Bretton Woods 2 - the end of an era?

With the worst of the current financial crisis apparently past, now is perhaps a good time to reflect on what was and what was not correctly anticipated beforehand. For my own part, there is no escaping the fact that my record has been pretty mixed. Looking back over some of the past posts on this blog and recalling my own views at the time, it seems that I was very much correct in my skepticism of the "de-coupling" thesis, and particularly of those investors who were bearish on equities generally but bullish on China, India, mining etc. However, the events of the past couple of months have shown my bullish (relative to consensus) views on equities to have been spectacularly wrong. So the natural question to ask is how did I manage to get half so right and half so wrong? (Or was it just luck!?).

First off, it is important to recognise that crises are always so much clearer with hindsight. What started with some property related write-downs at US banks had escalated, despite numerous policy interventions, into a global banking crisis, and now what looks like a recession in the real economy too. The following diagram shows my understanding of how the financial system worked prior to the beginning of the crisis in summer 2007.




This is not particularly ground-breaking - indeed, many observers no doubt had a similar view of how the system operated. What is interesting however, is that fact that many commentators (although by no means all) expected the crisis to emanate from the emerging markets, rather than directly inside the western financial system. There was much analysis of the build up of Chinese reserves, whether this was a good thing or a bad thing, what would happen to the dollar and interest rates if they started diversifying etc. etc. When the crisis did hit, I think many people (especially equity investors) failed initially to understand its significance because they were looking for it elsewhere.

For my own part I was certainly guilty of this. When you look at the above diagram, it is so blindingly obvious that the breakdown of the process of credit creation should put a serious spanner in the works. It is not hard to see that a de-levering puts the whole cycle of flows into reverse (switch all the arrows round and then think about the consequences!). I had correctly understood that de-coupling was a myth, but I had not correctly anticipated the extent to which the de-levering itself would drive down all equity prices. I simply looked at valuations and said - "well, clearly mining and commodities are overvalued, but the rest of the market is pricing in a recession anyway and therefore doesn't look too expensive".

But my valuation argument has been shown to be largely irrelevant as many company valuations have gone careering through trough multiples anyway. Stocks that I thought could not go any lower have indeed continued to go lower. In fact, the cheapness of equity markets really depends on your time-frame. My valuation assumptions had been based on data for the past 15 or so years. What I should have realised was that the scale of the structural changes under way presented a serious risk to these assumptions. On longer-term valuation metrics, equities did not look quite as cheap. After the recent falls they do now look cheap, although (somewhat worryingly) they have in the pas fallen even lower.