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Crisis? What Crisis?

August 29, 2006
Stephen Martin

Stephen Martin

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Capital markets, in general, have shrugged off a cornucopia of negative information this summer and the Dow Jones Industrial Average, that ole' bellwether of investor sentiment, remains within spitting distance of its all time high. Growing geopolitical risks, rising interest rates, slowing economies, collapsing real estate markets, trade disputes and even the rising spectre of a flu-pandemic are just some of the negative information the markets are not too worried about. However, it is for this reason of complacency that the markets are at most risk from a sudden dose of collective reality.

I recall a discussion I had on Efficient Market Hypothesis (EMT) in 1987 with a former colleague and current professor of economics at INSEAD. The stock market crash in October of that year had changed my opinion on EMT forever. Despite the 23% one day decline in share prices, my friend was fervently arguing in favour of the theory. I was not convinced, as there was no single piece of information that could account for the dramatic revaluation of shares in such a short period of time. I realised then that markets are often inefficient and that mass psychology could probably better explain the event that became known as Black Monday. In fact, mass psychology could probably best explain the behaviour of the markets leading up to the crash as well.

Alpine skiers are often familiar with avalanche risk. Yet, the lure of a warm spring day following several weeks of fresh snow is too great for many. Skiers tend to focus on the reward of enjoying this perfect environment because the risk is not readily apparent. Deep in the snow, the potential energy is consistently built up until at a critical moment it is converted into kinetic energy. The capital markets can behave the same way at times. Investors and speculators develop certain amnesia to risk and focus almost exclusively on the potential returns. This behaviour is reinforced when each setback in the market turns out to be a buying opportunity. The Greenspan Put is often referred to as an example of this Pavlovian stimulus. If there is a financial crisis, the FED will react quickly to pump in liquidity. If there is a geopolitical conflict, the United Nations and diplomacy will sort things out. If there are global imbalances, the free market will ride to the rescue (eventually) and adjustments will be slow and painless for all.

Another way to look at this situation is to call it a form of collective complacency. Policy makers, strategists, economists and politicians all have difficulty interpreting market behaviour that does not appear to conform to historical experiences or to academically defined relationships. This state of affairs only further adds to the risk because the conflicting information becomes diluted in its ability to change perceptions. As a result, indicators of market risk perceptions as defined by the VIX, TED spread, ARMS, CBOE Put/Call ratios and others have been remarkably benign. The stock markets, in general, do not appear expensive as measured in traditional terms but not cheap either. The bond market, with its inverted yield curve, is implying that inflation is not a threat and that the possibility of a recession (at least in the U.S.A.) is growing. The stock market, with a relatively low earnings yield is implying that a soft landing is more likely. Furthermore, optimists point out that the stock market (again, in general) is going through a process of "de-equitisation" where the net supply of equity is declining due to share buy-backs and M&A activity. Combined with a large level of private equity money, this supply/demand balance is tipped in favour of rising equity prices.

Unfortunately, I am in the bearish camp. It is a little lonely here but more people are joining every day. Most analysts and economists are too bullish at the cycle peak (and too bearish at the bottom). This observation may be explained by the tendency of analysts to seek safety in a group and for the very real fact that calling inflection points is often more art than science. Academic studies and discounted cash flow models are no help here. I think we are more likely to see an increase in downward earnings revisions and this will make the market more expensive than it appears now. Furthermore, liquidity can dry up pretty quickly, particularly if any of the growing potential risks are suddenly realized. The risk premium in equities could rise quickly, even if there were little change in the fundamentals, when complacency turns to fear.

I believe there is a growing risk of a severe and sudden re-pricing of equities. The assumption of a soft landing and 1995 type recovery is just too weak. I have outlined the four major risks to the capital markets in previous articles and following my theme "The Four Horsemen of The Capital Markets". Each one of these risks continues to rise and are not yet being priced into stocks. The oil price continues to be volatile and will likely trade between $50/bl and $100/bl for the next year. Fundamentally, oil should bottom to around $50/bl as demand erosion trumps supply concerns. I don't see much risk of oil spending a lot of time below the $50/bl as the cost of producing a barrel of oil has risen and there will likely be production/exploration/exploitation cut-backs at these levels. On the other hand, oil could spike to $100/bl on speculation of supply constraints brought on by increased geopolitical risks (Iran, Nigeria, Venezuela, etc.). While the U.S.$ is fundamentally weak and in the long term could be losing its role as global reserve currency, it will likely remain strong with any flight-to-quality and if U.S. rates stay higher and for longer due to uncertainty over inflation expectations and to finance the current account deficit.

Gold has been weak lately as the market focuses on declining inflation fears. It may be a buying opportunity as gold will likely shine (pardon the pun) in the upcoming environment. As you probably know, I currently like NYMEX gas and its derivatives. I may change this view by the end of the year but it continues to do well since I first recommended it. I don't think it is imprudent to maximize cash and diversify currency at this time. If you must be exposed to stocks, I like large cap pharma, tobacco, consumer staples and utilities. Pretty obvious this is a defensive stance. If we get through the autumn without a major correction and evidence of a soft landing appears then I will re-visit my assumptions. If we do get a major correction, then there will be great buying opportunities.

Remember, the stock market is the only market where people run from a bargain!

About the author:

Stephen Martin
Stephen L. Martin has published articles, studies and research on investments over 20 years and has appeared on national television and radio. He currently works for Fairfax I.S., a private U.K. based investment bank. The views expressed are his own and are not representative of his employer.

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