Taking Stock / The Worst Investment Adviser in the World

"Safety net." Or how about "Huge withdrawals from provident funds." And then there's "The end of the era of stocks! And let's not forget "state panel of inquiry."

These were some of the headlines in the recent past. Do they ring a bell? They should, as they were plastered all over the front pages not ten years ago or even five or one, but only half a year ago.

Some reflected true fear among capital market players that the general public would succumb to panic, setting off a snowball whose resultant roll would trigger an avalanche that would bury the financial system.

But most of the headlines concealed behind them the vested interest of certain players who actually stood to gain from public panic.

Happily, leaders at the Finance Ministry and the Bank of Israel didn't take fright at the headlines. They were not manipulated into unnecessary moves. More important, the public didn't succumb to the dirge of the panic-mongerers. There were some panicky withdrawals from provident funds, for a few weeks. But overall the financial system outside the banks proved extraordinarily resilient to the unprecedented external jolts that were shaking it.

The government stood firm against calls to inject tens of billion of shekels into the capital market. Nor did it infuse money into the bond market or subsidize provident funds, executive insurance policies, the new pension funds or the training funds. The safety net it did finally lay out was symbolic, designed to soothe certain politicians who did take fright at the headlines.

No committee of inquiry was set up, nor should one have been. The main reason for the retreat in the capital market last year was the global economic crisis, the inflation of credit around the world in the last five years, and the sudden deflation of the balloon in the second half of 2008.

If such a committee were to be appointed today, its members could have found themselves in a quandary. About half the losses suffered by provident fund holders last year were recouped in the first five months of 2009. Particularly adept fund managers recouped two thirds of their funds' losses.

After the crash of 2008, nobody can say they aren't aware of the risks lurking in the capital market. Nobody can claim to have been misled into thinking that a provident fund is a safe cuddly vehicle that will protect the value of their money. After all the reports of the provident funds' massive losses last year, only a blind and deaf illiterate could claim to be unaware of the risks.

The rapid surge in stock and bond prices has created a golden opportunity for holders of provident funds, insurance policies and pension funds who were previously unaware of the risks to transfer their money into less volatile avenues.

But it would be very surprising if we suddenly see a rapid outflow of money from these vehicles in the months to come. That's because almost all investors find the gains have whetted their appetites and diminished their fear of risk.

The gains this year were mainly fueled by three things.

That third reason is the most worrying one. In it are the seeds of the next crisis.

One of the main reasons for the financial crisis of 2008 was cheap money: the low interest rates around the world during the preceding five years. Cheap money led players to take bigger risks and borrow more, reaching the highest leverage levels in history. The ratio between credit to GDP peaked in late 2007, at about 100% above the level on the eve of the 1929 crisis.

What's going on now? Washington and the U.S. Federal Reserve have started to administer double and triple doses of steroids to the economy. Trillions of dollars are being injected directly into major veins and arteries.

This violent action will bear a heavy price. It may take the form of high inflation, collapsing currencies and much more, most of which we can't foresee.

At today's bottom-crawling levels of interest, the temptation to return to risky assets and longer-term bonds (which promise higher yields to maturity) is huge and growing by the day.

But bottom-crawling interest rates create a dangerous environment in which to make business decisions, for several reasons.

For one, when interest rates start climbing again investors could suffer huge losses on all kinds of financial assets, mainly long-term government bonds, even the safest of them. Secondly, the situation leads investors to lose their sensitivity to long-term risk, until the next crisis.

So the next time you're at the bank, or participating in an investment committee, or sitting on the board of directors, and cite the low rate of interest as grounds for a decision - remember that just as revenge doesn't pay, neither does basing decisions on low interest rates. Low interest is a terrible investment adviser.