Global financial markets, or the kite that would never break

Credit: Canadian Kites

When I was a kid, I had a kite. I could spend hours playing with it. It was one of those dual-line prism kites that you control with two handles and that look like a wing. I could spend hours playing with it. Of course I would crash my kite most of the time on the beach and, to the untrained eye, it looked like I broke it at every crash and that it was not very robust. What was happening was precisely the opposite. To prevent the kite from breaking permanently at every crash, the pieces were assembled together but not to tightly, such that at every crash, all I would have to do is put the pieces back together, but it never broke.

Why am I telling you this and what is the link with financial markets? Because what central banks have been doing ever since the financial crisis happened in 2008 is the exact opposite: they have been tightening the pieces together as strongly as they could in the hope that the system would not break in the event of a new crash. Sure in the short term it helps as the system does not break (at all) when faced with mild uncertainty, but come the more violent shocks, the system is at risk of breaking beyond repair.

A dangerous experiment

So what have central banks done since the 2008 crisis? They have been using the printing press (the electronic one) to create trillions of dollars of money to buy government bonds, corporate bonds and even equities lately. How much have they been printing? More than $14,000,000,000,000 ($14 trillion). Trillions of US Dollars, Euros and Yens have flooded the financial markets and crowded out private investors. The result, as expected, was an inflation of asset prices (for assets, people usually do not say “inflation” but rather “price appreciation”, but do not be mistaken it is still inflation) fueled by lower interest rates (as the price of government bonds went up, their yields went down, it is how bonds work). The reason central bankers did that was to trigger the “wealth effect”. As asset prices increase, people feel richer — at least those who own assets — and are more likely to consume more and thus support economic growth. What it mainly ended up doing was make the wealthy wealthier (those that have benefited from asset price inflation) and the poor poorer.

At every market dip, central banks responded by expanding their balance sheets through even more purchases on the market. Market participants responded accordingly, they learned to “buy the dip” in anticipation of even more actions from central banks. This creative weird behaviors as bad news on the economy were followed by gains on the stock market (the opposite would be intuitively expected).

What investors were doing was simply front run the central banks. The central banks became more worried about volatility in the stock market than about the real state of the economy. They effectively suppressed all volatility in the market and corrections disappeared, which is not healthy as the market has to be able to go down sometimes to avoid catastrophic crashes when the system finally breaks (remember the kite example).

An unsustainable situation

So much free money also incentivized rational but not economically helpful behavior. Instead of investing in new projects, companies took advantage of the cheap debt they could raise to buy back their own shares or pay fat dividends to their shareholders. But this is only a quick and temporary fix, when you borrow to pay a dividend, you use future profits to pay for dividends now, so you effectively only gain the time value of money. Of course companies assume that they will always be able to rollover their debt at good terms in the future, nobody ever assumes that the music may stop at one point. In the past, eras of cheap money have always ended up in disasters. It is very simple to understand why: when money is cheap, lenders are more lenient, borrowers can fund barely profitable projects and the overall discipline of the market weakens. “History doesn’t repeat itself but it often rhymes” the quote says, well it is about to rhyme, big time.

By historical standards, asset prices have never been so high. Price earnings ratios of equities have only been higher in 1929 and in 2000, we know what happened next. Homes prices in the US are now above their pre-financial crisis levels in many cities. But nothing comes even close to the biggest bubble out here: the bond bubble. More than $7 trillion of bonds are currently trading at negative yields.

What makes negative bonds so special — apart from the fact that they should not exist — is that if you buy one of those, you are 100% guaranteed to lose money if you hold them to maturity. This is what happens when a buyer with unlimited fire power such as the European Central Bank decides to buy everything there is on the market no matter the price. Nobody knows how such an experiment is going to end as it never happened in the past. My guess, not too well.

Run for cover

There has not been any significant market crash in the past 6–8 years, one is bound to happen but it is impossible to predict what will trigger it or when it will start. But think about it, you do not know if or when you are going to get into a car accident, but you still get car insurance, right? You can do the same thing with your financial assets. I have listed below a few ideas to help you protect your assets or even make money in the event of a crash.

Move into cash. The obvious choice but not a great one in the long term as you end up losing purchasing power over time as your capital gets eaten up by inflation. Only works in the very short term.

Buy gold. Historically gold has proved to be a good hedge against inflation and political uncertainty. But owning physical gold is a hassle and buying a financial product such as an ETF (Exchange Traded Fund) that replicates the performance of gold is not great either as you take a large counterparty risk (all you have is an “I Owe You” from the financial institution that holds the gold on your behalf).

Buy insurance. You can buy put options on individual stocks or indices. Such options will pay off if the price falls below a certain threshold. You can even buy these options if you do not own the underlying, so you can basically make money in the case of a crash.

Buy cryptocurrencies. You have heard of Bitcoin, right? Cryptocurrencies are now a $140 billion market (from $10 billion just 18 months ago). They are out of reach of governments and can be moved in seconds across the globe. No wonder they are so popular in places like Venezuela, Bolivia or Nigeria.

The right portfolio is most likely a combination of all four options listed above. But just like I am not mad if I do not crash my car and I consequently do not end up using my car insurance, you should be fine with options expiring worthless most of the time, one day they will not. I am also a big believer in cryptocurrencies (“cryptos”) and the underlying blockchain technology. I have written about the underlying blockchain technology here and about the value of cryptos here. They could prove to be very useful in a portfolio when the next crisis hits.

Always protect your downside

Warren Buffet famously said that he only had two rules about investing:
- Rule #1: never lose money
- Rule #2: do not forget Rule #1

Does that mean that you should only invest in risk free (but also return free) assets? Absolutely not, it means that you should always protect the downside. Seeing your portfolio take a hit now and then is a normal part of the investing process, what you need to avoid is catastrophic losses that jeopardize your future or your ability to get back on your feet quickly. Whether you are bearish or bullish, you cannot be right 100% of the time, so diversification is key to ensure successful long term wealth.

Be more like my kite, be ready to have superficial damage in the case of a crash, but then make sure you can put the pieces back together quickly and get back on your feet.

The views and interpretations in this article are those of the author and do not necessarily represent the views of the World Bank.

World Banker, Investor, Blockchain enthusiast