Each time optimists had thought the “worst is over,” fresh events emerged to further strain financial markets. Now, as the year draws to an end, worries abound about global financial stability, the general mood is somber and despondent, and “Minsky Moment” has become a catchphrase in the financial pages.

Economists, bankers and investors have realized that recovery could drag out for years and will weigh on banks, companies and consumers alike. Although the International Monetary Fund, in its World Economic Outlook in October, noted a modest recovery may begin later in 2009, it said the situation is exceptionally uncertain. So, while there are grounds to be cautious, perhaps even fearful, in the time ahead, are there reasons to be brave? For the long-term investor, the answer is yes. Why? The answer lies in the nature of long-term investing itself, as well as a belief that, as grim as many current numbers and graphs may now appear, long-term forces should ensure areas of growth and investment opportunities.

In Manias, Panics and Crashes, Charles P. Kindleberger observed financial crises have occurred at roughly 10-year intervals over the last 400 years. Examining more than 40 financial crashes from 1618 to 1998, ranging from the currency crisis of the Holy Roman Empire to the Dutch tulip bubble, the Great Depression and Black Monday, Kindleberger explained the boom/bust cycle: “What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone, in ways so closely resembling irrationality as to constitute a mania. Once the excessive character of the upswing is realized, the financial system experiences a sort of ‘distress,’ in the course of which the rush to reverse the expansion process may become so precipitous as to resemble panic.”

The relevance to recent events is striking. Undoubtedly, as Paul Samuelson noted with uncanny prescience during publication of the fourth edition of Kindleberger’s book in 2000, many people may now be kicking themselves for not reading and re-reading this work. Yet, two questions still emerge. First, if financial crises occur so frequently, why are we surprised when they happen?

James Wolfensohn, former president of the World Bank, commented in an interview that “the history of financial markets is that the crisis that comes is never exactly the same as the last one. We have an endless capacity to invent new ones.” Then again, it could simply be that in times of optimism, greed, euphoria and despair know no limits, that regardless of the trigger, the root cause remains the same. This then leads to a more critical second question. How can investors prepare for times of such financial turbulence?

From a long-term perspective, the current market turmoil should come as no surprise. Centuries of experience teach that bubbles don’t deflate slowly – they burst. Afterwards markets recover, grow and develop. A recent study of 255 recessions (defined as a year in which the rate of growth of real GDP in a country is less than zero) that occurred in 17 Western countries between 1871 and 2006 found that 164 lasted just one year, and the large majority were over in two. *

Based on these findings and the scale of the current crisis, predictions that a recovery would begin in the second half of 2008 always seemed optimistic. It could even be that 2009 will turn out worse than 2008, but a long-term investment perspective dedicated to fundamentals should have helped investors avoid many of the worst problems of the crisis.

Indeed, it is important to remember that fundamentals have always prevailed in the long term and such an approach even finds opportunities in times of crises. Mohamed El-Erian, the co-CEO and co-CIO of PIMCO, and winner of the Financial Times Business Book of the Year award for When Markets Collide, has noted that the markets provide a duality of both great opportunity and enormous risk. Central to his argument is the belief that the toxic mix of conditions is causing high-quality assets to be divorced from the underlying quality. “Rather than reflecting fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruptions in the financing of highly leveraged owners that have no choice but to dispose of assets in a disorderly fashion,” El-Erian commented.

Roderick Munsters of ABP, the Dutch civil servants’ pension fund, expressed it more succinctly: “This is hunting season.” The giant €195 billion fund avoided the losses associated with subprime and is positioned to take advantage of the credit crunch. Integral to the approach of long-term asset managers like El-Erian and Munsters is the admission that predicting the precise direction of current global markets is difficult, particularly as many of the vulnerabilities in both the real economy and financial sector remain hidden. However, implicit is the belief that markets will recover and that such wild market swings can be compensated for. Munsters cheerfully admits to turning in negative numbers because he has faith that investments will rally. When it comes, the new normal will not be as exhilarating as the recent past, but in the long term markets will rebound.

With the credit crisis blame game in full swing, what lessons can the long-term investor take from events of the past 18 months? In its 2008 Global Risk Report, the World Economic Forum commented that globalization has allowed greater participation in the risk economy and improved financial diversification, but it may have resulted in a systemic under-appreciation of risk. The increasing complexity of financial markets and the rate at which they are evolving make the task of avoiding and managing systemic risk extremely difficult. Plus the increasing global interconnectedness has multiplied the possible pathways for the contagion of financial risk. The paradox is that “while the financial system has been made more efficient and stable in normal times, it is more prone to excessive instability in really bad times.” As a result, an awareness of risk and risk management will be increasingly viewed as a prerequisite for effective control in years ahead. Failure to do so means a repeat of recent experiences: the destruction of corporate reputations, the erosion of wealth and the collapse of institutions. Critics will be quick to note that many institutions hardest hit by the crisis have some of the largest risk management teams. However, over-reliance on limited risk assessment or particular models should be avoided. And particularly when emotions and greed override reason, it lays the groundwork for disaster.

El-Erian has also stressed the importance of risk management. He has commented that we are “exiting a world in which the difference among individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.” Be brave: sophisticated risk management, divorced from the emotions that have characterized the markets in recent years, is an important element in the informed investment strategy of the long-term investor, along with proven instruments such as true diversification. This supports long-term growth.

No one is predicting that volatility will diminish soon, or that nasty shocks may not still lie in wait. In fact, with justification, the current crisis is described as the worst since the Great Depression. Certainly, long queues outside UK and US banks evoke parallels. But then, this label has been applied numerous times since 1929. And “worst since” highlights similarities between the two eras, not differences. Between 1930 and 1933, the annual output of the American economy fell by nearly 30% and the unemployment rate hit 25%. US shares lost three-quarters of their 1928 value and did not regain it again until 1952. This catastrophic collapse remains by far the worst to ever hit the Western world since the Industrial Revolution.

In the intervening years, economies have sustained potentially devastating shocks and emerged largely unscathed. For example, on Black Monday in October 1987, stock markets around the world collapsed. In a single day, the Dow Jones Industrial Average fell by 22% alone. Yet, this failed to tip the world into recession. Central banks moved quickly to buoy credit market conditions and confidence was regained. By 1989, the Dow Jones had climbed back to the pre-panic levels. The focus on gloom and doom also means the underlying structural success, the grand themes shaping our times, are downplayed, such as the performance of the emerging economies and the massive growth of the middle class within these markets.

Although the IMF expects global real GDP growth to slow significantly, from 5% in 2007 to 3.9% in 2008 and 3% in 2009, this would still be more robust than many years in the two decades until 2000 (3.1% average annual growth). Emerging markets will drive the bulk of the growth, as they have done from 2000 to 2007.

Although these economies are expected to lose steam, with growth projected to drop to 6.9% in 2008-2009 (down from 8% in 2007), they have proved relatively resilient to the crisis so far.

Behind these figures is one of the most astounding events of modern times: the explosion of the world’s middle class. It has been noted that about 70 million people a year are entering this wealth group globally and that the emerging markets will be home to an estimated 1.15 billion of them by 2030. The hopes, aspirations and financial power of this segment will help emerging markets continue to develop as an independent driver of growth in the decades ahead.

For brave investors, opportunities exist for the long term. However, we caution that bravery in financial terms is not so much the notion of someone rushing into a burning building without thought for the dangers. Rather it is the courage of those who remain steadfast in the face of turbulent seas, who hold their course – and nerves – while those around panic. 

 * Paul Ormerod, Global Recession as a Cascade Phenomenon with Heterogeneous, Interacting Agents (May 2008)