the government's fault; it’s a Wall Street conspiracy to take over the world.

Politicians inevitably get involved, condemning the evil profit-makers. These are the same politicians who’ve been all too happy raking in the campaign contributions the past 7 years, and customising legislation to suit their important supporters.

Why does a crash occur? Because typically too much money is chasing too few real investment opportunities. When a market opportunity is saturated, it inevitably means that economic returns are far less than cost of capital, and in many cases less than the cost of inflation. Why? Because the innovation stage of the cycle is over; because market demand has been fulfilled; because too many competitors are driving down price; because markets have not yet adapted.

The point is that you can always tell when this point has occurred by fundamental financial analysis. The problem is that the very same people who are doing this analysis are usually the people who have the most to gain from propagating the current system. I’ve seen this up close, and while it's very seductive, it’s never pretty.

So what will come after this crash? The US Presidential Election will be held on November 4th: I’m betting Barack Obama will win. Equity values will settle in a few weeks, and start rising steadily from the first quarter 2009. (Some sectors will continue to be hit: retailers, home-builders, automobiles, etc.) The spring will bring new confidence and possibly a new bull market. It will be “morning in America” again, and as values of equities and homes begin to recover, everyone will optimistically plough their money into the next best thing.

What could go wrong? A number of things. The hedge fund sector could finally melt down. This would be a real crisis. There could be another terrorist attack, or an attack on Iran: these are likely to be mere speed bumps on the road to the next boom. That is, stock market boom.

What will that be? I’ll make two bets:

1. Renewable Energy
The Obama Administration and Democratic Congress will pass legislation favouring renewables, granting tax holidays, emissions limits and funding. Otherwise worthless tracts of the Sonoma desert will suddenly become priceless assets; little-known companies will appear with the solution to change our world. The cycle will start again. Everyone understands renewable energy: everyone loves it.

2. Biotech/Nanotech/Gene Therapy
For the first time, we are near real breakthroughs in mainstream gene therapy and the biotech/nanotech systems needed to deliver them. I’m less confident about this choice, since research is very capital intensive, valuations are already high, and big pharma is already involved. Also, it’s a terribly complex subject, and your average investor may not be in a position to evaluate it.

My advice? Be reasonable. Do the math, and do your homework. Don’t bet the farm. If you have a real opportunity, develop it within your means. All this has happened before, and it will all happen again.

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