When the dog days bit

An observation, if you please. With stock markets, I would suggest it’s some exotic term — an abbreviation or acronym you’ve never heard of — that will upend, at least temporarily, the best-laid plans now gang aft agley (to borrow from Robbie Burns).

But let’s step back a minute. After a solid four-year run, the TSX gave up most of the year’s gains, as did many other stock markets. About the only thing unusual about this is that it took so long. Four years without a serious correction? If you believe in reversion to the mean, that’s an unusually long bull cycle.

Nevertheless, things come to a stop for a reason. The reason this time? Not the usual suspects. Many folks are banking on a Chinese recession — surely that economic expansion cannot be sustained — and with it, a collapse in commodity prices. Others point to the eventual exhaustion of the U.S. consumer, who kept the economy aloft for years by using houses as ATMs. Others have pointed to excessive liquidity: cheap interest rates have led to excesses (just as in the late 1990s, when the U.S. dollar was too strong, the current account deficit too large and so on).

Has China crashed? Not recently. What about the U.S. consumer who keeps buying those things from China? Not yet. Excessive liquidity when interest rates are going up? Nuh-uh. Nor has the U.S. dollar crashed, nor has China moved to collapse the U.S. current account deficit.

So what was it?

Something that most people have never heard of. After all, as my wise friend noted, it’s what you didn’t expect that defies all risk management calculations. Not just now, but in the past too.

Remember 1997. Thai bahts were swinging for the fences — until they got called out. Folks who had no exposure to emerging Asian markets suffered the consequences of something they didn’t know about, and wouldn’t know how to analyze if it had been offered to them on a plate. So it goes.

Yet, a year later, the same thing happened, dragging down world markets as Russia defaulted on its sovereign bonds. Who, given the chaotic Yeltsin administration, would have invested in Russian debt? It could only have been a tiny corner of the investment universe, yet it walloped markets and gave us a new shorthand for failure: LTCM.

LTCM — Long-Term Capital Management — was a quant shop advised by Nobel Prize–winning economists who bet that debt prices would converge — which they did, but too late for an LTCM suffering a run on the bank.

And this summer, again, markets were toppled by some strange nomenclatures: ABCP, CDO, MBS. They were triple- or double-A credits, until you looked underneath and recognized they were sustained by a U.S. housing market that sooner or later had to falter.

A few years ago I heard a warning from an analyst at a bank that had gathered some of these high-yield credits in a closed-end fund: he said just because the overall product had a triple-A rating didn’t mean all the underlying credits did. He had taken steps with the bank’s own brokers to make certain they understood the nature of the product.

In other words, what a product seems to be and what it is may be entirely different things. That’s what, if you’ll excuse the expression, I learned on my summer vacation — not for the first time, and not, I’m sure, for last time. Risk occurs in the most unexpected places, precisely because most people aren’t looking for it there. Like the bus, there should be another one along in ten minutes.

Filed by Scot Blythe, senior group editor Advisor’s Edge Report, scot.blythe@advisor.rogers.com

(09/05/07)