Back in November 2007 I logged onto the website despair.com. It specializes in sardonically humorous gifts such as ‘demotivator’ calendars. As well as a couple of calendars, I ordered half a dozen or so Pessimist’s Mugs. These have a line halfway down that declares: “this glass is now half empty”. As loyal readers will remember, this column was profoundly gloomy in 2007. It did not just say that structured credit was worrying; it warned against excess leverage and the business model of the credit rating agencies, and said the cycle was turning as early as May. However, even as the credit crunch took hold, many believed it would be a short-lived crisis. Some of my newly acquired mugs were destined for some of those mugs.
The choice of this present and its sentiment were not subtle. But, with the exception of one email strewn with four-letter words, most received their Christmas gifts in good spirit. My Tourette’s-suffering correspondent even accused me of being a perma-bear, which was and is absurd. But one person who seems to relish in this soubriquet is Société Générale strategist Albert Edwards.
It is probably not news then that last month Edwards predicted an equity market rout. He sees the S&P500 falling to a 20-year low of 450, bond yields collapsing and the gold price at $10,000 an ounce. Perma-bears are not alone in being fearful. In the week ending August 23, $14 billion was pulled out of US equity mutual funds, the biggest outflow since June 2008, according to the strategy team at Bank of America Merrill Lynch.
If investors in 2007 were far too sanguine, this current bunch is way too gloomy. The intriguing question is, why? Psychology might offer part of the explanation. In 1999, as the TMT bubble inflated, a book called “Dow 36,000” was published. It promised “a new strategy to profit from the coming rise in the stock market”. The best way to do that would have been to sell.
Since 2000, investors have endured two savage bear markets and a lot of volatility. The Dow would need to rise more than 150% to get to the 36,000 that was predicted to be just around the corner 15 years ago. Hindsight is a wonderful thing. But the authors of this comedic piece of non-analysis are only really guilty of something that is all too common: the linear extrapolation of a trend.
Equity investors in 1999 and 2007 were used to seeing the good times roll. This introduces a psychological heuristic. The reference point, or anchor, for investors and all too many analysts that should have known better, was that stock markets go up. Today’s investors are no longer anchored to this belief. The financial crisis has cast them adrift.
Stock market bubbles are not characterized by outflows from equity funds. The time not to invest is when there is widespread euphoria. That is one of many reasons why the summer sell-off should not be viewed as the beginning of a new bear market. Flows are important. But fundamentals are what really count.
Two things have changed in markets. First, the US Federal Reserve has said that it might not continue to bloat its balance sheet at the rate of $85 billion every month at some point in the future. Secondly, the reorienting of the Chinese economy away from mercantilism and excess investment is starting to be reflected in slowing growth.
Neither falls into the category of unknown unknowns. With safe-haven government bond markets priced for perfection, a back-up in yields was inevitable. What was surprising was the indiscriminate sell-off in commodities, equities and anything badged with the suddenly unfashionable emerging markets label.
The end of quantitative easing and rising developed-market bond yields is a more challenging market environment. Yield tourists who held their noses and bought assets they did not understand have been given a reason to sell. Marginal buyers and sellers will always drive markets and when investors head for the exits at the same time those moves are exacerbated. The lack of liquidity in bond markets did not help.
Emerging market economies with high deficits and a reliance on international funding, particularly if a large proportion of their external debt is denominated in US dollars, are facing a new reality. The slowdown in China is further cause for concern for countries with substantial trade links, particularly commodity producers.
But many emerging market economies have accumulated sizeable foreign-currency reserves and have some ammunition to fight this war; 1997-style contagion with recurrent currency crises, banking collapses and economic dislocation across Latin America and Asia is far from inevitable.
As the world adjusts to life without QE, volatility will increase. Another layer has been added to the wall of worry that equity markets must always climb. But the corollary of policy normalization is that the world economy is healing. Myriad data – UK factory output, Chinese purchasing manager indices, US labour reports, passenger air traffic, even a slew of numbers from the eurozone – all scream this message. Despair.com is still a very funny website. But this year I will leave it to the true perma-bears to buy their stocking fillers there.