Market turmoil: Thin end of the wedgie?

One of the stand-out phenomena from the recent mini-crash in equity markets has been the sight of investment strategists flocking, like bees around honey, to the meme that these recent economic woes represent an opportunity to invest, even repeating this mantra as the Dow Jones Industrial Average experienced its most volatile session in almost 120 years.

Many of these comments have led me to assume that either brains weren't engaged before mouths or the commentators just don't understand what's actually happening -- like the observer who tried to minimize China concerns by claiming that when he looked at Chinese equities he didn't look at Shanghai, but Hong Kong instead. That's quite a worry: It's precisely mainland China that we should be focusing on right now.

Complacency can be the greatest enemy of risk management.

The biggest worrying trend is the widely repeated mantra that this is a great time to invest because "markets are lower now than they were and everything works out for the best over five years."

Personally, I don't believe it's possible to accurately predict short- or medium-term market direction at any time but, right now, to expect that equity markets will be higher in five years than today is over-simplistic.

Equity markets do tend to be higher at the end of most 5-year periods but not always, especially in extremis. And there are signs that economic conditions today could well be in extremis.

It's important to recognize that there's a possibility that there could be a bubble out there waiting to burst and, if so, it could well be the biggest burst we've ever seen. A minority of observers, such as my colleague at IDEA Economics, Professor Steve Keen, who alluded to this in his 2015 Outlook , seem to be aware of this.

To show just how dangerous and misleading the view that markets bounce back within five years can be, let's take a look at the prelude to the Wall Street Crash. What's particularly worrying is that if we compare that with today, we can see that a similar pattern exists, with the trend similar to where we'd reached in 1928.

What's more, there are fundamental similarities too: Wall Street asset prices are high mainly for financial rather than commercial reasons. There isn't the Main Street economic performance to justify this as evidenced by pitiful year-on-year gross domestic product (GDP) change, historically low employment levels and consumer price inflation that is trending towards deflation.

This is particularly worrying because after 'The Crash' it took until 1955 for the DJIA to get back to its 1929 peak – with a crash, depression and world war in between.

Whenever there's an outsize bubble, speculation tends to turn to seeking out where there might be a pin to burst it. The biggest pins out there right now seem to be the euro zone, the Federal Reserve and, above all, China.

Following the GFC (global financial crisis) prices, the Chinese private sector (with government encouragement/coercion) has taken and is still taking on extreme amounts of debt. Corporate debt alone has grown from nowhere to officially over 125 percent (and in reality probably closer to 200 percent) of China's GDP in 2014 Q2.

In addition, it seems certain that the Chinese banking sector has "restructured" extreme amounts of historic bad debt and is understating current non-performing loans. Add in local government loan platforms where the problems are being hidden plus the prevalence of highly dubious wealth management products and it's a time when being fearful feel more appropriate the being cheerful.

In short, the investment market discomfort of recent months may be the thin end of a very long and painful wedgie.

Paul Gambles is co-founder of advisory firm, MBMG Group.

Disclaimer: Please Note: While every effort has been made to ensure that the information contained herein is correct, MBMG Group or I cannot be held responsible for any errors that may occur. My views do not necessarily reflect the house view of MBMG Group. Views and opinions expressed herein may change with market conditions and should not be used in isolation.

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