Sunday, January 30, 2011

Will Monday Morning Show More Blood in the Streets and Contagion?

Most of the time writing a blog on a Sunday for Monday consumption is a relatively low risk endeavor. Not today. The riots in Egypt (with some echoes in other Arab countries) are building to a climax that can frighten or relieve market participants Monday morning. More likely the surface political issues will not be settled and the underlying causes of unrest will not be really addressed. Nevertheless, those of us in this blog community have an obligation to act responsibly for our portfolios. Perhaps one of the few benefits from these events is to follow the dictum of the President of Caltech and others, not to waste a crisis as a motivator for fundamental change.

What have we learned?

Ever since Vietnam, the ultimate outcomes of war have been manipulated (or if you prefer, directed) by people viewing various actions on their home screens. In this more modern age, the home screen is increasingly a computer or smartphone screen. The regime in Egypt is probably mindful that the Iranian revolution was sparked by smuggled audio tapes imported surreptitiously and played in darkened rooms which spurred the unhappy into action. Today’s response is to pull down the country’s Internet and social network sites, rallying many young people to stream into the streets and squares.

The first lesson here is to more fully appreciate how electronic communication is reshaping our world politically as well as economically. For us in the investment world, we should understand that the Internet and smartphones are the new electric and gas utilities of our era, as their services have become essential to billions of people. While some of the providers run significant technological risks, there is little risk that the demand for communication services will decline. This suggests that there is some form of guaranty of activity similar to what made electric transmission and gas pipeline stocks and bonds more attractive than their industrial competitors for investors’ capital.

The second thing that I learned on Friday is that not a single market pundit that I know identified a general market risk of a disruption in Cairo. Risk managers were once again unaware of these risks. True, many of us were nervous as to the acceleration of bullish statements being issued by many pundits. Some of us were nervous and curtailed purchases, but none that I know accelerated sell programs. From a technical viewpoint, the January gains masked some deterioration.

A similar situation occurred in the week before the assassination of JFK. The internal structure of the market was weak due to fears of additional brokerage firm failures coming from the Salad Oil Scandal. When the announcement of the tragedy in Dallas was made, buyers disappeared except for some brave and foolhardy specialists on the floor. Sellers dumped positions fearing a possible coup d’├ętat. Following a nervous weekend, the markets rallied.

Asset allocation in times of crisis

If there is a bad perceived outcome on Monday, most portfolios will decline in value and the correlation (at least in terms of direction of the various allocations) will be similar. The appeal to most investors of asset allocation is that it creates diversification, which is meant to lower the overall risk of the investor. One of the lessons of the sharp market movements over the last two years is that price movements of many different types of assets moved somewhat in lockstep. I suggest that normal asset allocation today is not a major help in risk reduction. What may well be of better use is the selection of advisors and analysts that see the future quite differently. Some bearish inputs can help a long biased portfolio. In theory, this is one of the benefits that could be derived from various long/short hedge funds. My problem with the execution of this strategy by many managers is that the bull and bear segments’ price movements go in the same direction, perhaps at different speeds. In the equity world I have seen very few short portfolios producing worthwhile gains in down markets. (This is not necessarily the case in the fixed income world.)

Most investors find it difficult to hold contrary points of view within a single managed portfolio. One of the advantages of investing in different types of mutual funds within a client portfolio is that we can have extreme portfolios within a single account and vary the commitments to the extreme in anticipation of future market moves.

What will we be looking for on Monday?

One of the quotes attributed to Lord Rothschild is the time to invest is when there is “blood in the streets.” We will see whether there is a large coterie of opportunist buyers snatching up bargains in various, largely Middle Eastern markets. On the other side of the coin is the possibility of repeating the experience from the Russian defaults on treasuries that tipped over Long Term Capital Management and potentially much of the Wall Street trading community. Emerging Market traders who quickly needed to restore their capital balances after the recognition of the Russian losses, sold whatever they could out of their other emerging market portfolios. Thus, the Russian default led to slumps or collapses in many Latin American markets. The term for this rapid transmission of risk is contagion. This brings up a need to avoid investing in markets that are dominated in terms of trading from the same sources. When we wake up on Monday, I will be curious as to what level of contagion is visible in the Far Eastern markets, who will have a half trading day advantage over the Mid Eastern markets and a full day on the US markets.

What are your thoughts and learned lessons from the streets of Cairo?

P.S.: “Egypt Today, What it says about the region”

As few securities analysts read the Marine Corps Gazette, I would like to pass on a few of the points made in an article from the February edition, as it explains a number of the reasons we saw the five days of rage in Cairo. In the article by Lt. Col. Edwin O. Rueda, the following points were made:

  1. The perceived stronger, better Arab armies in the 1967 war with Israel lost because of the Arabs' “lack of religious fervor.”

  2. There is a sense that Egypt is the center of the Middle East both geographically and politically. It should be treated that way. There is the perception that the United States does not seek Egypt’s advice in dealing with the Arab world.

  3. Many people admire the western model and would like to move closer to the west, but they are afraid of not supporting the Egyptian way.

  4. There is an enormous economic gap between the wealthy and the poor.

  5. An enormous part of the population is without hope of anything better for them.

  6. “Loss of face” is critical in Egypt’s machismo society.

  7. Arguments/discussions are based on perceptions, often sourced from “word of mouth” or Arab media. No credence is giving to “facts” as we know them.

I will be happy to email the full article if you contact me.
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1 comment:

Andre Sharon said...


I have never contributed to a blog before, so you'll have to be patient. I can't even find the space to post a response! Perhaps you can cut and paste this for me, since I'm too much of a technophobic Neanderthal to do it myself.

It may be just as well that I'm reacting late --- i.e. after the market closed on Monday. Confounding all logic, the market closed UP. It is either clueless, or else very smart, confirming the adage that one should buy at the sound of cannon and sell at the sound of trumpets. Likewise, gold, supposedly the ultimate safe haven, has bee relentlessly declining since the beginning of the crisis in the Arab world. Go figure. I can't, unless it's the prevailing idea that cash is trash and needs to find an outlet in financial assets rather than the real world.

The risks in developments in Egypt are huge. It is not only the dominant and most populous Arab country (some 75 million, with approximately 19 million in Cairo alone), but by far the most influential, politically, culturally, and militarily. It is at the crossroads of three continents. It also contains the Suez Canal, critical for transporting oil from the Persian Gulf, as well as Western trade with India and the Far East .

It is also a poor country, with few natural resources. It fits the description of an oasis: a place in the desert where water exists. Herodutus' observation that " Egypt is the gift of the Nile " is apt.

But other countries with few or practically no natural resources have survived and even prospered ---- think of Japan and South Korea . Indeed, there is a commonly cited statistic that is worth pondering. When Gamal Abdel Nasser came to power in 1952 after overthrowing King Faruq Egyptians were rightly proud, correctly saying that this was the first time since the Pharaohs that a native son of the Nile was in charge of the country, and would set free its creative energies and potential. At that time Egypt 's per capita GDP was the same as South Korea 's. Today South Korea 's per capita GDP is nine times larger than Egypt 's. There are many reasons for that, but for the most part you won't find them in academia or the media pontificariat.

Not that we're doing to brilliantly in the States or in Europe , in my opinion, as we continue to collectively avoid painful self-confrontation after some 50 years of self-indulgent living beyond our means.

My own pusillanimous asset allocation: (proportionately) a high percentage in cash , commodity and natural resource equities, gold mining stocks, exposure to emerging market consumption and infrastructure, selected technology stocks, and high dividend paying equities. Not as smart as it looks: the cash has a negative real rate of return but allows me to sleep at night, amazingly the gold mining vehicles historically leveraged to the gold price have underperformed the metal in recent periods, and the simple emerging market consumption thesis have proved disappointing during the past six months ---- one would have been better off in U.S. multinational participants.

Andre Sharon