How to ride the boom-panic cycle

The market's roller-coaster pattern might be with us for years. Here's how smart investors can try to protect themselves.
By Jim Jubak
Soon the financial markets will return to normal. That's the current prayer on Wall Street.
The Federal Reserve will flood the market with cash -- and lower interest rates -- on Sept. 18. The Japanese and European central banks will call off plans to raise interest rates. Banks will resume lending to buyout and hedge funds. Overseas investors will again buy bundles of mortgage- and loan-backed securities. And the Dow Jones Industrial Average ($INDU) will resume the kind of steady march that took the index to 14,000 in July from 12,000 in March.
But what if the August panic isn't abnormal? What if a panic that threatens to shut down buying and selling is instead a part of the normal pattern of the financial markets?
The current panic is, by my count, the fourth of the past 10 years. On that evidence it's at least worth considering that "normal" now consists of a recurring pattern of market booms driven by excess global cash that leads to a global mispricing of risk and is punctuated at regular intervals by panics.
Crazy rhythms If a pattern of boom, panic, boom, panic is indeed the new normal, it has profound implications for how we should invest. I'll try to spell out the case for the new normal in this column and how thinking about the market in this way suggests new strategies for your portfolio.
Here's my list of the major financial panics of the past decade:
The Asian currency crisis of 1997.
The Long Term Capital crisis of 1998.
The Nasdaq bubble of 2000.
And the current contender, the subprime crisis of 2007.
On the surface, these panics seem significantly different because they all have involved different players and different market vehicles. The Asian currency crisis saw a huge devaluation of the Thai baht, the Indonesian rupiah, the Korean won and other East Asian currencies. It also saw a devastating stock market crash and stalled economies throughout the region.
The Long Term Capital crisis the next year was exacerbated by Russia's default on its debt and was the result of an over-leveraged hedge fund, Long Term Capital Management, getting swamped when currency prices moved against it. At one point, the fund had borrowed $129 billion on assets of just $4.7 billion.
The 2000 Nasdaq crash was a classic stock market bubble built on ever more feverish expectations for parabolic growth in revenue and profits.
And the current panic is rooted in a boom in home prices that produced a boom in mortgage lending to ever less and less qualified borrowers, who are now defaulting at levels above those projected by the banks that originated the mortgages and the investment banks that packaged them for resale.
Risk, bailout, repeat But note the similarities below those surface differences:
Each was rooted in a surplus of global cheap money. Inflows of overseas capital inflated economic-growth rates in East Asian countries, sending stock prices in those countries higher and attracting more capital, because investors were more than willing to finance the large current-account deficits being run up by these countries. Long Term Capital's investment strategy required massive leverage because the profit from each transaction was relatively slight. The Nasdaq bubble required rivers of cash to chase stocks as they climbed ever higher. And the current crisis saw mortgage lenders recklessly pursue marginally qualified borrowers so they could generate more mortgages to sell to insurance companies, pension funds and foreign banks hungry to put mountains of cash to work at slightly higher rates of return.
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Continued: Reaching for returns
Reaching for returns Dig down another level and I think you'll find the global trends that produce and reproduce these similar panics.
First, the financial markets are being asked to redistribute massive amounts of cash. Higher oil prices have produced a gusher of cash flowing from the developed economies to the oil-producing economies. All that cash has to be reinvested somehow, often in the financial assets of the developed economies, thus completing the cash cycle.
But that's only a part of the global gusher. The massive trade surplus reaped each year by China -- and to a lesser extent by other developing economies -- has to be recycled, too. And again, much of this money goes back into the developed economies because even a developing economy such as China can't -- or won't, by government policy -- absorb all this cash.
Reinvesting this much cash without inflating asset values in some part of the market is probably impossible given investors' propensity to chase returns. Many of the countries with the cash are also relatively new to the investment game and haven't developed reliable in-house methods of assessing risk.
Second, the globe is at a demographic turning point. Like an individual in middle age, the globe as a whole is in its prime earnings period. Taken as a whole -- largely thanks to China and the developing world -- the world is a net saver. That saving adds to the global cash flow. But everyone from the savers (China) to the relatively older spenders (Europe, Japan and the U.S.) feels the need to get the most return on each of those investments. That has produced a global search of any potential extra penny of return and an understandable willingness to underestimate the risk of reaching for that extra return. (See my Aug. 10 column, "How Wall Street got into this mess.")
And third, with the aging of their populations, the economies of the developed world are slowing, both absolutely and relative to the younger and faster-growing economies of China, India and the rest of the developing world. That may be completely natural in the life of an economy, but that doesn't mean it sits well with the governments of those aging, slower-growing developed nations. Engineering economic growth and preventing recessions has moved up on the agenda of every central bank in the developed world, whether they admit it or even recognize it themselves.
That means more active efforts to help the economy after a bubble bursts and more willingness to turn on the cash spigot to head off any slowdown.
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Continued: Some guidelines
Three general rules will help:
Watch risk like a hawk. You can't count on anyone else for reliable risk measures, and when you're likely to hear the most reassuring talk about risk exactly when the markets are riskiest. Do your due diligence yourself. Make sure that you are getting a good return for the risk you take. And don't be afraid to move to the sidelines when the markets look too pricey. If you're able to devote any extra time to your investments over the next decade or so, I think you'll get the biggest return from studying risk.
Expand the number of asset classes that you invest in. In a market subject to booms and panics, asset classes that don't move with the market averages will be sources of extra return. For example, gold is doing just fine now, thank you, exactly because of the current panic. Try to think a cycle ahead. It's too soon to invest in financials now, but remember that the best time to buy energy stocks was when everybody hated the sector.
Growth -- real honest-to-goodness growth that comes from good management selling good products into a good market -- will still pay during this period. The ample supply of global capital is a big plus for companies that need to raise cash to grow or that are reinvesting in growth opportunities. And the search for extra return by investors means that companies that can actually deliver growth will be amply rewarded by rising stock prices. There's no reason to ignore growth companies in the developed economies, but the biggest opportunities -- and the hardest to research unfortunately -- will be in the developing world.
In my next column, I'll tell you about five global growth companies that fit that bill.
New developments on a past column "Why investing is safer overseas": Lan Airlines (LFL, news, msgs) has recovered almost all the ground lost in the August panic -- a solid performance that supports my belief that developing stock markets in financially sound countries such as Chile aren't nearly as volatile now as they were, say, a decade ago.
Lan reported solid and better-than-expected second-quarter results July 25. Revenue climbed 12% from the second quarter of 2006 as passenger revenue increased by 19% and cargo revenue rose 4%. Analysts had expected flat cargo revenue growth for the quarter. Thanks to lower-than-projected expenses, earnings were up 17% from the second quarter of 2006.
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Jubak's Picksare for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest rate environment, see Jim Jubak's portfolio of Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the worldor Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com.