Markets revert to common sense

By Felix Salmon
June 20, 2013
John Abell has a good question for me: how could everything be selling off today?

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John Abell has a good question for me: how could everything be selling off today? Aren’t the various different asset classes (stocks, bonds, gold) meant to be hedges against each other?

The simple answer is that although it would be great if that were the case, it isn’t — it never was. You do get a certain amount of diversification benefit by investing in a series of asset classes, but, as we all learned during the financial crisis, correlations have a tendency to go to 1 exactly when you don’t want them to. If you want to hedge your long stock exposure, you’re going to have to do that with some kind of short stock position: a long bond position, or long gold position, won’t help you when you most need help.

The interesting thing about today’s market action is not that the risk-off trade materialized in markets around the world, from the Australian dollar to local-currency emerging-market debt. Rather, it’s the lack of any flight to quality: Treasury bonds got whacked for a second successive day, with the yield on the 10-year rising more than 10bp to reach 2.42%. And gold fell almost 7% as well: the world’s oldest safe-haven trade wasn’t working today.

There’s something counterintuitive here: if money leaves one asset class, you’d think that it should turn up in another. You can’t have everything fall at once. But the fact is that you can. Volume was heavy today — but remember that, as always, the number of shares bought was exactly the same as the number of shares sold. What we really saw today was not a move out of stocks, or bonds, or gold, but rather a repricing within each asset class. Think of it this way: if the price of Damien Hirst paintings falls, that doesn’t mean lots of people are selling them. Quite the opposite. It just means that potential buyers aren’t willing to pay as much for such things as they used to.

Buy-and-hold investors can safely ignore everything that’s going on here, or possibly step up their buying pace if prices start looking increasingly attractive. Because the big picture here is that what we’re seeing is markets returning to normal — or, to be more precise, markets anticipating that, finally, almost five years after the crisis hit, a return to normal might be coming at some point in the foreseeable future.

“Normal”, here, just means a world where the Fed isn’t dropping money from helicopters; a world where global interest rates aren’t all stuck at zero; a world where real interest rates can’t happily sit in negative territory for years on end; a world where metals don’t have especial value just because they’re particularly shiny; a world, most broadly, where assets are valued based on fundamentals, rather than being based on capital flows.

At his press conference yesterday, Ben Bernanke reiterated his view that the way QE works is through simple supply and demand: since the Fed is buying up fixed-income assets, that means fewer such assets to go round for everybody else, and therefore higher prices on those assets and lower yields generally. In reality, however, the flow always mattered more than the stock: when the Fed is in the market every day, buying up assets, that supports prices more than the fact that they’re sitting on a large balance sheet. And even more important is the bigger message sent by those purchases: that we’re in a world of highly heterodox monetary policy, where the world’s central banks can help send asset prices, especially in the fixed-income world, to levels they would never be able to reach unaided.

Traders always try to skate to where the puck is going: if they see that the Fed is embarking on a round of QE, they’re going to start buying up assets so long as they’re cheaper than they will be at the end of that round. And similarly, once the Fed signals that it’s on its last round of QE and that from here on in monetary policy is only going to get tighter, they’re going to sell assets so long as they’re more expensive than they will be once money is no longer falling from helicopters.

As a result, the common thread which explains all of the different market moves over the past couple of days is that they’re all part of what you might call the “reversion to sensible” trade. If real rates are bizarrely low, they will rise. If the Australian currency is bizarrely strong, it will fall. If emerging-market debt has rallied to the point at which it no longer prices in all the idiosyncratic risks associated with buying assets governed by Ruritanian law and denominated in the Ruritanian currency, then it too will fall — a lot.

In the long term, this is a good thing: it means that markets are doing their primary job, which is price discovery. In the short term, of course, there will be disruption and volatility: it’s not going to be easy getting there from here. But if you’re an investor, rather than a trader, there’s nothing to worry about here. In fact, there’s a lot to welcome.


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Very good post.

Have to say that I find Bernanke’s view odd. A focus on the Fed’s stock rather than flow seems to presume a fixed quantity of Treasuries (or, more precisely, Treasuries plus agency MBS). That stock isn’t fixed, however, – the amount of Treasuries are growing both in total and as a percent of GDP. (I’m not as certain that’s true for Treasuries plus agency MBS as a percent of GDP, but fairly certain it’s also happening there in absolute terms.) It therefore follows that the supply available to other buyers expands unless the Fed keeps buying.

Posted by realist50 | Report as abusive

“‘Normal’, here, just means … a world, most broadly, where assets are valued based on fundamentals, rather than being based on capital flows.”

That’s pretty to think so.

But since there is no timeless, unarguable, god’s-eye-view of the “fundamentals” upon which you posit asset values are based, Platonist thinking like yours compares poorly with Oliver Wendell Holmes’ pragmatism, circa 1905:

“People will endeavor to forecast the future, and to make agreements according to their prophecy. Speculation of this kind by competent men is the self-adjustment of society to the probable. Its value is well known as a means of avoiding or mitigating catastrophes, equalizing prices and providing for periods of want.”

Posted by dedalus | Report as abusive

Bull market in cash today. Everything else fell.

Posted by TFF | Report as abusive

dedalus – the future is obviously, by its very nature, uncertain.

There is, however, a difference between buying an asset based on a view that one wants to ride an irrational market and flip that asset to a greater fool in the near-term versus buying based on a longer-term view of economic prospects and resulting cash flows.

I would argue that buying based on central bank asset purchases and near-zero interest rates is far more similar to the former than the latter.

Posted by realist50 | Report as abusive

@realist, there have been few sensible alternatives these days. People who would normally buy bonds have been buying blue-chip stocks because the yields are comparable. I pushed that very idea myself on this forum three years ago. Yet that only makes sense if the principal is similarly secure (at least over the long term). When those blue-chip stocks are trading at a PE of 20, there is a likelihood of eventual revaluation to a much lower level. That stock is in some sense a permanent bond, with a correspondingly long time horizon.

The market really hasn’t corrected yet. Valuations are still very high. It simply retraced the nonsensical rise from May.

Posted by TFF | Report as abusive

QE has had no impact on money growth; all of it is sitting at the Fed in the form of sterile excess reserves. Money growth, especially the broader aggregates, has been abysmal since 2008. This is due to credit contraction following the Minsky Moment. Money growth should pick up later this year if household credit starts to grow. QE is irrelevant to money growth and to economic growth.

Posted by nixonfan | Report as abusive