The stockmarkets: irrational nonchalance
- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -
Before the credit crunch, we had what I called a Prozac market. Investors on both sides of the Atlantic seemed to be in denial, as irrational as the people who end up in the bankruptcy court because for years they have kept on smiling while the bills piled up unopened.
Last Fall, reality caught up in the shape of the worst banking crisis in history, and we have now had to mortgage our earnings for decades to come in order to bail out the banks. Not surprisingly, by mid-March this year, the Dow had fallen by well over 50 percent from its peak level at the start of October 2007, and the FTSE by nearly as much. In the last three months, however, the FTSE has risen by 20 percent and the Dow by nearly 30 percent. What has happened to justify the recovery?
The best that can be said is that there have been signs that the economic situation is deteriorating more slowly than in the second half of last year.
For example, the fall in house prices may be slowing. But in both UK and the U.S., they remain a long way above their long run levels by most yardsticks. Moreover, in the early 1990s, after the last British house price bubble popped, it took almost a decade for prices to recover, against a background of far higher inflation and a much more robust economy than today – and of course without an accompanying banking collapse.
Insofar as the construction industry is concerned, any increase in demand from the residential sector is likely to be overshadowed by continuing weakness in commercial real estate and, in the UK particularly, brutal cuts in public sector capital expenditure.
For the foreseeable future, the UK and U.S. governments, households and much of the corporate sector will be forced by record levels of debt to rein in their spending. Long term bond yields are already above 4 percent. Insuring against the risk of default costs 39 basis points for U.S. government debt, 80 points for UK gilts, and 300 or 400 points for a number of major multinationals, which clearly indicates that some financial markets have few illusions about the future.
Pricing equities usually involves a comparison of historic dividend yields with long term interest rates. Unfortunately, in crisis conditions, past levels of earnings (and hence of dividends) are no guide to the future. As government and consumers begin to repay their debts, they will both have to cut spending, or at least prevent it growing at anything like the rate seen in the last few years.
Ideally, the slack would be taken up by export demand. But with world trade in the doldrums, it is hard to imagine the UK and U.S. can export their way out of recession.
I can only visualise two possible exits from this impasse. Either the future involves years of Japan-style deflation, high unemployment and stagnant output. More likely, Anglo-Saxon electorates will opt for monetary expansion, inflation and devaluation, implying a de facto default – which is exactly the outcome being priced by the CDS insurance premia mentioned earlier.
Neither scenario is attractive for equity markets. Add to all this the danger of another round in the banking crisis (possibly involving the European banks), thinly-veiled threats from China to dump their dollars, long term problems which have not gone away, like global warming, pensions and health care……if the market was on Prozac last time, it must be on Ecstasy now.
So what should investors do? My own choice would be a mix of two components:
1. Corporate debt and/or equity of low-leverage companies in “safe” industries: pharmaceuticals and healthcare, food processors, utilities, etc.
2. Conventional and index-linked gilts in pounds, dollars and euros.
Of course, if you think governments are going to default on their debts, rather than inflate them away over the next decade or two, you need to buy gold……and a gun might be useful too.