What a trying year 2001 was for risk managers. The markets generally performed poorly, with US equities in the aggregate down for a second year in a row, and lower grade bonds suffering as well. Yield spreads between corporate bonds and US Treasury bonds rose to the largest spread in over 20 years, as lenders became cautious. Bankruptcies rose to levels not seen in 10 years, and among the walking wounded was possibly the largest bankruptcy in US history - Enron Corporation. For me there were a few lessons from 2001 that I think are worth repeating as we head into the new year. I'd be interested in hearing from others. What did you learn about risk in 2001?#1 - The business cycle still exists The first lesson is that the time-honored recession model still works, and the economy is still sensitive to the credit cycle. The Fed raised short term rates, the Treasury yield curve became inverted, economic growth stalled, a few shocks hit the system, creditors became cautious, businesses then slashed their capital spending and .........waallaaa! Recession appeared in the US once again. #2 There are negative effects from the new information technology tooThe second lesson is that yes, the new economy is here, but that it is not all a positive. The rapidity of the changes that occur now due to the IT that businesses have at their disposal is much greater than ever before. While most observers have publicized the great gains in productivity that technology has brought to the economy, it is less well understood that technology can now also slow the economy much faster than in the past, pushing the "angle of attack" of an inventory correction and production slowdown into a steep nosedive. What became apparent in 2001 is the degree to which IT allows a business to adjust to new conditions. In effect, IT has created a situation where the rapidity of decline is much faster than ever before.#3 The global village is becoming increasingly synchronizedThe third lesson is that the global village is more synchronized and more dependent on trade than I first thought. The increasing synchronicity of the global business cycle is becoming more and more evident. Unlike 1982 and 1990, this time the US was the first major economy to move into recession and it did not take long for the rest of the developed nations to follow. Steven Roach of Morgan Stanley Dean Witter points out that there are three important characteristics of the current global economy: First, as the 1990's wore on, the US accounted for as much as 40% of the cumulative growth in world GDP in the 1995-2000 period. Once that engine of global growth slowed and went into reverse, the degree to which everything was tied to the US became very apparent. Second, global trade now accounts for a record 24% of world GDP. This has probably helped to synchronize the economies of the world. Third, global trade has gone through an unprecedented sharp transition from boom to bust, as growth in world trade went from a record +12.4% in 2000 to less than 1% in 2001.#4 Balance sheets still matterIf we are entering a new era of more volatility in markets and economies, flexibility will increasingly become the key concept for capitalization. As many businesses found out once again in 2001, covenanted debt does not leave one with a lot of flexibility if cash flow experiences any type of disruption, no matter how temporary. The number of bankruptcies in the US in 2001 was surprisingly high. With increasing leverage even a modest slowing in business can create a massive squeeze on profit margins and earnings. Indeed, 2001's plunge in corporate profits in the US was the sharpest in 50 years. Businesses used to employing operating leverage found themselves in a bind as lenders turned skittish, yield spreads soared, and credit availability contracted. In other words, many managers once again learned the lesson that there is a positive correlation between the need for debt and the reluctance on the part of lenders to lend.#5 The risk premium on US assets may have permanently increased.As the Romans built roads out to all corners of their empire, trade grew and business improved. However, the Romans eventually learned that the roads worked both ways - the roads used by the legions to expand the empire were also used by the Vandals and Goths to march to Rome and sack the city. So it appears to be with the new globalization and the US. It is not only the terrorists that present a problem either, immigration problems as well as the potential spread of Mad Cow and Foot and Mouth disease are other examples of the downside of global integration (the Kudzu problem).tr
Well, 2001 was certainly a good year for me, but I'd be hard-pressed to say what, if anything, I learned from it all.#1 Keep your eye on the puck: I felt like the Red Queen last year, running like hell to stay just ahead of the pack. I indicated on Dropout's Den that I was up 60% as of October 31, and that I was going to tune-out for a while, stop trading my face off, and hold into the New Year. But I was still holding a hedged portfolio of what I thought were sensible long-term longs and shorts. I had sugar-plum visions of finishing the year out at 100%. Instead, I gave 25% of it back, most of it in 2 days on a couple of short positions that just killed me (AZO and EBAY). AZO has since dropped back, but not before I harvested the tax loss. New Year's resolution: don't think for a moment that what was successful last year is going to be worth a hoot this year.#2 The short side has it's moments: I got brutalized going short in the fall of 1999. Total losses in puts on NT, QQQ, JDSU, and a couple others. And it stung enough to make me give up short-sales for a whole year. I climbed back on board in Oct 2000 and did very well, on average, for the next 12 months. But the last 2 months have been no time to be short. I'm realizing that exuberant prices are not enough justification for a short position (e.g. AZO, EBAY, KKD). You also need a fetid corpse in the CFO's office. I shorted Enron back in the spring of 2001, but I was only shorting based on price, and I covered after a $8 move. If I'd of had some conviction based on understanding of the underlying business (or, more correctly, inability to understand it), I might have had the courage to play it for a near-terminal short. I'm reading Kate Staley's book now, and my New Year's resolution is to be more selective about my short positions.#3 Litigation: I vow never to buy another stock without searching the last 5 years' worth of annual reports for that sneaky word "asbestos." I knew what I was getting into with USG, but thought I had margin of safety on my side. Total blow out (I used calls to hedge some of the risk). I bought National Service Industries without realizing they had asbestos exposure until after the fact. I almost bought Goodrich before you tipped me off that they scurrrying away from asbestos exposure. Right now it happens to be asbestos, but what will it be next? I don't think any company is immune from these concerns, not even a Fort Knox like Berkshire. In fact, Berkshire probably has higher risk because it is Fort Knox. Resolution: stay diversified, among companies and industries.#4 Currency Risk: I calculate my returns in Canadian dollars, so my U.S. port did better than expected in part due to the Cdn dollar tanking against the U.S. dollar. Right now I'm more worried about the U.S. $ collapsing than I am about further losses in the Cdn $, but I'm not really sure how to address this. It's only an issue because we're considering moving back to the states. But I'm not willing to take the write-off on Cdn $ denominated assets knowing that purchase-price parity is about $0.85, but the market price is about $0.65.#5 Monster Risk: I generally agree with your thesis that there is no general risk, only specific risk. But as I look at still overvalued equity markets on almost a world-wide basis, overvalued real estate, artificially-depressed interest rates, lurking inflation (i.e., money supply is growing too fast, even if CPI isn't), excessive debt, underfunded pensions, etc., etc., I worry most about Enron repeating itself with the whole U.S.-global economy. But, we're debt free with a decent wood pile and green-beans and venison in the freezer, so maybe I should just not worry about that too much.Todd
Todd"#4 Currency Risk: I calculate my returns in Canadian dollars, so my U.S. port did better than expected in part due to the Cdn dollar tanking against the U.S. dollar. Right now I'm more worried about the U.S. $ collapsing than I am about further losses in the Cdn $, but I'm not really sure how to address this. "I'm not a hige fan of margin as such, but if you hold some cash in Canadian dollars and borrow in US dollars (yeah, I know margin rates range from not-cheap to exhorbitant) you are in effect shorting the US dollar and long the Canadian.It's not free, it's not cheap, but it is comparatively simple and accessible to lots of people.peter xyz
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