When Markets Collide

I have learned a lot during the two weeks reading "When Markets Collide," a book by Mohamed El-Erian, a bond specialist who focuses on developing countries and who, among other things, worked for a while managing Harvard University's endowment fund. The investment world has changed quite remarkably during the last decade. Among the best and brightest investment managers during that time have worked managing large, multi-billion dollar university endowment funds and have been remarkably successful. So successful, in fact, that they often move on after several years to establish private hedge funds which are much more remunerative. In fact, they usually earned more than anyone else employed by the universities whose funds they managed, but still far less than their subsequent income managing private funds, since their income while working for the universities was public knowledge, whereas their earnings managing private funds was not.

I learned about ETFs or exchange-traded funds, which have many forms but whose purpose is to offer securitization of almost any asset of value, such as a stock market index, a commodity (oil futures, for example), or a bundle of real estate mortgages of various qualities and duration. It is this last creation that was one of the instruments that got the big multinational and investment banks in this country into such big trouble. The sub-prime mortgages were packaged, securitized, and then bought and sold almost like stocks and bonds. When people began to realize that many of these pieces of paper were worthless, they became frightened and refused to put good money after bad. The flow of money slowed down and almost stopped. The country developed a liquidity crisis which required a government bailout in the case of Bear Stearns. Since then, the concern about liquidity has reoccured intermittently. But there is another form of ETF that increased in popularity: commodity ETFs. These commodity funds enabled a much larger group of people to speculate in commodity futures than before their development.

Since WWII, the common consensus has held that real estate, including residential real estate, was in a long-term or "secular" trend upward. Popular wisdom held that you were wise to buy as much home as possible because "they ain't makin' any more land" and steadily rising land and construction costs will always put a floor under today's price. There may be short-term fluctuations, but the long-term trend has always pointed up. And this wisdom has held true throughout the 50 years of my adult life, with a few exceptions, the last about 18 years ago. Until now. The current situation has engendered a lot of FUD (fear, uncertainty and doubt). The current decline in real estate has lasted a year and most believe that the worst is yet to come, with a round of new foreclosures about to hit the market. David, who has to tell builders and developers almost every day that the bank is about to foreclose on their property, that they are going to loose their real estate investment and may have to declare bankruptcy, can tell you that he is worried about the current trends in California and Utah. For the first time in a generation, people are concluding that their real estate investments may not be a sure thing. Many are feeling much poorer. Their home is no longer a big piggy bank. They can't take out a second anymore to pay for whatever. President Hinckley's advice to Church members 5-10 years ago to avoid indebtedness to fund lifestyle seems prescient (prophetic?) and sound.

Those who still have money to invest have turned from real estate to oil. ETFs in oil companies and oil futures have become very popular. The same kind of popular wisdom holds: "They ain't makin' any more oil," increasingly more people are using oil and increasing their consumption of it, and the price of oil points only in one direction: up. So buy oil futures or ETFs in petroleum and other hydrocarbons. It's a sure thing. Almost certainly, the expanded securitization of commodities, particularly petroleum, has had some effect on the price of oil and oil products. We can only hope that it is a bubble waiting to pop, but with both China and India growing at 8-10% a year and the per capita use of petroleum rising greater than that, don't count on a long-term downward trend in gas prices at the pump. At least not until some years after 2010.

I also learned about SWF or sovereign wealth funds. These have been created by the more prudent oil and gas rich countries. Norway created one of the earliest SWF. Kuwait, Abu Dhabi and Qatar three others. Saudi Arabia is a late comer to the SWF table. Almost all oil and gas rich countries have developed one or more SWF. China and South Korea also have SWFs. These state owned funds are giant, nationally-owned but privately run hedge funds. For many years, they were very conservative and invested mainly in U.S. Treasury notes and British debt instruments. More recently, however, they have shown a willingness to invest in a wide variety of financial instruments, concerned primarily about both security and return on investment.

The size of these funds is massive. China's fund is young, but the country has $1.5 trillon surplus, fully a third of which is invested in U.S. treasury notes. Another third is also invested conservatively in debt instruments. We have no greater friend; China makes and sells us cheap but good quality goods, buys little in return, and stashes the money away in the U.S. to fund our debt, keeping interest rates low. We use the liquidity to pay our lifestyle debt, which we tend to use the way others use earning.

The emergence of SWF and ETFs allow oil rich countries to invest their money in oil futures, which serve to keep the price of oil high, maybe even artificially so. So Kuwait, for example, sell their oil for $130/barrel, then takes the profits and invests item in oil future ETFs, making profits from their oil in two different stages. Great for them but not for us.

The book is packed with excellent explanations of the current economy and what is likely to happen to the world economy over the next 10 years. He offers general investment ideas but no specific recommendations. [No stock picks, but invest in scarce commodities over the long haul. Diversify at least half of you money out of the U.S. and Europe and into Asia, particularly China and India.