How should we intrepret the stock market rally? Can we call the bottom, in terms of financial distress and economic crisis (as Goldman Sachs is apparently doing – so it must be true…)? Or are there still potentially serious problems that are masked or exposed by the rally? NYT.com is running a discussion right now; you can post reactions/comments either on that site or here.
By Simon Johnson
The Baseline Scenario 
No risk no reward.
Green shoots, Professor Johnson. Green shoots.
Obama sees glimmers of hope. I myself am wondering when we will see “glimmers of change”.
Vested interests (brokerages) and political cheerleaders love to call the bottom so YOU will risk YOUR money and acquire false hope for the future. Then there are the more nefarious “pump and dumpers”; they will promote a stock or market to get people to buy and then they sell as the price rises.
One rally says little about the actual underlying economy or about the future prospects for the economy. Never has and never will.
What it may say is that some investors are grasping at straws of hope in a desperate effort to recover losses. Others may be in a state of denial regarding the seriousness of the problems we face.
I would not be long or short this market unless you are an adept trader and have no trouble sleeping.
When the money supply is overwhelmingly sustained by debt, the whole thing becomes an endogenous loop. Maybe Soros’s theory of reflexivity has some substance, and the Efficient Markets Hypothesis is a sham.
Having said that, George Soros has gone back into retirement, citing a “return to normality”. So let’s pretend the market means what it said.
From the outside, it looks like the Dow 8k level was a reasonable floor in terms of the inherent value of the firms. The dip below that in February was charged by a perception of utter failure by the government to take obvious and necessary steps. The rally merely reflects a return to pre-February expectations, wherein govt. will do what everyone expected it to do (print some money). It does not signal a recovery or a future contraction – just a leveling off.
The CDS chart looks more like a response to the govt. policy on GM – fear that this policy signals the administration’s future approach to the bondholders for other bailed out institutions. That is, threaten (perhaps credibly) to deny support without forcing some bondholder concessions (such as a debt-to-equity swap). The stability of the stock market (which the general public and the major media view as far more visible to consumers than the CDS swaps) gives the administration the leverage to isolate problem banks one at a time and squeeze bondholder concessions. If the administration proves successful in managing GM through a bondholder negotiation and/or a fast bankruptcy, this will give it greater credibility to deal with bank bondholders and allow it to recapitalize banks through debt reduction.
In this scenario, the “stress test” is a vehicle for allowing the administration to credibly go on TV and isolate a handful of institutions for punishment. Indeed, if the administration stands up and says “we examined 18 major banks, and we found three that are deficient, and we’re going to fix them”, then this actually helps the other banks by signalling that the stress test program isn’t a complete sham. If this theory is correct, and the market is accurately pricing this, we should start to see some amount of divergence in the CDS prices for different banks (less correlation over time).
Fundamentals aside,
look at stock charts from past crashes and all of the bear market rallies that followed. Those old investors were no stupider or braver than investors today. Each rally represents hope that the worst is over and each decline a fear that it isn’t. Of course we won’t know the answer until we have hindsight.
Do you think, looking at the old charts and knowing the human psychology doesn’t change much, that enough fear, despair, disillusionment and disgust has been inflicted on market participants that they will be able to sustain their optimism for investing in equities in the face of bad news?
With the S&P 500’s price-earnings multiple just south of 100 times earnings, I don’t think I’ll be *buying* equities any time soon.
Ahh – the expertise of Goldman Sachs. One would have thought we’d have learned to question their judgment by now.
Guess not.
Personally, I have no idea what to think. But given that we live in a time where all sense has gone out the window and people seek to wrest significant profit out of fumes, a bear market rally is not surprising – and does not mean we’ve reached the bottom yet….
To use an analogy, where we are now is like being at the scene of the accident and the patient (in this case the economy) has had emergency treatment done by the paramedics and we’re loading the patient onto the ambulance to take him to the hospital. The initial trauma is over and the patient is somewhat stabilized. The difficulties have just started though – you’ve got many surgeries ahead, not to mention the recuperation time and then, eventually, rehabilitation. The patient may never be the same.
We’ve been through the shock, but we haven’t gotten to the despair yet. The consumer doesn’t flame out in the same dramatic fashion that Bear or Lehman did. Life habits change slowly, but eventually the consumer dies a slow death as sources of purchasing power and the will to indebt fade.
So many companies out there (especially in the retail sector) are just barely hanging on. How many are operating under the assumption that consumer demand jumps back to where it was in the next year or two? Here’s a different kind of stress test – how many public U.S. companies survive a 5-10 year downturn in consumer demand?
For the stock market, I expect the wild swings to end soon as we head in to the despair stage. What does despair look like? Many years of flat-to-down movement.
Retrospective PE, in non-normal times, means nothing. Many companies used Q4 08 as a chance to claim losses they’ve been keeping off the books for years, and both Q4 and early Q1 09 represent drawdowns in inventories that will need to be partially rebuilt – aka, temporary dislocations.
The question is future earnings capacity relative to other investment classes.
The fundamental long term problem is the debt-web. Consumption will remain suppressed as long as debt detroys spending power, but any destruction of debt wipes out incentives to save/invest and rewards 20 years of conspicuous consumption.
Team Obama is clearly looking for a middle road, which probably means sustaining some level of consumption through redistribution and public investment. And bank bailouts.
And facilitating some level of inflation to avoid destroying the finances of the federal government and all consumers. (e.g. consumers are going to be punished for not saving, but bad savers are going to be punished for making bad loans and/or sitting on cash). It is not possible to simply “work” the debt off when asset prices and wages are declining relative to loan valuations, which is why some level of inflation is needed.
Most concerning, however, is the lack of real commitment to public _investments_ (the infrastructure/energy portions of the stimulus bill were slim compared to the transfer payments, with the tax refund clearly being a transfer payment due to its structure). This, in combination with the retiring boomers, creates huge draws on the real economy 10 years from now – particularly with the declining physical health of our current workforce resulting from such issues as obesity, and the ability of modern medicine to keep people alive but unproductive.
If we don’t invest massively in infrastructure right now, and fix certain fundamentals, we are fubared in 5-10 years.
Don’t call me an optimist, but it should be noted that those markets DID bottom somewhere. So the question remains, is this one of those little bumps on the way down, or not?
Right. Look at the charts. It seems like it takes longer than this to completely discourage people.
Glimmers of Hope?
I’d say Glimmers of Green. For those of us who invested our tax return refund 6 weeks ago in stock funds, we’ve already seen a 30% return.
We can sit around speculating on “How should we interpret the stock market rally? Can we call the bottom?”, but you’ve already missed a 30% updraft. Don’t opine too long…
This current move will continue to be swift and steep leaving many in the dust…
http://mast-economy.blogspot.com/2009/02/bull-market-move-swift-and-steep.html
Hopeful
It is no more desirable to reward conspicuous consumption by destroying debt than it is to reward bad decisions by banks with bailouts paid for by the conspicuous consumers’ tax dollars. It seems that improvements in the education of both bankers and consumers is in order.
I’m looking for more infrastructure/energy spending to come in Stimulus II.
Simon,
I agree with your points on the Times discussion, but I don’t think CDS spreads can be considered a reliable indicator of default probability any longer. At least not in the aggregate. Given the outcome of many of the AIG contracts, where the government backstop meant a payout even without the occurrence of a default event, it stands to reason that credit protection as a whole should be more expensive. If there’s even a small probability that you’re going to get a payout from your insurance without suffering the loss you’re insuring against, you will no doubt pay more for the privilege.
Glimmers of green shoots of hope!
Prof. Johnson,
I believe the operative paradigm of the market has been steadily outmoded over the last 20 years. With this outdated market paradigm, we have not created enough jobs for middle- and lower-income people. It means that we have not achieved the level of consumer spending on the demand side that we could have had.
Without replacing the existing outdated market paradigm, we might eventually be able to stabilize and revitalize the economy, but I strongly believe that it will take too much time at too much cost. Accordingly, our national prosperity, social security and competitiveness will be seriously eroded. Moreover, much of the middle- and lower-income class will be reduced to a new poverty class, and social and political unrest may result.
Unfortunately, none of the so-called experts have recognized the inefficacy of the operative market paradigm. Accordingly, nobody has tried to develop a new market paradigm – until now.
“How should we intrepret the stock market rally?” – We may be able to escape the crisis once or twice with the powerful expansionary and stimulus economic policies. Eventually, however, we will face bigger crises in the midst of revelations of other concrete economic and social problems. This will eventually lead to a bigger economic catastrophe which we have not experienced before. – If we do not develop a new operative market paradigm.
Luke
I think the rally is being supported by the primary dealers, and maybe, by the 12 member banks of the Fed with all the interest that they are accruing off the 12trillion dollars that is floating around thanks to the big BAILOUT BONANZA. They decided when to pull the trigger, then ran with it till the all the rest of us (us suckers ) just took it and ran–and, when they decide it’s time, i am sure we will feel the great dumping again, as they take the profits from this round, and wait till the prices fall below the last round.
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May be you can have a try.
Hope can help you.
YOU, are correct sir. There’s no “real” money coming in, just the primary dealers, trading back and forth amoungst themselves. That data is out there, and very clear.
AA
just sell into this rally …. else be ready for stucking yourself for next 2years … sell sell sell
kaushik India
Thanks AA! I knew it but i don’t know where to look–can you give some ideas please, but i am guessing, this info has to be surmised, since it is likely concealed like all inside trades would be– i like what someone said before, it is illegal to manipulate the market, unless you are the government.
Dear Simon,
I use to be a fan of Dylan Ratigan on CNBC because he seemed to be the only one reflecting truth on the network–as it turns out, he left the network and in this interview, it seems part of his reason to do this was because the issues facing the country were far bigger that what was being reflected in his work on CNBC. I really wish you would give him a call…just in case there is any way he could help the cause…if you see him, tell him a little birdie sent you.
Thank you!
Here is the article:
http://www.businessinsider.com/henry-blodget-dylan-ratigan-speaks-and-hes-angry-2009-4
Here is an article he wrote back in Feb. but with his new independence, there is no telling what he may be able to do.
http://www.thedailybeast.com/blogs-and-stories/2009-02-05/nationalization-now/full/
dissenter:
The data you’re looking for is here:
http://zerohedge.blogspot.com/2009/04/incredibly-shrinking-market-liquidity.html
and one of the components that clearly aggravates the market dynamics is exposed here:
http://zerohedge.blogspot.com/2009/04/quantology-revisited-negative-convexity.html
As for this peculiar phenomenon that is “negative convexity” a primer can be found here:
http://zerohedge.blogspot.com/2009/02/negative-convexity-of-cds-trading-and.html
Hope this helps
Dear Dr. Frankie,
Thank you for your kind consideration!
I have figured some of these things out by deductive reasoning, without knowing how to prove the issue with data…your source does a great job. I love the zerohedge post and i thank you again for sharing this info!
You are most welcome.
I discovered Zero Hedge via Naked Capitalism. This Tyler Durden persona clearly knows his stuff, and he sure knows where the financial cockroaches hide.
I urge consideration of stock market price manipulation. See here:
“ Stock market price manipulation would be ‘dirty’ — but, of what we can already see, what do we know that is ‘dirty’?” at
http://groups.google.com/group/misc.invest.stocks/browse_thread/thread/8c6e5dbd8152d13a/cd6a82d17af8b9f3?hl=en&q=ttsmyf+%22maybe+dirty%22#cd6a82d17af8b9f3