Newspapers haven’t reported any new Wall Street crisis for at least a couple of weeks. Does that mean that financial markets are likely to be stable for a while? Let’s look at how we compensate money managers (old news) and how managers of blown up funds and companies are regarded (new news).
Most of the investment dollars in this world are managed by professionals. If you look at the way leverage is typically used in hedge funds, you could even argue that professionals manage more than 100 percent of our savings.
Most professional money managers are compensated with a percentage of the return on investment that they achieve, e.g., the famous “2 and 20” of hedge funds (2 percent of the total just for showing up to work; 20 percent of any advance; 0 percent of any decline).
Let’s suppose that every 10 years the markets suffer a big stress, e.g., the Russian default of 1998, the dotcom implosion of 2000, or the subprime collapse of 2007. Let’s also suppose that every 50-100 years the markets suffer a catastrophic stress, e.g., the 1929 stock market crash and subsequent depression. An investment strategy that ignores these risks can yield a very high return for 5-15 years. Would you want to pursue such a strategy as an individual? Probably not. A high return for the next 5 years isn’t so great if you might be wiped out in the next crisis.
Consider the professional money manager. If a fund generates high returns for 5-10 years, he benefits handsomely. Then one day the fund blows up and the investors are wiped out. The old theory was that the fund manager would be sad and ashamed. Sure he had the beach house in the Hamptons, the coop in Manhattan, and gold bars under every mattress. But he would never work again and he would be forced to spend his remaining 50 years Gulfstreaming from golf course to golf course.
The entirely predictable subprime “crisis” and the way that it has been treated in the industry and in the media should embolden professional money managers to take even more risk in the future. The guys who blew up are mostly excused. They didn’t act irresponsibly with their customers money for personal gain. They were caught up in an industry-wide and worldwide “crisis” that was practically unavoidable. It seems that the very same folks who wiped out a lot of American dreams will be back on the job in a few months, collecting their 2 and 20 from the next round of investors. And what strategy will they pursue in their new job? The same one that you or I would if given the same incentives: maximize personal income by taking some risks that are unlikely to blow up the fund before the new jet is paid for.
[Exceptions to this rule are money managers like Warren Buffett who keep most of their own wealth in the fund that they manage.]
What do we get when we have tens of thousands of professional money managers worldwide operating with these same incentives? Unstable markets.
That leaves the question of what the next meltdown will be. We have had the dotcom meltdown. We have had meltdowns of debt from various countries that were obvious houses of cards, e.g., Argentina. We have had the U.S. “sold by criminals to deadbeats, rated by idiots, bought by fools” mortgage meltdown. We have had a substantial meltdown in the value of the dollar. My prediction is that the next collapse will be caused by a collapse in the prices of oil and gold, items that people currently believe can only go up and are making big bets based on those beliefs.
How could gold not go to $2000/ounce and oil to $200/barrel? The Earth contains an unlimited supply of gold if you’re willing to spend enough to extract it. That’s also what we were always told about energy, i.e., that if oil went to the seemingly ridiculous price of $50-80 per barrel, all kinds of alternatives would become viable. We would have geothermal systems pumping cold water down into hot dry rock. We would have all kinds of solar. We would be melting down shale into oil. Maybe folks in the U.S. won’t do any of these things since our government is investing all of its money in trying to make Iraqis love each other and our companies are investing all of their money in China and Mexico. But nothing stops the Canadians, Chinese, Indians, Europeans, et al., from pursuing technological innovation in energy and gold mining.
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