Global Agenda: Learning the hard way

IKGW - "It Keeps Getting Worse" - is still the watchword as we move into 2008.

stocks down 88 (photo credit:)
stocks down 88
(photo credit: )
There are two ways of looking back at 2007. One is to note that, a year ago, in the innumerable forecasts for the coming year, no one - not even the most extreme pessimist - envisaged a situation in which entire sectors of the bond market would freeze over and activity in them grind to a halt so that banks and other financial institutions would face enormous losses on credit derivative instruments. Housing slump - yes, many had been predicting that for years. Spillover of housing slump into consumer spending and hence possible recession - same. But generalized collapse of confidence in the bond market and, especially, in the money market to the point where major banks were wary of lending to each other? No one had yet envisaged that nightmare when 2007 dawned. That way of looking at the outgoing year must lead to a pretty gloomy conclusion. Yet, there is an alternative way of seeing the same facts. If, 12 months ago, any expert had been presented with a scenario of paralysis in trading and slump in values in the bond market, with consequent huge loan losses for banks, and asked to predict the impact on the stock market - how many would have said that the impact on the main indices would be marginal? That they would make new multi-year or all-time highs during the year, even after the bond and money markets went into funk, and would fall from these highs by only a few percent? The most likely answer to this hypothetical question is - none. So things are not straightforward. Rather, they are very complex. Not only was what actually happened in 2007 unprecedented and hence totally unexpected, but even explaining retroactively what took place and how we got to where we are now, in all the markets, is a hazardous undertaking, strewn with weak links in both the logical and empirical senses of the phrase. How, then, can anything useful be said about 2008? Well, maybe it can't - but that won't stop people asking the obvious questions, nor others proffering a very broad spectrum of answers. At the least, though, it seems legitimate to point to some of the things we learned in 2007 that are actually both clear-cut and provide useful guidelines for 2008, which is surely going to be another very difficult year to navigate. The first principle to be reconfirmed in 2007 was that "if it seems too good to be true, it is." In the early months of the year, all measures of risk in the bond and credit markets were at unprecedented low levels, as if investors had decided that accepted risk premia were an anachronism in the 21st century. They soon learned that risk was alive and well, and that those who had discounted it had made a very serious miscalculation. We also discovered that risk has an elder brother, called uncertainty, which is much worse for the markets - because risk can at least be calculated and priced in, while uncertainty cannot be accounted for at all. It, therefore, causes markets to stop functioning altogether. The next important lesson to emerge from the debacle of 2007 is that "denial is not just a river in Africa." For most of the year - and even now, in many cases - many people refused to accept that their comfortable assumptions, their complex models and the very viability of their jobs and firms, were being shot to pieces. This syndrome affected not just condo-flipping speculators in Miami, but was rife in the biggest financial institutions and permeated right to the very top. There is still a general reluctance to accept that the excesses of the housing boom ensure a prolonged housing slump, much less that that the greed-driven piling up of leverage on a rickety base of reckless lending has resulted in a systemic meltdown, with potentially horrendous consequences. Finally, and perhaps most immediately useful, is the application of the basic adage that "the trend is your friend" to the developing crisis. A few months ago, I suggested the term "IKGW" - It Keeps Getting Worse - as the simplest slogan to use in following the crisis. Since then, things have indeed deteriorated, but those commentators who live not in denial but rather in reality, have consistently marked down their forecasts in line with, or even faster than, the decline reflected in the latest data. In other words, IKGW is still the watchword as we move into 2008. Given that brutal fact, caution, risk avoidance and, above all, liquidity, must be the key guidelines for entities of all sizes, for the foreseeable future.