Afraid of Another Financial Crisis? Watch the Banks

Financial crises like we had in 2008 before the Great Recession, and earlier in the 1930's before the Great Depression, are the triggers for big, long lasting economic downturns that require painfully long times from which to recover.  They differ from ordinary economic recessions (i.e., two quarters of negative economic growth), which generally don't last more than a couple of years and are usually followed by good levels of growth.  Financial crises are caused by liquidity shortages in the financial system.  When major banks and other financial institutions cannot obtain ready access to loans, especially short term loans, the financial system can teeter, and in worst case scenarios, collapse. 

Recent news articles report that European banks are under stress because of the decline in oil prices (http://www.cnbc.com/2016/02/08/european-banks-face-major-cash-crunch.html), and because of low interest rates and legal costs, as well as oil prices (http://money.cnn.com/2016/02/05/investing/bank-stocks-worse-than-oil/index.html?iid=EL).  Things got so shaky today that Deutsche Bank, Germany's largest, felt compelled to put out a statement reassuring shareholders about its financial condition.  http://www.reuters.com/article/us-deutsche-bank-stocks-idUSKCN0VI1WI.  If Europe's major banks begin to encounter liquidity shortfalls, we could have a problem.  If not addressed properly, it could be a big problem.

Europe's big banks are in general not as well capitalized as America's big banks, so it's not surprising that the Europeans might encounter turbulence sooner.  But if Europe's big banks teeter, America's big banks will, because of the interconnections between all major banks worldwide, at least feel pretty nauseated.  Of course, in such a scenario, the European Central Bank and U.S. Federal Reserve will mount up and ride to the rescue.  But not even the Brobdingnagian bailouts of 2008 prevented the Great Recession.

If the financial system stays sound, the slowdown in China and the other BRICS may cause a recession, but probably not a catastrophe.  But if the financial system dives into the septic tank, as it did in 2008, then we can expect a stinky mess.  So watch the banks.

The Key to Long Term Investing: Liquidity

Paradoxically, liquidity is a very important component to success at long term investing. Stocks have a good long term record, if you measure in decades. Real estate is less profitable overall, but is the long term investment of choice for many Americans since they are homeowners. Having to sell unexpectedly early, though, can ruin the value of either stocks or real estate as investments. If markets are shaky when you have to sell, you can be a big loser.

To increase your chances of long term success, you need liquidity--cash to keep you going without having to sell your long term investments. This includes having a bulked up emergency fund to cover unexpected cash needs (like unemployment or a medical crisis). It also means having a stable source of cash for a long period of time. Most people work for that stable source of cash. Those with pensions have a steady cash flow in retirement. Highly rated bonds and stocks with a strong record of paying dividends can also serve this need. Immediate fixed or inflation adjusted annuities from highly rated insurance companies can provide long term liquidity. Don't forget Social Security. It's like a pension. Even if it doesn't cover all your needs, its predictable inflation-adjusted monthly payments are the financial foundation for most retired Americans.

If your day-to-day liquidity needs are met, you can hold your long term investments until the moment you, and not circumstances, choose as the time of sale. Avoid borrowing to meet these liquidity needs. Debt tends to destabilize your finances. (See http://blogger.uncleleosden.com/2010/07/why-you-should-avoid-debt.html.) Instead, securing a steady income and living within your normal cash flows can give you a good chance to win over the long haul.

How Liquidity Can Be Bad for Investors

It is axiomatic among finance professionals that liquid investments are preferred for individual investors, especially those that aren't wealthy. It's easier to buy and sell liquid stocks and bonds. Information about them is easier to get. They tend to have readily ascertainable values.

But these qualities, especially the ease of buying and selling, make liquid investments the focus of computerized trading. Computers can observe prices, and buy or sell stocks, all in milliseconds. Their great speed allows them to profit from holding stocks for just a moment. It's not unusual for a computerized trading system to complete a purchase and sale of a stock in ten seconds or less.

All this frenzied computerized activity requires highly liquid markets. The program has to be able to trade quickly at or very near, the prices the computer observes. Otherwise, the algorithm (i.e., the mathematical formula) on which the program is based won't work well, and, horror of horrors, money could be lost.

So the banks, hedge funds and other institutional investors deploying computer-driven trading strategies have come to dominate the markets for the most liquid investments. Over half the trading in the stock markets today is computer-driven. The small investor, who thoughtfully researches investments before timorously buying a couple hundred shares, is playing on an interstate filled with tractor trailers. For little apparent reason other than a deluge of lickety split orders spewed out by immensely powerful computer systems, investors can lose 10% or more in a matter of minutes. This happened during the flash crash on May 6, 2010. It could happen again.

The markets for the most liquid of stocks and bonds are beginning to look like commodities markets, where positions are bought and sold for momentary profit, and where the big, powerful traders garner almost all the profits. The Model T version of investing--buying and holding--is taking on a distinct resemblance to the Tin Lizzy.

The stock markets have always favored the big firms and large investors. Small investors (a/k/a chumps) have always been at a disadvantage. But there once was, or at least seemed to be, something in it for Mom and Pop. Today, however, the stock market, unadjusted for inflation, is trading about where it stood in April 1999. That's 11 years ago. Factor in inflation, and we're back to mid-1997, 13 years ago. Either way, that's a long time with no gains. The Moms and Pops who put faith in CDs and money markets came out ahead.

Individual investors have largely stayed out of the most recent bull market. The last few weeks' volatility will only reinforce their skittishness. They know that, should they ever get the urge to go back into stocks, they'll never beat a computer to the punch. Why put your hard-earned savings into a market where you're behind the competition and have no hope of catching up?

High tech traders argue that computerized trading adds liquidity to the market and therefore is beneficial. They overlook that fact that long term buy and hold investors (so-called "natural" investors in market parlance) are the true fount of liquidity. Drive them out, and the market, and we, will be poorer for it.