Saturday, February 27, 2010

The Ring of Fire

In his latest missive, Bill Gross, PIMCO’s Managing Director, aptly summarizes the major themes Carmen Reinhardt’s and Kenneth Rogoff’s study of over 8 centuries of financial crisis. Simply put, if you play with fire, you will get burn. Maybe not today or tomorrow, but at some point, when you least expected, you will. In any event, three points become evident from the study:

“1. The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.

2. The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years.

3. Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%.”

Based on these observations, he names the following countries likely to become culprits: Spain, Ireland, UK, USA, France, Greece, Italy, and Japan.

Mr. Gross makes the salient point that the aforementioned study, “if anything, points to the inescapable conclusion that human nature is the one defining constant in history and that cycles of greed, fear, and their economic consequences paint an indelible landscape for investors to observe.”

Against this background, quantitative measures—the order of the day in risk management and stock picking—are a ticking time bomb. Black swans, low probability but highly explosive events, are bound to come up when least expected. In this environment, investment returns are akin to picking up pennies in front of an oncoming train.

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