How to Detect Early Indicators of Financial Chances and Risks

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How to Detect Early Indicators of Financial Chances and Risks

Was the gravest economic crisis since the big depression of the thirties predictable? Most of the experts have been caught by surprise how drastic the economic world was driven to an abyss during September and October 2008. Now, when we look back about what has happened, we get aware about subtle signs of warning that have occurred a long time ago. No crisis comes completely out of the blue.

Some early indicators of the crisis

The crisis started in the US economy. The Gross Domestic Product of the US has shown a sound and stable economic growth during the beginning of that decade. “The Economic Blue Screen of Death – John Maudlin’s Weekly E-Letter” reveals, however, that there would have been only a very moderate growth of the GDP, if the accumulation of debts on mortgages were subtracted. It seems that the increase of the real estate prices has influenced the GDP. There was furthermore an accumulation of debts on consumer credits. The favourable GDP development was propelled by debts. Without the high accumulation of debts, the GDP would have shrunk.

The big investment banks, commodity firms, private equity firms have taken higher and higher risks. They have financed their growth with loans and they have increased the leverage on their balance sheets. Some big players on the financial market have accumulated loans that have been 50 or even 80 times higher than their own equities. Thus they could impress their shareholders with brilliant returns on equities. The pyramid of debts collapsed as the investments loosed their value. Prominent banks and in the case of Iceland even a state have worked like a hedge fund. This has been insane.

A colleague has shown me the indices of the real estate prices in the US. A series of indices during the actual decade does not have shown alarming signs. It only has shown a moderate decrease since around 2005. Long term indices, however, that started around 1963 have shown a sharp decline since 2005. It seems that long term data analyses might reveal early indicators of trends.

Another sign of warning are widening spreads on yields on interest rates. They indicate higher risks.

What are the lessons to learn from the crisis?

We always get wiser after a disaster. We usually detect the early indicators of alarm after and not before an event but we can draw some conclusions from the actual crisis. Following indicators could be considered as early signs:

Consumption and real estate prices are driven rather by an insane prevalence of debts than by an increase of productivity and purchasing power.

Banks and other firms blow up the leverage of their balance sheets. They drive their business with a disproportionate high level of loans on their balance sheet.

We always should consider if an enterprise as well as an individual person is able to cover the liabilities if circumstances alter, e.g. the interest rates increase. Do they achieve a sufficiently high income in order to pay back their debts? Does the balance sheet show a sound current ratio?

Are forecasts based on long term data analyses or short term indices? It seems that long term data could reveal further trends, if we were able to read and interpret them.

Are the presented success stories plausible? Common sense may be helpful. Is a return on equity of 20% or even higher sustainable? An old rule tells us: high yield means high risk.

Some discipline is inevitable in order to survive. If everybody runs to the stock markets or deals with commodities and the media announces new record data, it is usually time to withdraw. The abyss follows the excess.

Can we detect early indicators of promising opportunities?

Another exciting issue would be, if we were capable of detecting early indicators of promising business or investment opportunities in the future and how we could use them to make money. The audience is invited to discuss such ideas at the Forum of Make Money Tip. The website is http://www.makemoneytip.com

Liliane Waldner

Article Source: http://articlenexus.com

Liliane Waldner is a business economist. She lives in Zurich. She has been in a member of the parliament of the State of Zurich during 17 years. She has attended the board of several public entities and companies, some of them dealing with the financial markets. Her website is www.makemoneytip.com

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