The Pareto Principle and our chances of catastrophe
In 1848 Italian Vilfredo Parato was born and his insights today ring true in almost every facet of life. He observed that 80 percent of the land in Italy at the time was owned by 20% of the people, this also correlated to the fact that 20% of the pea pods in his garden contributed to 80% of the actual pea production. This principle is famous in business and a naturally recurring phenomena.
With the looming second round of the global financial crisis hiding around the corner we have to consider the chances of this occurrence happening.
There are three factors that can significantly contribute to the next crisis.
Contagion in Europe: Greek debt will be taken care of, but Italy, Ireland, Spain will be to much for the political will and the economic might of Germany to bail out. What are the chances of contagion?
U.S. Debt Crisis: The Republicans standing shamelessly in the way of doing what is right for the American people, and preferring to play chicken with the global economy in order to retain tax benefits for the rich, is a sad day indeed. The fact that an inspirational leader like Obama and the well meaning Democrats can be held to ransom is sad, yet that is democracy. However, the Republicans have a weakness. They have to approve the debt ceiling increase and be flexible on a real plan for change. If they are not and the U.S. credit rating is downgraded or seen as a higher that AAA risk, then the cost of borrowing for the U.S. could increase by at least 1%. 1% on the U.S. debt equals $140 billion dollars (per year). That is not going to get the Republicans re-elected for another decade. Chance of default?
China’s Economic Overheating or Handover of Power: China is taking steps to counteract the beginnings of a few economic issues. The economy is starting to overheat, the threat of inflation is looming and the government is clamping down on business to keep it in check. Also the advantages that China has in terms of an abundance of cheap labour in the countryside is beginning to recede and in a few years the working age population will peak, presenting Xi Jinping (the potential next leader) and his successors with the real challenge of managing the problems that the one child policy will bring to the future generations of overburdened children. China problems are not tomorrow, they are in 20 years from now.
Is the chance of a crisis 80% or 20%?
Given the factors I have laid out what does the “Market” think our chances of catastrophe are.
Lets have a look at the Russell 3000 (RUA-X)
Chart Courtesy of Worden Brothers Inc.
Judging from this chart of the Russell 3000, the market participants do not believe there will be another crisis, otherwise the markets would be significantly lower than they are today. Considering the clash of the triumvirate of potential causes of crisis, the market in the U.S, and indeed in the rest of the world are staying buoyant. However, the markets are waiting with baited breath.
My view is that there is only a 20% chance of a crisis. there is too much too lose for everyone involved from the Republicans and the U.S People to the European nations in the European project. The power handover and economic management in China will be ruled with a strong (unfortunately for the people) hand.
So, if there is an 80% chance of averting a crisis and it is indeed averted, what could happen? Well there may be a 20% chance of a strong rally to take us truly to a new high. However, until the U.S. truly overcomes its flustering political system I suggest the may be an 80% chance of slow growth in the markets. It will take something special to beat the 10 years of no growth in the U.S. markets. The 20% chance of growth will be nice if it happens.
What if the 20% chance of a crisis occurs.
I believe that if all goes wrong in the U.S., Europe and China, there may be a crisis like we have never in our lifetime witnessed. There are too many investors that have lived through the last financial crisis and hold it in recent memory. If things take a turn for the worse, the volatility of the market will be incredible. People will pull their money from bonds which suddenly have become risky and will not put in in the stock market as that will be collapsing. Where will the money go? Banks? Under the mattress? Gold? Silver?
If the 20% chance of a crash does occur, you will need to be out of the market as soon as possible. Why? So you can preserve your capital and wait for the biggest buying opportunity of your lifetime. Presuming that is, your capital is still worth something.
Maybe we will want to invest our money in seeds and grow a vegetable garden like Vilfredo Pareto had. At least we could observe the production of our peas and have something to eat.