Fragile Equities

May 17, 2010

It’s beginning to feel a little like late 2007 in financial markets.  The loss of confidence in European sovereign debt is rattling other cages, specifically confidence in big European banks in both directly affected and comparatively healthy economies.  Also, stock markets around the world have run into turbulence.  Investors are uneasy about the possibilities of contagion and uncertain over what institutions are most exposed.  Economic activity looks sound enough, but it did in the summer of 2007 as well.  U.S. GDP grew 3.6% at an annualized rate in 3Q07, slightly faster than the 3.2% in the year’s second quarter, and slowed only to 2.1% in 4Q07.

Still missing from the equation is major micro-level damage. No institution has failed in sovereign debt crisis, but it took slightly over a half-year after the sub-prime mortgage crisis began until the bail-out of Bear Stearns was needed.  We learned then that festering uncertainty can be very toxic to the basic trust upon which market functionality depends, and that the risk of spontaneous combustion mounts with the passage of time.

Equities are a good place to get a reality check on risk aversion and views about the coming six months.  From the start of 2009 until it bottomed on March 9, the Dow Jones Industrial Average fell by 1.0% or more on 44.7% of all trading days.  The ratio previously had been 41.5% of days in 4Q08, 29.7% of the sessions in 3Q08, and 21.7% of the time in the first half of 2008.  In a control group to calibrate a ratio for “normal times”, the Dow in 2002-06 had declined 1% of more on just 11.8% of all trading days.  In a bull market during the last three quarters of 2009, the ratio of days with declines of at least 1.0% fell to 18.5% in 2Q09, 7.6% in 3Q09, and 13.6% in 4Q09.  This year, there had been just seven such days through April 26, a ratio of 8.6%, but another seven drops of at least 1.0% occurred in the next fourteen trading days, a ratio of 50% that compares with the worst parts of the Great Recession.

In some respects, it is more worrisome now than in the summer of 2007.  Governments do not have dry ammunition to throw at the problem.  The spark this time is the debt compiled by governments, and interest rates remain near zero and so cannot be cut if growth falters this time.  Quantitative easing has become a pejorative expression, considered the problem rather than a solution.  Voters are angrier than in the summer of 2007 and venting their feelings on the streets of Athens and Bangkok, in voting booths in Germany and Britain, and in loud U.S. tea party rallies.  I believe a world depression every bit as bad as 1929-32 was avoided by the pro-active reaction of enlightened policymakers on all continents, but people will never know for sure because the road of letting the private sector sort imbalances out was, well, not taken.  But my opinion is not  a mere hunch.  Prior to 1940, governments generally took a laisez faire approach, and depressions and economic panics occurred with reasonable regularity.

Can the Fed raise interest rates in this environment?  Markets are convinced that the ECB will not lift rates but assume that the Fed will be doing so before yearend, and that is a major factor feeding the dollar’s strength.  Conventional wisdom in the U.S. sees a public-sector problem, distinct from the troubles of 2007-8, not a second generation issue spun off by the earlier crisis when markets misfired.  There is now insufficient will or adequate means for governments to prevent a crisis from spreading if market forces fail to handle the problem.  U.S. data have been producing more pleasant than unpleasant surprises, and the recovery and equities should move in the same direction especially since the stock market, which is lower than in 1Q00, appears undervalued. Stocks were due for a period of consolidation, but if the percentage remains high much longer of days when the market drops at least 1%, it will signal that the recovery is not as sound as thought.  In such circumstances, I doubt the Fed would risk tightening credit in the second half of this year.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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