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Stepping back from market madness
Posted on August 17, 2007 by Richard Beddard
Filed Under Markets |
I’m off on holiday tomorrow. With the market running wild, it’s a nervy time to be away, so I thought I’d sign-off by trying to put things in perspective.
Nothing that serious has happened, yet:
Before yesterdays 4% fall in the ‘footsie’, and today’s rise, The Financial Times’ Lex column wrote:
…The uncomfortable fact is that by any historical standard, nothing that serious has happened… For example, in the second-last week of July, US junk debt yields jumped by 50 basis points using Lehman Brothers’ index. But since the end of 1986, a weekly rise or fall of at least 50 basis points has been seen no fewer than 37 times. Also, the idea that equity volatility is unprecedented is dubious. The S&P 500 index has lost 6 per cent in four weeks. An equivalent move in either direction has been seen 123 times since 1986.
To put the last four weeks in perspective, the FTSE All-Share has fallen 12.6% in the 25 trading days between 13 July and yesterday. That’s a little bit more, a lot less quickly than the 10% it fell in nine days in May 2006, and it joins decreasingly severe sell-offs of 6.5%, 5.7% and 5% as we trace the bull market back to 2003, when it started. Of course the difference between now, and then is we know then the market bounced back then, previous sell-offs were steps backward as the market climbed the wall of worry. Every time the market loses confidence, investors wonder if this correction is the big one that turns the overall direction of the market. Lex again:
The tremors of the financial superstructure show how fine margins for error now are. It is hard not to wonder what would happen if something serious – such as a downturn in US profits – occurred.”
Profitability underpins the market, but it may not last:
Taking comfort from corporate profitability, though, depends on your time frame. Since profitability is the fundamental driver of stock markets they shouldn’t crash while companies are performing well, but New York Times columnist David Leonhardt reminds investors*1:
…To focus on long-term trends and not to get caught up in the moment.
One way to do that is to look at profits over a much longer period. Compare the price of the market to last year’s corporate profits and you get a price earnings ratio of 16.5, a few tenths of a per-cent above the post-war average, and nothing to be afraid of. But:
Based on average profits over the last 10 years, the P/E ratio has been hovering around 27 recently*2. That’s higher than it has been at any other point over the last 130 years, save the great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was so big, in other words, that the market may still not have fully worked it off.
Or to use yet another set of words, the bull market since 2003 is an upswing in even bigger downswing. That doesn’t mean that the bear market will reassert itself now, though. The market could rise from this point for years, buoyed by current profitability. But it does, perhaps, zoom our perspective out an order of magnitude. If profitability falls back to more normal levels the bear will come back. Perhaps soon.
If this is the ‘big one’ the debt crisis must be significant, is it?
It’s the fact that debt and profitability are inextricably linked that fuels the belief that this could be the end of the bull market. If people can’t repay mortgages, then they’re going to struggle to pay for other things as well. If lenders perceive debt is more risky, they’re going to seek higher returns from the individuals, companies and governments that borrow it and push up the cost of borrowing. All of this could slow growth and reduce profitability, if the crisis in the debt market is significant.
The difficulty is, working that out from the ground up; identifying every hedge fund and investment bank carrying debt it can no longer put a value on, and establishing whether they have the financial strength to survive, is no mean task. The debt is parceled into derivatives and distributed throughout the financial system, as the Economist explains:
The old-fashioned financial system was like Old Maid, a parlour game once beloved of small children. The banks were like players, dealt hands from a pack of cards, which they swapped among each other. At the end, one player was left holding a lonely queen—a bad debt, if you will—and lost. Over the past few decades the game has changed. Securitisation has snipped the old maid into pieces; new faces, such as hedge funds, have joined the party, enabling the banks to distribute those pieces among a larger number of players. When the game is over, lots of players are left holding small losses instead of one player holding a big one…
…Working out who has won and who has lost in this round will take a long time.
Frank Partnoy, professor of law at San Diego University, writes in the Financial Times that because of the imprecise accounting of derivatives and their complexity it’s impossible for investors to know. Evidently the institutions holding them are in the dark too:
The common denominator of derivatives fiascos such as that of the Bear Stearns funds is that the answer to the above questions is: “No one knows.” Subprime exposure can remain buried and unexplained for months.
Now that investors seem to understand this, the markets are swinging wildly. Volatility is highest when people realise they cannot figure out what investments are worth.
In attempting to add up all the potential defaults, lies madness, which probably explains traders’ actions these past few weeks. As with profitability, zooming out and looking at the big picture might offer a more sober perspective. Recently, I haven’t noticed any credible commentary on the overall level of debt and the economy. The most compelling view I’ve read is in Ken Fisher’s book ‘The Only Three Questions That Count’, published earlier this year. In it he concocted a balance sheet for the US (the UK’s is much the same) and analysed it as if it were a company balance sheet. He concluded that society’s return on assets is far higher than its borrowing costs. At the time he estimated a 12% return on assets and 4% borrowing costs, or, to put it another way, we could borrow at 4% and invest it for a return of 12%. We should do that he wrote:
We’ve never had enough debt. From where we are, more debt would be good, less debt would be bad. We aren’t taking enough risks with debt. If we borrow a lot more, you can see how that would put pressure on interest rates, driving them up, right? And if we buy enough more assets, we will engage in ever more marginal activities and our return on assets must eventually fall. Doing the two together is exactly how you move to optimization in economic theory.
I don’t know how quickly the debt and profitability situation can change but it’s interesting to see ‘independently minded investors’, some people call them contrarians, sensing opportunity in this sell-off.
Ken wrote on Interactive Investor earlier this month that crisis in the debt markets is a buying opportunity. Bloomberg interviewed David Dreman, the famous contrarian earlier in the week. He said:
The market is pretty solid and fundamentals are good… Earnings are good and it’s not overpriced. The economy is picking up.
And CNBC collared Warren Buffett at a fund raising, you can see it here, but blink and you’ll miss it. He said:
We get more excited when there is a lot going on. When dislocations occur, things get more miss-priced… It can be a time of opportunity.
As for me, an ordinary Joe sitting in a corner of Cambridgeshire. Once I put a full-stop at the end of this article, I have a few emails to send. Then I’m going to set my “out of office email autoresponder” and pack my bags. I won’t be back until after the bank holiday. And unlike our friends in the City I won’t be ’selling my positions’ or ‘de-risking my portfolio’ before I go. In the unlikely event this is the beginning of the end and I get a rude awakening in September, I’m prepared. You might think that complacent. I think it’s rational, and it’s the current gyrations in the stock-market that are irrational.*3
Footnotes:
- Hat tip: Economist’s View
- All the data is on Robert Schiller’s site. Robert Schiller is Professor of Economics at Yale University. He coined the phrase, and wrote the book: “Irrational Exuberance”
- If you comment for the first time on this blog while I’m away there may be a delay of a day or two because your first comment must be approved. My colleague, Tim, has promised to check from time to time for new comments, but he’s a busy guy, so please be patient!
Comments
4 Responses to “Stepping back from market madness”
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Hi Richard,
I hope you had a good holiday (by the time you read this!)
I thought I would comment on Ken Fishers observation that ‘we’ve never had enough debt’.
I agree that if we could unwind debt at a moment’s notice, in order to repay our obligations, then using debt to buy assets is probably more efficient than keeping cash. However the reality is that you cannot always unwind debt quickly so you need some cash as a buffer.
I would be interested in Ken Fisher’s viewpoint on this.
What is the optimum amount of debt you should hold and how much cash should you have to back it up (if any)?
Does the size of your portfolio restrict the amount of debt you should hold? After all, 5% of someone’s portfolio might represent 1000 pounds or 100 million pounds. Surely the two cases are very different. Unwinding one will have no impact but unwinding the other could move markets.
Hi,
“And if we buy enough more assets”. My question.
Is this saying, that if our debt is £1,000,000 causing the bank to charge high interest because, say we have tipped our pre-set limit at £250,000 by £750,000. But it allows us to invest very profitably, say in property. Then by adding a further £1,000,000 debt for investment could see less profitable results? ie every £1,000,000 borrowed becomes less profitable!! Only if the investment is poorly thought out or the market (demand) dips.
Can you please explain. Thanks.
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Hi Robin, Tosh.
I think Ken’s talking in aggregate, so by ‘we’ he means everybody. But yes, that’s what he’s saying as we borrow more pushing interest rates up it becomes increasingly less profitable but its still worth doing until it costs more to borrow than we make the investment. Actually I’m not sure he’d take it right to the wire, but the point is - the gap when he made his calculation - 4% to 12% - was very big so there’s bound to be room for more borrowing - in general.
Regarding the optimum amount of debt an individual should hold - you’ve got me in a quandary… In theory I suppose the same idea applies but in practice unless you know (and how can you?) you’re going to get the matching return a rational person or business would keep something in reserve. However that disregards all the people and businesses (and governments?) who have much higher debt to equity ratios: first time house buyers, students, companies owned by private equity etc, so maybe it can all balance out in the round. Does that make any sense?!
I’ll put it on the list of things to discuss with Ken next time I get the opportunity.