World stock markets this week survived the nastiest test yet of a slow-moving but relentless crisis that has now persisted since credit markets suddenly seized up last July. The latest move towards the edge of the abyss came as the Federal Reserve was forced to help engineer a rescue for Bear Stearns, Wall Street’s fifth-largest investment bank.
The news prompted a brief period of panic last Monday. Traders digested the news that Bear, worth $171.50 per share last year, had been sold for $2 per share. Fresh from the profits made betting against Bear, many hedge funds then turned their attention to the fourth-biggest investment bank, Lehman Brothers, whose shares also endured a precipitate decline.
But then the selling stopped. Wall Street seemed to rally to Lehman’s defence. After reaching a trough shortly after 1pm on Monday, Lehman’s share price more than doubled in less than 24 hours. It was part of an impressive rally that buoyed markets in the US, Europe and Asia.
By Thursday’s close, the S&P 500 had gained 6 per cent from its low on Monday, while the S&P financials index, covering the US financial sector – the centre of global concern – had gained 18 per cent to stand at its highest level of the month. Even if it remained 30 per cent down from the peak it hit last year, this gave grounds for some optimism.
Meanwhile, foreign exchange markets staged a dramatic shift, with the dollar rallying by 3 per cent after falling to historic lows, while commodity prices tumbled from historic highs.
That in turn led to a new wave of speculation: had Bear’s collapse, and Lehman’s near-death experience, finally signalled a stock-market bottom? Several analysts put out commentaries boldly making that prediction. A note from UBS, headed “Ready for a rally”, was typical. The Federal Reserve joined in with its biggest ever cut proportionate to its main target interest rate, and shares enjoyed an upward surge.
At the centre of almost all the arguments was the notion of “capitulation”: the idea that market extremes are driven by excesses of emotion rather than market fundamentals. When investors finally panic and shares fall as swiftly as they did on Monday, this can often be a sign that the last optimists have given up. That is classically a signal that shares have been sold down to a “bedrock” cheap valuation, prompting new investors to start looking for bargains.
The collapse of an institution as big as Bear Stearns is a significant and rare event. Previous such incidents, optimists say, have come shortly before market bottoms. Turbulence continues for a short while but, once the worst has finally happened, markets are at last ready to move forwards. By this argument, Bear’s collapse has lanced the boil for this market and paved the way for a rebound. JPMorgan published an analysis last week showing that after the last four big Wall Street collapses (Continental-Illinois in 1984; Drexel-Burnham Lambert in 1990; Kidder Peabody in 1994; and Long-Term Capital Management in 1998), the S&P 500 was up a year later by an average 10 per cent.
Unfortunately, the historical parallels look stretched. The case of LTCM, for example, revolved around a stricken hedge fund that was plainly the centre of the market’s difficulties. Once it was resolved, the market could rally. Bear Stearns was nowhere near as central to the market’s current difficulties.
Another argument that we are near the bottom comes from an analysis of the economy. Stock markets try to predict macroeconomic trends, and historically, they have generally done so successfully. Thus, when the US economy is headed for recession, as many believe it is today, share prices tend to hit bottom and start to rise some months before economic activity begins to recover. By this seemingly perverse logic, the two consecutive months of falling payrolls to start this year might actually be positive for equities.
James Paulsen, equity strategist at Wells Capital, points out that in the recessions of 1970, 1975 and 1990, the stock market’s recovery started within weeks of the second month of falling employment. In 1980 it started even earlier.
Mr Paulsen admits that this is not fail-safe. It did not work for the recession of 2001, which was relatively mild. The stock market entered that recession at historically excessive valuations, and needed longer to reach a low. This theory might not work if the current slowdown turns into a long and deep recession.
Many commentators still argue that this will be a very mild recession. So it is quite possible that stocks have not yet discounted the worst of what is to come. But generally stock markets do seem to start their recoveries fairly early in a recession.
More substantively, optimists point to the strenuous attempts by the fiscal and monetary authorities to deal with the problem, particularly in the US. The Federal Reserve has introduced several innovative ways of funding banks and brokerages in the past few months as it fights the problems in the money markets and it has also made unprecedentedly swift cuts in its target interest rates.
The federal government will oblige with its “fiscal stimulus” package of tax rebates, which will deliver about $600 each into the pockets of US taxpayers over the next few months. “The markets are responding to the strong policy actions taken by the administration and the Federal Reserve, helping to restore confidence,” says Larry Kantor, head of research at Barclays Capital.
Earlier in the crisis, the Fed had been more sensitive to the political implications of bailing out rich Wall Street bankers. William Poole (below), governor of the St Louis Fed, said last August that “punishment” had been “meted out to those who have done misdeeds and made bad judgments,” in what was seen as a message that market participants should not expect help from the Fed if they ran into trouble. More broadly, the Fed said as recently as October that it thought the risks of inflation were as great as those of a slowdown in growth – normally a coded message telling the market it should not bank on any more interest rate cuts.
In this version of events, the Fed’s attitude contributed to the sell-off in stocks, and so its new determination to avert further carnage could show that the bottom has at last been reached.
So-called “technicians” – who study the market by looking at patterns in charts rather than at fundamentals such as earnings or macroeconomic growth – also suggest there is reason for optimism. Throughout the turbulence of the past six months, the S&P 500, the world’s most widely tracked index, has never closed more than 20 per cent down from its all-time peak in October last year. It has come close to doing so several times. This can be seen as a positive, as it appears that the market has set a level (a “resistance level” in the jargon) below which it cannot fall. Whenever this is approached, buyers emerge. Once traders believe that a bottom has been found this way, they become much more confident.
Also, the scale of the rallies in recent days gives grounds for confidence. According to Mary-Ann Bartels, technical analyst at Merrill Lynch, the S&P 500 enjoyed two days in the space of a week when it gained more than 3 per cent, and when more than 90 per cent of stocks were up. This is very rare: the last two times such events happened so close together were in July 2006 and November 1987, which both turned out to be significant market bottoms.
The problem with these arguments is that on all the occasions when the market was about to hit its “resistance” line, there has been external intervention of one kind or another from the Fed. Thus these strong days may indicate a response to news, rather than telling anything about the internal forces of the market.
There is evidence – notably from a Merrill Lynch survey last week – that many fund managers have high cash balances that they are keeping on the sidelines. This would provide the fuel for a rally.
Valuation also offers some glimmers that an end to the crisis is in sight. Price/earnings multiples are low: for the S&P, they are currently at about 20, compared with an average since 1990 of about 24, according to Bloomberg. But thanks to falls in earnings, multiples have actually risen since last August.
However, the most popular method for valuing stocks is to compare them with the yields on bonds. If bonds are cheap, offering a high risk-free yield, the traditional theory holds that stocks become less attractive. Recently, bond yields have dropped to very low levels as investors seek low-risk assets during the crisis. On that basis, equities do indeed look under-valued.
Unfortunately, again, this argument is not as persuasive as it sounds. Bonds tend to have a low yield for a reason – the likelihood of a recession. If economic activity slows down, more people buy bonds, and yields fall, but that is still bad news for stocks.
Another issue concerns earnings. Analysts entered the year with what appeared to be wildly optimistic estimates for the profits US companies could make. That has dramatically reversed in recent weeks, at least as far as the current quarter is concerned. While analysts expected S&P 500 companies’ earnings to grow at 5.7 per cent at the turn of the year, that has now turned into a forecast for a decline of 7.8 per cent, year on year.
However, this is concentrated in the financial sector, where Wall Street is braced for a fall of 49 per cent in profits. It is debatable whether valuations yet reflect the risks a recession would pose for the earnings of companies beyond banks and brokers.
Finally, optimists dismiss the notion that stocks will have to fall because credit is in the midst of a renewed sell-off. Throughout the market drama of the past few months, stocks have tended to follow credit downwards, with a lag of a few weeks.
Optimists point out that the credit market now implies almost unprecedented levels of default. According to Deutsche Bank, prices available in the credit market imply that European investment-grade companies will default at the rate of about 16 per cent over the next five years. The worst default rate in any five-year period since 1970, according to Moody’s, is 2.4 per cent.
Implicit default rates for the UK and the US are even higher. Thus, either the world’s economy is heading for a recession without parallel since the second world war, or prices in the credit market are being driven more by the lack of liquidity – as nobody is willing to buy credit – than by the fundamentals.
If the story of the credit market is about lack of liquidity, then it should recover once confidence returns. On this argument, it is the price of credit that needs to increase to be in line with stocks, not the other way around.
Pessimists have an array of arguments against the case that the worst is over. First, the Fed has completely changed the way it goes about lending in the past few weeks. Trust between banks has broken down, and problems in the money markets show that this is not improving. The view is taking hold that this crisis is a turning point that will lead to fundamental changes in the way the financial system works, rather than another downturn in an established cycle.
If this is right, the crisis could have a long way to run. Even if it is wrong, so many people currently fear this kind of scenario that no lasting recovery will be possible until the uncertainty has been put to rest.
There is also a fear that the weaker stock market will at some point become self-reinforcing. Americans have savings concentrated in equities, generally in vehicles (such as 401(k) pension plans) whose value is very transparent. When receiving valuations monthly, they are acutely aware of the damage done to their wealth. That could affect spending.
But the biggest problem is that almost all optimists ignore the central issue: the housing market. There is ample evidence that house prices have further to fall. That will be bad for the economy and will also inflict fresh damage on the credit market.
The uncertainty caused by concerns over US house prices is one reason why equity investors who are used to picking out undervalued companies are finding this hard to do. “The actual fundamentals [on many retail stocks] haven’t been that bad, but the investor sentiment is so bearish,” says Whitney Tilson, founder of T2 Partners. “If you’re investing in anything related to the US consumer, you’d certainly want to be following what’s going on in the housing markets. The macro factors are what is driving the stock prices and it doesn’t matter if our individual stock level analysis is right.”
Mr Tilson expects “at least” two more years of falling home prices and very high rates of mortgage default and foreclosure.
Jeffrey Rosenberg, credit strategist at Bank of America, says: “The inability of the Fed to directly impact the underlying source of uncertainty – the erosion in housing – may lead to only a temporary reprieve in market uncertainty.”
Perhaps the most convincing argument that we are not yet at the bottom is that so many people think that we are. The clamour to call an end to the crisis in recent weeks in itself shows that optimism has not been extinguished. History’s worst bear markets have been punctuated by many rallies when people thought the worst was over.
The collapse of the Dow Jones Industrial Average after 1929, and of the Nasdaq Composite after 2000, saw falls of about 80 per cent over three years. And yet both saw several “bear market rallies” when the index recovered by 20 per cent or more. Hope springs almost eternal.
In both cases the declines ended with the markets bumping along for a while, and then making advances that went unremarked at first. As Ian Harnett of Absolute Strategy puts it: “We’ll know we’ve hit the bottom when we look and see that share prices are a lot higher than they were a few months ago – we won’t know at the time.”
The case for a bear market rally in the next few weeks looks strong, provided the market can avoid more bad news on the credit front. But it looks hard to call a bottom. One sceptical analyst says: “The bottom will come when everyone at last gives up ever trying to find it.” That moment, unfortunately, is not yet in sight.
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