Chapter Seventeen

Overcoming Irrational Market Panic

Learning to Be Objective

If the world needed any greater proof that globalization was (1) here to stay and (2) a force to be reckoned with, the negative impact displayed by Latin American markets in the wake of the Asian crisis supplied it in spades. On a morning in late fall 1997 after we checked into our hotel on Rio de Janeiro’s Copacabana Beach, the high-flying Rio stock market took a stomach-churning 15% tumble, prompted by desperate doings in far-off Hong Kong. That same morning, a sickeningly swift 10% drop on the São Paulo exchange in the first four minutes of the session forced the governors to halt trading for the first time in the exchange’s history.

Riding the Rio Roller Coaster

The steepest declines were racked up by a series of high-flying Brazilian blue chips that had enjoyed an average 93% climb in the first nine months of 1997. Anchoring the group were the three prime poles of the Brazilian privatization tripod: Telebras, the state-owned telecom company, Eletrobras, the state-owned electrical utility, and Petrobras, the state-owned oil and energy company. With the Bovespa (Brazilian Stock Exchange index) dropping like mercury in an ice storm, it looked as if the second-best-performing stock market in the world (after Russia) was heading full-speed into a brick wall.

So why were global investors getting so hot and bothered over Latin America, when the currency crisis appeared to be confined to Asia, half a planet away? One easy answer, as well as a true one, was that the whole world was now so intricately interconnected that it was no longer possible to buffer any one market from the behavior of others due to distance alone. Just as chaos theorists had proposed that a butterfly flapping its wings on one side of the earth could cause a hurricane to break out on the other, the slightest trembles and tremors in one financial market could easily infect and influence the others, even if their commercial connections were rather remote. Of course, markets also move in their own directions, one often markedly different from the other.

First-Class Buying Opportunities

How does that affect the investor? Here’s how: These global perturbations often present an unprecedented wave of first-class buying opportunities. When markets overshoot and undershoot due to irrational factors, that’s when a cool head can win.

If market sentiment suddenly sours on an entire country mainly because it’s perceived to be linked to problems elsewhere, that sentiment may be a function of irrational panic, not cold calculation.

In the same way, if sentiment sours on a whole country when individual companies inside that country are still doing well, you can find bargains in stocks that are artificially depressed because of no other reason than popular knee-jerk reactions to temporary events.

With most emerging markets overexposed to the ins and outs and ups and downs of flight capital—money that can be moved in and out of a market at a moment’s notice—it’s critical to figure out whether these sudden panics (as well as flights of irrational exuberance) are justified by the fundamentals. Because if they’re not, betting against them can be your ticket to ride.

Let’s take Brazil, for example; the swift transformation from a mixed to a market economy that Brazil pushed itself through during the five years prior to 1997 had set the pace for a regional record 5% growth rate in Latin America in the 1990s, and a record US$45 billion in direct foreign investment flowing into the region as a whole.

In Southeast Asia, the forex traders’ alleged collective decision to attack a currency—otherwise known as short selling that currency, with many individual players placing the same bet that it would wilt under pressure—sent a signal to less-plugged-in investors that possibly a few things were rotten in the underpinnings of the so-called Asian miracle—things like rampant corruption, insider dealing, and a lack of transparent markets. That behavior sent those markets into a tailspin, but it would have been realistic, not masochistic, for government officials of Malaysia and Indonesia to bless those currency traders, not curse them.

Why? Because by shining their harsh speculative spotlights on the flagrant weaknesses in their economies, the forex folks were expertly diagnosing precisely what ailed them. Those governments didn’t need to hire high-priced consultants, because the currency traders were doing the job for free, with the icing on the cake being a quick profit if their bets went the right way.

But what about Latin America? The prospect of Asian contagion infecting Latin America was like a golden door swinging wide open for bargain hunters, because the supposed links between these two vibrant regional economies were not nearly so strong as popular opinion would have it. Yes, these countries did trade together, and did compete as exporters of goods to more mature markets. But just because they shared some superficial similarities didn’t make Latin America just like Asia. If anything, the two continents were growing less alike than ever before.

When the raft of Brazilian blue chips took their first real nosedive in a decade, mainly due to trouble in Asia, I felt in my bones that we were looking at a phenomenon known as spooking.

When the ordinary run of buyers gets spooked, that’s the time to step up to the plate and start putting your money down on the table.

Here We Go Again

A major reason that global investors were up in arms over Latin America, after those same markets had doubled, on average, over the previous six months, was that some of the same sins—low or negative current account balances, high foreign trade deficits, creeping inflation—that had brought the Asian tigers low were running rampant in Latin America.

Brazil was more vulnerable to being downgraded in investors’ books than its neighbors were, because its currency—the Real—was widely regarded as at least 30% overvalued. But it was important to recognize that although the prospect of a currency devaluation—either abrupt or gradual—represents currency risk in action, a devalued currency can be a country’s saving grace, because gradual, panic-free devaluations can kick exports through the roof.

Some simplistic strategies would have you bail out of a country at the slightest hint of a devaluation coming down the pike, because the same share of stock will be worth that much less, in Dollar terms, once the currency declines. But I see things differently. Combined with the negative sentiment that such a prospect represents, I view signs of an impending devaluation as a possible signal to buy into a country—because even if the markets do pull a temporary nosedive, the eventual bounce-back will be all that much stronger than before.

In Rio, the first casualty of the currency traders’ preliminary skirmishes was the confidence of local stock traders, who found themselves caught with their pants down by a wave of frantic short selling in anticipation of the coming currency crisis. As one young Rio derivatives trader gloomily observed to the New York Times on the morning of the crash (euphemistically called by some brokers a “correction”): “What can I say? Brazil today is no-man’s-land. The future is cloudy and stormy, and everyone around here is concerned and desperate. Everything here is so exaggerated. Brazil is a land where death comes suddenly.”

Talk about an upbeat assessment!

From my point of view, reading words like these in a daily newspaper was like being handed an engraved invitation to a party. If Sir John Templeton said it once, he said it a thousand times: The right time to buy is always at the point of maximum despondency. Well, here we were at rock bottom, and I was drawing up a shopping list the length of my arm.

Having just left Thailand (which I would have nominated as the global capital of pessimism), it now seemed as if Brazil might be a contender for that dubious distinction.

Among the many reasons being proffered in the press to back up the purported link between Brazil (and Latin America in general) and the problems besetting Asia was that South Korean banks, when the going was good, had bought scads of high-yield Brazilian Brady bonds and would now be forced to dump them on the open market, at fire sale prices, in a desperate bid to raise cash. (Brady bonds, incidentally, were an innovation devised by U.S. Treasury Secretary Nicholas Brady of the Bush administration, by which the U.S. government backed emerging market debt, permitting such countries to borrow on international markets at lower rates.)

Though the Brazilian-Korean bondfire sounded fine on paper, personally I wasn’t buying it. For one thing, the amount of money involved, when compared to the size of Brazil’s economy, was inconsequential. Another supposed connection between Brazil and troubled South Korea was that South Korean producers were going to start flooding the world with cut-rate cement. Although not entirely off the mark, the adverse effect on a single industry was hardly sufficient to justify the downgrade of a whole country, much less a full-scale market stampede.

It’s important to realize that when a panic starts, it takes only the slightest hair-trigger to turn a run into a rout. It can be cement, Brady bonds, or bubblegum—it doesn’t matter. The reason for turning tail could even be a missing millionaire. On our second day in Brazil, a completely unfounded rumor that a major Mexican industrialist had disappeared—presumed kidnapped, or even killed—sent shock waves through the region’s capital markets. Just as inanely, they promptly bounced back once it was disclosed that the rich gent in question was alive and kicking.

Korean-owned Brazilian bonds, cut-rate Asian cement, and allegedly abducted industrialists all provided jumpy investors with the lazy-headed excuse they were looking for to start dumping Brazil big-time. When things are looking lousy from any number of angles, the collective unconscious always starts snooping around, looking for evidence—no matter how far-fetched—to bolster its depressed emotional state. And that’s just the time, as a savvy investor, that you should start taking a serious look at the country.

If the whole world is down on a country for exaggerated, short-term reasons, think of shifting it from a hold to a buy.

Note: You can take advantage of rumors like the missing industrialist by snapping up stock during the moment’s downturn, and riding the shares back up north when the smoke clears. But this sort of market timing is a risky, hair-raising strategy—not a move for the novice player or an investor most interested in maintaining a long-term investment horizon.

Don’t get me wrong. There were more than a few superficial similarities between Asia and Latin America. Like South Korea and like Thailand, Brazil’s once-red-hot export growth had been slowing to a crawl all through the fall, a slowdown that had spread to other Latin American economies. The country’s current account balance was starting to look like the credit card bill of a confirmed shopaholic. But in contrast to Thailand, where the government had proved ludicrously ineffective in staving off the alleged forex traders’ assaults, Brazil’s popular president, Fernando Henrique Cardoso, was determined not to let that shadowy crowd get the best of him. If they wanted to fight, he was more than willing. In fact, for better or for worse—personally, I felt for worse—he was willing to defend his currency to the political death, if need be.

Facing Reality

Unfortunately for his citizens, who would soon start feeling the heat, President Cardoso had an election coming up. So he had to act, and act fast. The 66-year-old president knew better than anyone that if the Brazilian Real—which he had personally created—were to start heading south, he would be hitting the South Polar ice cap right along with it. In short, the man’s credibility was on the line.

The only problem I had with Cardoso’s tough-it-out strategy was that there are times when a devalued currency can kick a failing economy back into high gear, by jump-starting exports. Preventing a currency devaluation can have as much to do with salvaging national pride as with hard-core economic reality. When, in January 1999—shortly after his reelection—he was forced to let the Real float freely, the Brazilian market surprisingly soared. Why? Because the markets were finally forcing the Real to face reality.