In the wake of the global financial crisis of 2007-2009, economists have cause to ponder the adequacy of their intellectual frameworks for understanding the way economies, and especially systems and markets, function. Many of what had come to be widely-accepted verities – including the ‘efficient markets hypothesis’, the merits of self-regulation, the assumptions that people behave in rational and predictable ways, the use of statistical models to measure risk – have been seriously challenged by the course of events. So too has our reputation for being able to forecast crises and cyclical turning points.
Saul Eslake, The Shann Memorial Lecture, University of WA, 19/8/2009
We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called ‘animal spirits’ are fundamental forces driving macroeconomic fluctuations.
Paul De Grauwe, Financial Times, London, 22/7/2009 – "Warring economists are carried along by the crowd."
Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. BUY when others are despondently selling. SELL when others are greedily buying. When too many people are doing the same thing, the market will adjust. Bull markets are driven by liquidity.
Ecinya Investment Rule #4, 1997. Refer to ‘Market Wisdom’ tab for the complete set of rules.
Firm predictions are out of the question. The future depends on the policy responses the financial crisis will provoke. But we can identify the problems and analyse the policy options. We can also make some firm predictions about what the next era will NOT look like. The post-World War ll period of credit expansion will not be followed by an equally long period of credit contraction. Boom-bust processes are asymmetric (not identical) in shape: a long, gradually accelerating boom is followed by a short and sharp bust. Consequently, most of the credit contraction can be expected to occur in the near term.
The Bush administration shows no understanding of the predicament in which it finds itself. Eventually, the US government will have to use taxpayer’s money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent. The Bush administration resists using taxpayer’s money because of its market fundamantalist ideology and its reluctance to yield power to Congress. It has left the conduct of policy largely to the Federal Reserve. This has put too much of a burden on an institution designed to deal with liquidity, not solvency, problems.
George Soros "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and what it means."
The sharemarket posted its biggest one-day gain in more than a month yesterday, underpinned by US central bank optimism about the prospects for global recovery as well as earnings upgrades flowing from the local profit reporting season. The S&P/ ASX 200 Index added 135.5 points, or 3.3 per cent, to close at 4426.1, as upbeat US housing data and optimistic comments from Federal Reserve Chairman Ben Bernanke bolstered confidence about the global outlook.
Front page Australian Financial Review "Bernanke’s optimism lifts shares."
PROLOGUE
This week’s Insights follow on from last week’s "Navigate the Noise" and run in tandem with each of our Insight articles since our new site began on a stand-alone basis on 28 July (vis previously being part of the E*Trade web-site).
THE MARKETS’ ENDLESS DANCE
Economic recoveries are a waltz, and the market since the March lows has been doing the tango, the cha cha cha, and in some cases, rock and roll. The ASX All Ordinaries and the S&P 500, our global proxy, have performed as follows:
XAO/ S&P
- Wave 1 : 43 days UP +25.6%/ +37.4%
- Wave 2: 5 days DOWN -4.1%/ -5.1%
- Wave 3: 20 days UP +8.1%/ +7.3%
- Wave 4: 20 days DOWN -6.7%/ -7.1%
- Wave 5: 31 days UP +17.0%/ +16.6%
Overall primary trend UP from March lows: 119 days XAO +39.8%/ S&P 500 + 47.3%
Our models are suggesting that most stocks are at or near fair value and that forward earnings forecasts do not suggest a significant advance from here. Once forecasts are boosted by a more robust macro-economic picture of enduring quality, the market will have good reason to continue its advance.
About Mr Bernanke
Firstly, Mr Bernanke is an economist and an acknowledged expert of ‘The Great Depression’ so that his policy response has been appropriate. However, it has also been accompanied by a Congressional/ Presidential fiscal stimulus as great as that which followed the end of WWll. Mr Bernanke is up for re-appointment in about October of this year, as his term as boss of the Federal Reserve ends. Many believe he has saved the world economy from a serious depression-type melt-down, and others believe he is the architect of the next great crash. But it cannot be said by the AFR or anyone else that his remarks were ‘upbeat’ and ‘optimistic’. His remarks were heavily qualified, and though some tinges of optimism were evident, the colour of his remarks were a brighter shade of grey, rather than of vibrant red or yellow.
Secondly, though Ecinya attributes much of the ‘crash’ to Mr Greenspan (Mr Bernanke’s predecessor), Mr Bernanke was in The White House as Chairman of the Council of Economic advisers, and no statement of the coming melt-down, the manifest excesses or banking irregularities flowed from The White House. So, Mr Bernanke’s recent record is not without blemish. In fact, it could be said that he followed Mr Greenspan’s view of central banking, as being nearly always politically correct or obfuscatory to induce a sense of comfort. Central banking in the US appears to be only notionally independent, rather than strictly independent. The checks and balances were/ are not in evidence, at this stage of the recovery process.
The US Housing numbers
True, sales of existing dwellings rose at twice the rate they had risen in the previous month, and July was the fourth month of successive rises. However, the AFR reporting neglected to point out, at least at the beginning (our editor stopped reading after the second paragraph), that median house prices fell by 1.9% over the previous month, and on a year-over-year basis have fallen by 6%, and in some regions by double-digits. Given that the median house price is $US168,800 it could fairly be said that the United States housing market is the Aldi of the developed world. Houses are cheap relative to incomes and per-capita GDP.
Summary
The point we are making is that although the share-market rose, the attributed reasons are spurious, shallow, and misleading. A better explanation lies in a more holistic story that repossessions are high and speculation is being fuelled by massive liquidity injections by the Fed. Though housing has nearly stopped its precipitous decline, the housing turn-around only begins when both housing volumes and house prices move up together.
BUT
this ‘made in America’ global recession will, on Thursday of this week, be hit with a BIG important number. The Office of Budget and Administration is expected to report that the US domestic budget deficit forecast over the next 10 years will move from a projected deficit of $7.1 trillion to a projected deficit of $9 trillion. That’s bad news! But the ‘good’ news is that the 2009 deficit will go down from an estimated $1.84 trillion to $1.58 trillion, a reduction of 14%! Under President Bush there was considerable anguish when the actual budget deficit reached $400 billion, approximately equal to 3% of GDP.
At $1.58 trillion the ratio of debt to GDP is around 11.8%. Will this number be the catalyst that drives the US, and other global markets, down? During the week Warren Buffett warned that the US could become a ‘banana republic’, given the growing mountain of official debt. He is reported as having said: "Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of the currency to melt."
We can only wait and see. America cannot afford a national health scheme in its present economic state, but some comfort can be taken that a national health scheme that has to be paid for will not emerge until 2010 at the earliest as the debate ebbs and flows.
AND
Iraq and Afghanistan are still consuming significant resources
AND
US unemployment continues to rise, retail sales continue to fall (except for motor vehicles where the government ‘cash for clunkers’ scheme is proving effective), and the oil price is somewhat elevated above $72, threatening to go higher.
IN CONCLUSION
Though Rosy Scenario is on the dance floor with all of her beguiling charm and flamboyance, dancing with her and falling under her magical spell is dangerous folly at this stage in the markets’ advances. The market lyrics are out of sync with the economic tune, being too far advanced for our comfort.