Ins and outs of ups and downs: shaken markets face up to 'recoupling'

This has been no happy new year for the world's equity markets. US stocks have had their worst January in more than a century - and this sell-off has prompted both a wave of selling across the world and a truly extraordinary response by the Federal Reserve, with America's central bank making an emergency cut in target interest rates of 0.75 percentage points.

By the time news of a historic trading loss at France's Société Générale became public on Thursday, the market could no longer even show much surprise.

There is a growing belief that this spectacular sell-off portends more than just a periodic shift in the market cycle. Indeed, the events are now so dramatic that they are prompting many to call into question the entire capital market architecture that has emerged over the last decade, along with the approach the world's financial authorities have adopted since the last big break in the market - the bursting of the internet bubble in 2000.

"We have to pay for the sins of the past,'' says Klaus Schwab, founder of the World Economic Forum, which is currently holding its annual gathering of political and business leaders at the Swiss mountain resort of Davos. Or as George Soros (below), the legendary hedge fund manager, says: "This is not a normal crisis but the end of an era."

The scale of woes calls for an equally dramatic policy response, he argues. "Authorities ought to go in and examine the books" of financial institutions and promise to "rescue and even take over banks that become insolvent".

Even as their employers are propped up by injections of capital, investment banks' ever-diligent researchers have started publishing a flood of notes drawing comparisons with previous protracted bear markets and economic recessions.

The sell-off had two obvious triggers. First, very poor macroeconomic US data - including supply managers' surveys, non-farm payrolls and surveys of business confidence - convinced investors that the US was swinging into recession. Second, corporate results for the fourth quarter of last year began to show that highly optimistic Wall Street forecasts were untenable, particularly for companies exposed to the US consumer. They also showed that the financial sector had suffered much greater losses from the credit squeeze than many had thought.

The turnabout in expectations is striking. When the fourth quarter began, Wall Street analysts expected corporate earnings to grow at an annual clip of more than 11 per cent. In other words, they were betting that just about all the ill effects of the credit squeeze had already shown up in third-quarter profits.

But by the beginning of this month, analysts were instead braced for the quarter's profits to decline by 9.4 per cent. Just three weeks later, after a series of shocks, earnings for companies in the S&P 500 index are on course for a decline of more than 19 per cent - which would be the worst figure since the fourth quarter of 2001, immediately after the September 11 terror attacks.

Remarkably, consensus forecasts still call for earnings to grow by more than 10 per cent by the end of this year - implying that the US stock market might still not have priced in the full magnitude of the problem.

Such dreadful news on the economy and earnings, undiscounted by the market, can be expected to prompt a big equity sell-off. What is arguably more worrying, however, is that the sell-off has now prompted a reassessment of more fundamental assumptions.

One key issue shaping market sentiment concerns the concept of "decoupling" - the idea that the bigger emerging markets have discovered sources of internal growth. This would make them effectively immune to the effects of a US recession and also mitigate the effects of a downturn for companies in the US and Europe. In recent months, faith in decoupling has been a key issue buoying up sentiment in the equity world - and helping to offset the credit gloom. However, in the last couple of weeks that faith has crumbled.

"One reason [for the sell-off] is that people are questioning the decoupling idea," says one senior US policymaker, who confesses he has always found it odd that investors placed so much emphasis on the concept. "It has become clear that the challenges facing the US economy are global," he adds, noting that these "involve oil, which is a global issue, and subprime, which has been sold all over the world, and a housing downturn, which affects the US economy in a very broad way."

"Hope always remains, and in the face of a sharp US slowdown, that hope is called decoupling," says Gabriel Stein of Lombard Street Research in London, who describes this hope as a "very weak reed" to rely on. He adds: "The falls in stock markets around the world have been triggered by the realisation that US weakness is likely to persist and that everybody will be affected in one way or another."

There has been little new economic news in recent days to trigger this scale of investor shift. But financial history shows that investors often grasp for "excuses" when there is a change in market psychology - and the deteriorating condition of the US economy has prompted many investors to take note of how much money they had riding on the decoupling idea.

The bet on decoupling has been particularly evident since the Fed started cutting interest rates in August last year. That led to the belief that the US would slow but that the extra liquidity would help emerging markets grow all the faster. Share prices in "Bric" markets - Brazil, Russia, India and China - rose more than 50 per cent in a matter of weeks, while the S&P 500 gained only 11 per cent.

Since the MSCI World index peaked, on the appropriately ominous date of October 31 last year, the MSCI Bric index has fallen some 22 per cent and the FTSE-Eurofirst 300 21 per cent per cent. Both have performed worse than the S&P500 itself, down by less than 14 per cent, so markets have been gripped by a "recoupling" - troubles for the US have had more impact on the rest of the world than on the US itself.

A second form of reassessment is also going on among investors: about the impact of the credit crisis. Equity investors, having badly underestimated the influence it would have to date, now accept that its second-order effects could be much more severe than for the previous episodes to which it is most often compared - the implosion of the Long-Term Capital Management hedge fund in 1998 and the US savings and loans crisis of the late 1980s and early 1990s. This time, credit had been offered even more cheaply and bad debts spread much more broadly across the world financial system.

As financial institutions start to make adjustments, they are likely to restrict the supply of credit. "The arteries of credit that lay behind the vigour of the past economic boom are now becoming constricted," says George Magnus at UBS.

There are also fears that Europe has been slower to come to grips with the problems than the US. "I am particularly worried that there are some growing indications that the same bond sitting in different financial institutions is being marked and evaluated in very different prices,'' says Lawrence Summers, former US Treasury secretary. "There may have been some tendency for recognition to be delayed of these problems in Europe.''

Further, investors have started to recognise that there will not be any easy way for policymakers to counter the squeeze. The credit bubble got so out of hand in the last few years because credit creation occurred - on a massive scale - outside traditional bank channels and therefore beyond the reach of traditional regulation.

Thus, when the Fed cuts overnight rates, it may not stop credit from contracting. After all, the credit bubble grew most out of hand earlier this decade when the Fed, under Alan Greenspan, was steadily raising interest rates. As Joseph Stiglitz, the Nobel laureate economist, puts it, the Fed is "pushing on a piece of string".

"Typically interest rate cuts are effective in helping the corporate world when it is over-borrowed - but that is not the case now at all. In fact, it is not clear that interest rate cuts are going to motivate industry to invest more," says the chief executive of one large insurer. "There is a real disconnect between what the Fed can do and its impact on the real economy - and the problem is that [Fed chairman Ben] Bernanke's announcement may actually have a negative effect by signalling to the market that there is a problem."

Many economists say the present problems started because financial innovation was allowed to get out of control. This was partly due to lax regulation. "There has been a fundamental change in the financial system because of the emergence of the shadow banking system," says Nouriel Roubini, a US economist. But rectifying the shortcomings will require big regulatory reform. That means they probably cannot be addressed by the kind of policy "quick fixes", such as rate cuts, that might restore confidence in the markets.

"The reason why the US stock market is not responding is because the US policymakers are not yet focusing on the real problem. This is that the credit mechanism is broken," says Christopher Wood, analyst at CLSA. Wednesday's Wall Street rally, which appeared to start once word of an attempt by the New York insurance regulator to broker a bail-out for the bond insurers got around, further suggests that credit is what truly preoccupies the stock market.

Or as Mr Soros says: "This is not like previous crises. I think the Fed will have real problems convincing the markets [to calm down]. The Fed has cut rates in a rather panicky way but the stock markets are falling instead of rallying. That is because people fear that there are hidden problems which have not yet surfaced ... in the financial system."

Addressing even the short-term concerns about these financial institutions - such as the mounting capital pressures at the monoline insurers - is a big headache. It is far from clear that the US government can solve these problems by itself, as they cross borders. "What has happened in the last week is that equity investors have woken up and realised there just will not be a quick fix to the problems," says one senior international policymaker. "These are serious problems ... People are scared."

Disenchantment with the authorities' handling of the credit bubble has also led to a reassessment of the way they handled the fallout from the bursting of the internet bubble in 2000. When Alan Greenspan retired as the Fed's chairman in 2006, he was hailed in the markets as a skilled helmsman who had averted disaster on many occasions. Now, many complain that he merely postponed the reckoning for the excesses of the 1990s. By postponing it, they say, he made that reckoning far more severe.

His response to the crash in share prices that started in 2000 was to cut interest rates aggressively. This came to be referred to as the "Greenspan put", a reference to options that allow investors to sell a stock for a fixed price. Investors came to believe that the Fed would act to stop severe price falls.

The effects of this can be seen from the valuation of stocks. For more than a century, the cyclical price/earnings ratio - where share prices are compared with average earnings over the last 10 years rather than merely the latest year - has been a reliable indicator of market cycles (see chart). On this measure, US stocks in 2000 were far more overpriced than they had ever been. It thus correctly predicted the ensuing savage bear market. But stocks started to recover in 2003 at a point when cyclical multiples were still well above average. This was a startling deviation from the established pattern.

Jeremy Grantham, a founder of Grantham Mayo Otterloo, a big Boston-based fund manager, contends that excessive cheap money distorted the equity market at this point. Rather than completing their necessary correction and coming to rest at a defensible valuation, stocks were allowed by the cheap money from the Fed to rally. This paved the way for more uncertainty now. Cheap money from the Greenspan Fed is also now blamed for the housing bubble and for the subsequent bubble in emerging market equities.

While Mr Greenspan's reputation has taken a hit, his successors at the Fed are also sustaining criticism for their failure to act sooner or more forcefully. As Mr Summers says: "It is hard to give the central banks a high grade in the last couple of years in terms of the recognition of bubbles or actions taken to address them - and in the last six months they have been behind the curve. What has been sadly lacking is any effective co-ordination."

Yet even with opinion suddenly so negative, there are still intellectually respectable reasons for optimism - or at least, to believe that the worst will soon be behind us. James Paulsen, equity strategist at Wells Capital in the US, who candidly admits that he has been wrong in making bullish calls about the equity market in recent weeks, points out that there is still a very good case that the US can itself avoid a recession.

A few macroeconomic numbers have dominated attention. But he points out the US non-farm payroll figures are notoriously prone to revision - and in any case show that employment in the US is continuing to expand. Thursday's weekly figures on new jobless claims in the US showed a continuing falling trend. This argues powerfully against the notion that firings and lay-offs are widespread. Consumer confidence figures this month were better than expected. Housing figures, while dire, suggest that a bottom may be in sight.

Further, the acute liquidity problems in the inter-bank lending market seem to have been alleviated, even as the sell-off of stocks has gathered pace. Issuance of asset-backed commercial paper, a vital way for companies to raise short-term finance, is rising this year after contracting for many months.

A surprisingly good employment report next week is a real possibility, and might be enough to prompt a rethink on the markets, Mr Paulsen suggests.

Tom Sowanick, chief investment strategist for Clearbrook Capital in New York, goes further, and suggests that Treasury bonds are themselves now in a bubble. Thanks to "safe haven" buying, two-year bonds yield less than 2 per cent, a level that makes sense only if the very direst predictions for the American economy come true. They stood at more than 5 per cent only six months ago.

Such a swift change in investors' sentiment, he argues, shows all the classic signs of an irrational bubble.

"This could be the darkest hour before the dawn," suggests the deputy head of one international investment bank in Davos, who suspects the first quarter of the year will mark the bottom of the equity slide. His optimism is partly based on signs that US banks are recapitalising themselves far faster than in earlier financial crises - while the losses are becoming clear at an earlier stage due to the introduction of mark to market accounting. Another reason for the optimism is the scale of the stimulus the authorities have been providing.

"The world has gone through these cycles before - but the system readjusts. I think in a year's time we will look back and see this as the low point," he argues.

A cynic might suggest this is a case of financiers trying to talk their own book - or simply remaining in a state of denial. But one thing is clear: investors around the world will be hoping this particular banker is correct.

Investors also take heart from the historical evidence that waves of pessimism like this have proved to be a good time to buy stocks. Now more than ever, in other words, the old cliché that it is wise to buy "when there is blood on the streets" is about to be tested.

This idea of decoupling is a wishful thinking, considering that the clear division of roles emerged in the world economy where one part of the world serves as the area manufacturing cheap goods, and another part as the area for manufacturing overvalued assets to drive the world consumption.

Right about the time people started to have doubts that the latter may not continue to consume what the former produced, they cooked up the comfortable wish that the former may have developed enough consumer market to offset the world consumption decline. They tried pretty hard to convince themselves that it is true. However, the reality has kept disappointing them.

Shake hands all around.

What will happen in China when the masses realize all of the massive pollution and dislocations were for nothing?

Or, just to enrich a few at the top?

"Workers, of the East, unite!"

Cheers!

On this measure, US stocks in 2000 were far more overpriced than they had ever been. It thus correctly predicted the ensuing savage bear market. But stocks started to recover in 2003 at a point when cyclical multiples were still well above average. This was a startling deviation from the established pattern.

Being a numbers geek I found it easier to follow with the graphics that were at the original FT website article.

So what does the high long term PE mean? To me it doesn't say anything more than the fact that PE's fluctuate just like equity prices fluctuate. Duh.

For my money I'd be a lot more interested in looking at forward PE's for comparing eras...

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.