Lending markets

It’s time to listen to the markets

Renowned investor Warren Buffet offers a plethora of sage advice. By far my favorite line from Buffet, whether he invented it or often adopts it, is “it’s only when the tide goes out that you find out who’s been swimming naked.”

After the smirk this line always pulls at me, first reminding me of a particularly silly night in the Cayman Islands, but silliness aside, it’s important to understand the meaning of this cryptic wisdom and why the concept is particularly timely right now.

During the days of plenty, which we will define for this conversation as easy credit or low interest rates, rising stock prices, a growing economy, stable inflation and low unemployment, even the most careless can prosper. Botched business models get funded, botched corporate stocks go up, botched investors make money, botched banks make profits on botched loans, and botched politicians and governments convince their governed to entrust them with more money and control.

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These conditions encourage the mismanagement of risks of all kinds. Irresponsible business leaders burn capital, irresponsible investors leverage their portfolios with margin borrowing and speculative options, irresponsible governments create unsustainable programs using deficit spending, and the environment of plenty allows it’s up to everyone to get out of it. Until it doesn’t and the tide of abundance recedes. And it always ends up backtracking.

Despite our best efforts, our modern economic system has not eliminated what we in academic economics call the “business cycle.” The economic cycle is the ebb and flow of supply and demand based on a complex set of demographic, technological, financial and monetary factors that are difficult to contemplate and yet as fundamental as the passing of the seasons.

This all-important cycle isn’t as predictable as the cooling temperatures in October and the snowfall in January, but nonetheless, the cycle occurs so consistently throughout modern economic history that it seems almost constructed out of ‘a natural order, and much of the smart money tells us winter is coming, the tide is going out. This is where the bare part comes in.

Swimming naked can be fun for a while, but it always seems to end badly. Injury, embarrassment, or arrest are three likely outcomes I can think of (not to mention the start of “Jaws”). When it comes to the financial world, poor performance for those who haven’t hedged prudently often equates to insolvency, bankruptcy and, in the worst case scenario, collapse. The catch (or should I say friction) is, as Warren quotes, that it’s hard to know who the lean divers are until the cycle turns, which in a way sets us all in a dilemma. An ongoing dilemma.

To fight inflation, central banks around the world are using their policy tools to slow demand by trying to calm prices. The process looks likely to work, and stock and bond markets have already adjusted in response to this expectation. The problem is that, with the exception of the brief but violent interruption of the COVID lockdown, the economic cycle that we continue to experience has been very long, dating back to March 2009. In historical context, this is a very long period of expansion, which was built on and facilitated in part by the Fed’s policies of very low interest rates and almost continuous injections of expansionary liquidity into financial markets through now common quantitative easing. These policies contributed to the inflation problem the Fed is trying to solve and have come to an end. It would be prudent to anticipate an economic slowdown as a result, or simply put, while it’s not there yet, it could be time for a recession.

Unfortunately, the 13-year period of very accommodative interest rates and monetary policy has likely allowed for a lot of naked swimming. Some of the swimmers will be minor players, catching only their own investors in the “bad end”, but some may be major players with risk that could endanger financial systems, economies or even entire nations. And we just don’t know where and when the tide will really go out and who will get caught.

There are clues, however. I would have bet there were plenty of skinny dips in the cryptocurrency markets, and the tide there is already receding. This week, financial giant Credit Suisse was not doing well, which probably rattled markets in September, and the UK government and the pound could be swimming in deeper waters, but I’m not entirely sure they are concealed. There will be others.

So when markets turn turbulent in the absence of any overt news over the next few months, investors will want to pay attention. The bond market will likely sound the tidal warning first, and the stock market will follow. It’s time to learn to listen.

The opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations to any individual. Investing in stocks involves risks, including price fluctuation and loss of principal. Investing in precious metals involves greater fluctuation and potential for losses. Past performance is not indicative of future results. Dividend payments are not guaranteed and may be reduced or withdrawn at any time by the Company. Marc Ruiz is a Wealth Advisor and Partner at Oak Partners and a Registered Representative at LPL Financial. Contact Marc at [email protected] Securities offered by LPL Financial, member FINRA/SIPC.