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Pent-up pessimism

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Wednesday, Feb 28, 2007

A break from Billy Squier video deconstruction for something more trivial: Yesterday, stock markets around the world fell precipitously: In America the Dow dropped 3.3%, the S&P 500 was down 3.5%. What prompted the sell off seems to have been the Chinese market falling by 9% on Monday (which may or may not have had something to do with Greenspan talking about recessions in Hong Kong) and the report that durable goods orders fell 7.8%. But the truth is, as Felix Salmon reminds us here, that no one knows exactly why this happened.


any halfways-decent financial journalist gets it, and, if honest, would simply write a story saying “the market went down and we don’t know why”. But instead we’re inundated with “explanations”, from an assassination attempt on Dick Cheney (Daily Intelligencer: “Are investors balking because Cheney was attacked? Or because he wasn’t hurt?”) to a drop in one of the most boring economic series in the US. (Go on – quick – tell me what a durable goods order even is.)


CNN quoted Hugh Johnson, chief strategist at ThomasLloyd Global Asset Management, who shares this scary perspective: “Markets can decline in one seemingly isolated part of the world and that decline can be transmitted to other parts of the world through the psychology,” he said. This is by no means an isolated or unusually insightful comment about investor psychology. The Capital Speculator blog echoes the sentiment:


we don’t have a clue about what’s coming. But we do have a firm grasp of history, which is conveniently available for all to see in full clarity.
The fact that China and subprime mortgage markets have slipped may be dismissed as marginal events of no real relevance to the capital markets. But we think such stumbles are early warning signs of things to come. Granted, this is a highly speculative notion and so readers should proceed accordingly. Nonetheless, we think our view has merit if only because bull markets have flourished across the spectrum of asset classes for some time and, well, nothing lasts forever.
As such, we’re keeping a diary of market corrections large and small. If and when they accumulate, the broader investment community may become jittery. It’s virtually impossible to predict market peaks and troughs, but at this late stage in the bull market cycle we’re increasingly anxious and so we’re keeping an eye out for additional warning signs. Having built up a tidy nest egg, we’re in no rush to watch it evaporate. Been there, done that. Wealth preservation, in short, is at the top of our financial priorities at the moment.
It’s never clear what might trigger a broader sell off, but we’re mindful that it could be seemingly low-risk events when the supply of optimism reigns supreme around the world. History suggests no less. No, the financial gods don’t wave flags or ring bells at market tops or bottoms, although sometimes they whisper in your ear and suggest things.


In other words, bull markets last until they don’t anymore. 


It’s disturbing to think that shareholders are like Wile E. Coyote having just run off the cliff, and they can stay aloft only as long as they don’t notice there’s no longer any ground beneath them. Suddenly business seems much more like astrology, and the copious amounts of carfully scrutinized market data (which usually reassure me) become no better than the careful tracking of the stars’ movements and configurations. The data can be verified, but the interpretations seem more and more speculative.


Also, if confidence alone is what props up markets, the business press becomes implicated in either sustaining or undermining it; virtually everything one reads in it must be considered in that light and the optimism expressed must always be discounted: that means this sort of story about stocks bouncing back today must be held in some suspicion (unless, that is, you don’t really care why markets move as long as they move upward)—the headlines are almost always out of step with the information buried in the article. The widely disseminated bias against pessimism has roots in this; it’s a crime against the economy (just as it lets the terrorists win if we don’t go shopping).


For a real dose of unfettered skepticism, you need to dig a little deeper into to the econoblogosphere: Here’s arch-pessimist Nouriel Roubini, by way of macroblog with some unpleasant medicine:


The US is likely to enter into a recession in 2007; and even a likely and early easing of monetary policy by the Fed will not prevent such a recession as there are too many weaknesses in the US economy: a housing recession, an auto recession, a manufacturing recession, a real investment recession (as corporations are reducing real capital investment and inventories are falling), a US consumer that is on the ropes and at its tipping point; a meltdown in sub-prime mortgages that is leading to a generalized credit crunch in the economy. It is already ugly and it will get uglier in the real economy and in the financial markets. We are likely to observe a vicious cycle where a credit crunch and a persistent sell-off in equities leads to a worsening of the real economy with a hard landing (recession) that then weakens further the financial system. One cannot rule out a broader banking crisis if a deep recession occurs.


Dean Baker, after ridiculing the business press’s tendency to get only the opinions of the same prognosticators who failed to see the drop coming (“After all, once we accept that the earth revolves around the sun, we don’t want to get all our information on astronomy from believers in an earth centered universe”), also looks at the fundamentals and doesn’t like what he sees:


The fundamentals I see are the unraveling of a housing bubble, leading to further declines in the housing sector, and a big hit on consumption, as the fuel of bubble created housing equity disappears. The hope that declining construction and weak consumption would be offset by soaring investment disappeared with yesterday’s data showing a sharp drop in durable goods orders. It looks like investment is going the wrong way. Throw in the fact that rising interest rates in Japan may slow the inflow of foreign capital that has kept long-term interest rates so low and productivity growth appears to have slowed sharply (benchmark revisions next week will push reported productivity growth over the last two years downward) and it’s pretty hard to find much positive in this picture.


This WSJ editorial, hoping to forestall rate cuts by the Fed, blames the mortgage-related securities industry and the repackaged subprime loans that have been unwinding lately. You would think they would welcome rate cuts as stimulus, but that would run the risk of boosting inflation (which is bad for those who don’t live off wages) and also could spur currency movements and jeopardize the mysterious carry trade—borrowing money at low rates in Japan to invest elsewhere, where rates are higher. According to the NYTimes article:


The possibility of rate cuts by the Federal Reserve also kindled concerns that American interest rates might eventually fall far enough to significantly close the gap with Japan’s rock-bottom rates. That gap is wide now. Japanese overnight lending rates are 0.5 percent compared to 5.25 percent in the United States. But if the gap shrinks, it could slow or halt the so-called yen carry trade, in which investors borrow hundreds of billions of dollars worth of Japanese money to invest in stock markets across Asia and around the world in search of higher returns. If this flow of money stops, or reverses, it could prompt larger sell-offs on Wall Street and drive the yen even higher, hurting Japanese exporters even more, analysts said. “Bernanke holds the trigger,” said Kiichi Fujita, a strategist in Tokyo for Nomura Securities. “If he cuts interest rates in America, the worry is that the yen carry trade will unwind.”


I’m sure it’s my financial naivete, but the carry trade (like many forms of currency arbitrage) always seems immoral to me, like cheating—it seems weird to make money not for producing anything but for shifting nominal figures around—but I suppose they are taking on a fair amount of risk. When the value is nominal, it can go against you in a hurry.


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