Think Piece: On Current Stock Market Volatility

At this juncture, the data is patchy as opposed to conclusively pointing towards renewed recession. I think we are experiencing the aftershocks of the 08/09 tumult rather than something worse and more sinister. However, the likelihood of Greek default is more serious than the Lehman collapse was, in that it may portend the partial destruction of a (European) way of life. OECD economies are likely to track sideways but are reliant upon the ongoing health of the emerging economies to buoy trade. The spate of warnings about the economy from policy makers suggests that their models could be sketching worse outcomes than their core pronouncements indicate. In this context, notwithstanding the bulls’ contention that a high equity risk premium renders equities attractive, equities are probably no better than fair value currently. A bear market is underway, and cheaper valuations will likely be seen before the market bottoms. Analysts’ earnings expectations seem high relative to economic prospects, and the equity market will have to absorb a spate of earnings downgrades. The stage is set for lively debates about economic policy; has slavish adherence to a simplistic version of Keynesianism steered economies onto the rocks? Encouraging data from Ireland may point to a way forward.

More Questions than Answers

The current flow of economic data is sending a clear message, it’s a negative one. Economists surveyed by the WSJ now put the odds of the US economy slipping into recession over the next 12 months at 1/3.  The Conference Board estimate the odds of recession to be even higher, at 45%.  It has a very good track record – since 1988 each time it has handicapped the odds of recession at 40% or greater, the economy has indeed dived into recession.  In Europe, the latest projections by the European Commission show an essentially static economy, growing just 0.2% in the current quarter and 0.1% in the fourth.  What is especially germane for the crisis in the Euro Zone is that Germany is expected to tip over into negative growth by the end of 2011.  Of course, Germany is the great white hope on the part of many to rescue the entire Euro Zone from its current travails.  It will be unable to do so if Germany itself becomes mired in recession.  In interpreting this plethora of forecasts it is worth noting that the economic consensus almost never anticipates recession until recession is already well underway. 

Despite this caveat, the data is overall quite patchy and I am not convinced about recession, particularly in the US.  Usually, three indicators provide a pointer to recession.  To signal the imminent onset of recession, hours worked need to be high and falling, housing starts likewise need to be high and falling.  And the yield curve tends to invert, the most powerful signal of all.  The yield curve is currently flat over shorter maturities and rising beyond that.  The Fed’s operation twist will seek to change this. How could it invert, the astute enquire, with policy rates stuck at emergency lows? But despite dismal news on the jobs front in general, hours worked are currently heading upwards.

The most likely scenario I think is that the US economy will continue to track sideways for awhile, which will feel like a recession for many households, especially those displaced from the jobs market and who find that the opportunities to return to full-time work at incomes sufficient to sustain their accustomed standard of living are few and far between.

The Fed is currently attempting to free itself from the horns of a dilemma on which it has impaled itself.  It would like to be seen to be doing something to calm markets, bolster confidence, and especially cause unemployment to fall.  But it failed to raise interest rates when equity markets rebounded and the economy seemed to be clawing its way out of the doldrums.  So now the conventional response – to cut interest rates – is not available.  Prior to the recent action undertaken by the Fed, the majority of economists surveyed by the WSJ thought that the Fed would embark on another unconventional policy thrust, but most thought that it would do no good, and a significant minority, with whom I am inclined to side, thought such measures might well turn out to be as actively harmful.

Already, the Fed has tried to reassure its constituency and boost confidence by issuing a public “reassurance” that policy interest rates will remain at current low levels through to 2013.   But this is scarcely reassuring:  Such an envisaged protracted period of interest rates at emergency lows surely implies that the Fed believes there is a high likelihood that Japan-style economic conditions of sluggish growth or near stagnation will prevail.  For those who remain employed, this is not necessarily catastrophic. Despite Japan’s “lost decade” of no growth, most observers who visit Japan are struck by how normal it all seems.

Mothers of Mediocrity

More recently, the Fed attempted to restore order to the markets by engaging in “operation twist”, a policy action intended to lower long-term interest rates relative to shorter maturities.  At the same time, it provided more clarity on its outlook for the economy. Although the core forecast was mediocre but not disastrous, the Fed also emphasised that the risks to the outlook lie on the downside.  I suppose the way to interpret the policy action and the Fed’s statement is to conclude that what they are showing us is far from the most alarming of the forecasts generated by their modelling and simulations.  What the Fed has chosen to make public was probably a much tempered and moderated version of the range of economic futures its models generated. 

So it was rational for the market to sell off, rather than respond positively. Both in the context of maintained interest rates at emergency lows and  the economic statement underpinning operation twist, what has been crucial has been the subtext.  To continue to pursue unconventional remedies, the Fed must harbour a high degree of concern about the immediate outlook, whatever its core forecast shows.    

With respect to the Euro and the EU, it is important not to think about the future of the EU and the euro in purely economic terms.  The creation of the euro was first and foremost a political project, designed to achieve a giant step towards greater harmonisation between EU economies and societies. One should never underestimate the importance the ruling elite attaches to the survival of the euro, and the whole EU project.  Chancellor Merkel’s interventions over the past while make this abundantly clear.  Viewed in bald economic terms, there is only one possible outcome to the euro crisis:  Greece cannot honour its debt obligations at anything like its current rate of growth and will have to default on a portion of its loans.  This may be accompanied by devaluation rendering the economy more competitive.  Providing further loans to Greece piles on more debt and merely delays the inevitable reckoning. 

Eurovision

As soon as the narrow economics angle is broadened to include the political one the assessment changes however.  The Greek economy constitutes some 1.5% of the euro region.  Given sufficient political will, it is not beyond the realm of possibility that a solution can be found that avoids outright default on the part of Greece and perhaps other beleaguered countries. Such a solution will doubtless be unpalatable, involving as it does of necessity some sort of fiscal union and some loss of fiscal sovereignty on the part of member states. Moreover, those who see devaluation and a temporary or permanent exit from the euro as the only mechanism to restore competitiveness may well be underestimating the underlying political will.  Ireland has demonstrated that although painful, the restoration of competitiveness through deflation of nominal wages and prices is also a viable alternative.  Greece appears to be attempting a similar solution. There are those who contend that such an approach might succeed in a small economy such as Ireland’s, but can’t work in a larger economy such as Italy.  I am not persuaded.  The pain at the micro, household level is similar.  Italians have had to endure worse from their politicians.                              

This is the economic backdrop to what is undoubtedly a short-term bear market in credit first and foremost but also in equities. Trending through all the volatility, the 50 day moving average has now entered a clearly established downward phase.  Moreover September tends to be the worst month of the year for equities, perhaps because analysts at this time of the year are forced to revisit their earnings forecasts for the following year and concede that the outlook may not be as heady as the one they first pencilled in.  This year more than most analysts have more grounds than usual to concede to the reality of diminished expectations.  Hence the bear market can be expected to persist throughout September and beyond at least, as a trend surrounded by abnormally high levels of volatility, which implies there are likely to be some strong up days as well.    

However, for the longer run – say a three year view - I tend to draw mild encouragement from the periodic bursts of red ink on our screens, in the same way I might if the sports car dealer nearby were to slash prices on desirable models, many in red hues, were I in the market for such machinery.  (Died-in-the-wool greens will no doubt balk at this, but I cannot help liking such cars).  

Song of Opportunity

Many “name” investors presently contend that the equity risk premium has increased sharply, rendering equity purchases attractive in the context of an overall cheap equity market (i.e. anticipated rewards are high for taking on equity market risk) .  Some view the equity risk premium as the highest it has been for forty years or longer.  However, this viewpoint is predicated on maintained robust corporate earnings growth (any statement about the anticipated equity risk premium implies a view of corporate earnings growth).  Corporate earnings are currently at record levels relative to wages.  These are likely to subside as a share of the economy, unless the economy proves to be far more robust than anticipated.  And the challenge for the equity market in the near-term will be to withstand a raft of earnings downgrades.

But while these name investors see a cheap equity market and a high equity risk premium, the hedge fund industry at the start of September had the biggest overall “short” position on equities and the biggest net “long” position on gold in the history of the survey data compiled by Société Generalé.  It has certainly been right in the short-run to be short equities, but in the equally short-run it has been wrong to be “long” of gold. 

The single best indicator in my view of the overall equity market valuation right now is that compiled by Robert Shiller.  It takes as its earnings measure a ten year average of earnings and adjusts these for inflation before using this measure to calculate the overall price to earnings multiple for the equity market.  In this fashion it factors in that earnings are likely at a peak and reversion to the mean may diminish their share of the economy.

Chart 1:   Shiller’s Long-Run P/E multiple metric measure 

Shiller’s long-run measure of the earnings multiple reveals the overall US equity market not to be especially cheap. At least it demonstrates that de-rating has been unfolding over the course of more than a decade since the heady heights of 1999.  But at this stage it would be a brave man (or woman) who would venture confidently that the de-rating has run its course.  Valuations are currently only a little below those attained in 1969, which was itself an important peak.  Moreover, the chart shows that episodes of de-rating tend to end with equities at extremely undervalued levels, at long run P/E multiples of 5 or thereabouts.

We all know how destructive previous episodes of over-optimism have proven to be in the long-run. Examples from recent memory were the tech bubble of the late nineties, sub-prime mortgages in the run-up to 2008/09, and the bubble in Japanese equities predicated on the idea that Japan would enjoy a permanently lower cost of capital than other developed nations, and which pushed the Nikkei above the 40 000 level.  To some extent what we have currently is the mirror image of 1999.  A stock market move is underway that being fuelled by an increasingly pessimistic vision of the future, just as the octane for that previous move was a vision of a future of unbridled prosperity.  Could an equity market undershoot usher in a period of prosperity, just as overshoots heralded a protracted period of retracement and destruction of value? 

Nevermind the Middle Class

Unfortunately not.  Many who were employed on a wave of absurdly cheap and abundant capital for internet start-ups acquired real skills which they were then able to apply in more soundly based employment.  Those who are cast adrift from the current world of work experience an erosion of skills and capability.  Accompanying the erosion of wealth has been a destruction of capacity that is in the process of lowering potential output overall.  Investment in renewing the capital stock is also below par.

Greece is the most vivid illustration of the extent to which the economic turmoil is laying waste to middle-class living standards.  Those who had toiled for a lifetime in the assurance that they will at the end of it experience decent living standards in retirement are instead confronted with the reality of public sector pensions being slashed, and of being consigned to a likely tragic life of destitution, that is not of their doing, for their remaining years instead.  

There appears to be a stark choice confronting many Western Democracies:  Cut wages or raise productivity, or see jobs and incomes migrate to the lower cost economies of the East where middle-class standards of living have never been experienced by the majority.  Barring technological miracles an aging demographic probably means that the route to maintained prosperity through higher productivity is unobtainable, so the choice is between lower wages and job migration to lower cost centres. This is especially so because the service sector has become an ever larger share of total employment, and it is harder to raise productivity in service sector employment than in manufacturing. 

The swollen public sector deficits probably indicate that, for a time, governments attempted to maintain living standards through public spending financed through deficits.  This effort greatly increased in 2008/09 in the guise of Keynesian stimulus.  But now that governments, terrified by the spectre of Greece are paring public sector deficits as fast as they can, government is part of the problem, not the solution.

It is tempting to view present upheavals in the equity market as the after-shocks of 08/09. Is this too sanguine a view though?  The question is whether the bankruptcy of Lehman will turn out to have been of greater moment for financial markets than the probable default of Greece.  In turn, the answer depends on what happens to the Euro Zone as a consequence.

Liquidity

Seeking out parallels in current circumstances with the thirties has been a popular preoccupation of markets participants ever since I started writing about markets in the early nineties. Previously, it was relatively easy to dismiss such comparisons on at least two counts. Firstly, everybody understood pace Friedman that the Fed of the thirties mistakenly allowed the money supply to contract and presided over an unduly contractionary monetary policy when it shouldn’t have done.  Moreover, we had not in the modern world witnessed any real word manifestations of the textbook case of a liquidity trap – situations in which expanding the stock of high-powered money was ineffectual because the demand for idle cash balances had become so high. So there was always the reassurance that if monetary policy was sufficiently stimulatory, it would have the effect of rejuvenating a stagnant economy. The other reason why it seemed improbable that we could experience a re-run of a thirties-style depression was because public sector activity now constitutes such a large portion of GDP in developed economies.  During any significant economic downturn, the automatic stabilisers would work their magic.  Government expenditures on welfare payments and the social safety net would rise, while tax receipts would fall as incomes from employment and profits declined.  The swelling budget deficit would work alongside a deliberately stimulatory monetary policy to add impetus to a stalling economy.

But these days we do have a liquidity trap.  For an exposition of this, see for example the post by Stephen Nagourney of Regulus Ventures, An Aspect of the Liquidity Trap,

 http://regulusventures.blogspot.com/2011/09/aspect-of-liquidity-trap.html

But, were other aspects of the economy in alignment it is still probable that a liquidity trap could be overcome in time.  Were helicopter Ben to fly over my home in a generous mood I’d happily take his dollars and spend the bounty. The big difficulty policy makers have right now is that they are prevented from allowing the automatic stabilisers to work by the spectre of ever widening deficits and ever rising public debt as a share of GDP.  Whether they are right to be fearful is an issue for another day.  Larry Summers for example has argued that policy makers should seize the opportunity afforded by historically low long-term interest rates and borrow to create the infrastructure needed for a low carbon future, and in the process stimulate the economy to boot.  An illustration of current debt to GDP ratios is displayed on Chart 2 below.

At this stage many people harbour a vague expectation that Germany will lead the EU out of trouble, and underwrite the debts of peripheral countries. This is because of Germany’s superior growth record and higher levels of overall prosperity.  But the chart below illustrates that viewed in the cold light of day, Germany’s fiscal position is not as conspicuously better than that of other countries in the EU than is often assumed to be the case.  Germany’s debt to GDP ratio is fractionally higher than that of France;  French banks of course are currently under the spotlight.  And it is actually slightly worse than the UK where the whole of economic policy is currently predicated on the notion that fiscal retrenchment is an urgent priority or else the UK is in danger of becoming the next Greece.

Chart 2: Debt to GDP ratios are frightening policy makers; government has become part of the problem rather than holding the levers of the instruments to extricate us from the economic malaise.  

One crucial difference to the thirties that still remains is that  the spectre of stockbrokers (and investors) throwing themselves out of windows from multi-story buildings in tandem with a tumble in the indices should be a relic of the past.  Owing to the plethora of hedging instruments available to sophisticated investors today, fund performance and wealth creation is much less tied to overall market performance than would have been the case in the past.  Many funds generate enhanced returns during falling markets; indeed these days swings tend to be amplified by the fact that as soon as investors spot the emergence of a new trend they devise ways to profit from it and the swelling crowd of momentum investors tends to drive market movements longer and deeper.  And there are those who trade volatility through investible indices based on the VIX.  So while some will undoubtedly be facing uncomfortable margin calls, overall from a systemic perspective a swooning stock market may not pose the threat to stability and wealth creation it once did.            

Why I think that the current mayhem should be viewed as a continuation of 08/09 rather than the start of something new is that the evidence suggests quite strongly that economic sluggishness in the wake of deep financial downturns tends to be long-lived.  Based on historical patterns, following the shock of 08/09 we should expect to still be encountering economic obstacles as well as pressures on credit and equity markets.  And overlaid on top of this is the chaos in the euro zone which is a new development.   Financial crises and equity market downturns tend to feed off of each other.  An important paper by Stijn Claessens, M. Ayhan Kose and Marco E. Terrones ( IMF Staff papers, April 2011), which produced a quantitative account of the history of credit, property, and equity price cycles notes, “(w)hen credit downturns are accompanied by financial crises, they are much longer, deeper, and more violent than other downturns.... housing downturns are longer and deeper than other downturns. These episodes also witness substantially larger declines in equity prices”.  However, these data also indicate that equity markets tend to be more independently minded than other asset classes, and are more likely to plough their own furrow in opposition to prevailing trends in other markets.  Curiously, equity markets rather like crises, in that following a full-blown crisis they tend to recover more rapidly than would have otherwise been the case, all else being equal.   The paper presented evidence that equity market downturns that are accompanied by financial disruptions last on average for 12 quarters, so it’s not improbable that we are still in the world of the 08/09 shock.  

At this stage, I think the aftershocks will be milder than the 08/09 crisis turned out to be, especially with respect to world trade, employment, and other crucial indicators.  But I am also mindful of how dependent the developed world has become on sustained continued growth in the emerging economies, especially the BRICS, which were largely untroubled during the initial credit crunch.