In the world of finance, pessimism is seen as an affliction and pessimists are outcasts. Throughout the years of the great credit bubble, Morgan Stanley economist Stephen Roach was a naysayer and paid the price, socially at least.
Roach was what I call a realist, but he was more commonly labelled a bear, a pessimist, and a crank. When the market was soaring to new highs, Roach spoke about his professional ostracism, where so-called colleagues would pass him by, their heads lowered in embarrassment…for him, not themselves, in being so stupidly bearish.
Perhaps for the stress that this treatment brought about, Roach slightly wavered in his conviction and become more sanguine about the global economy he had for years rightly poo-poohed. This was just before credit markets began to seize up.
But he hasn’t turned to the sunny side, in all its unthinking radiance, just yet. Roach began a recent column for the Financial Times with, “Hope always seems to spring eternal in liquidity-driven financial markets. That is very much the case today in the aftermath of the biggest liquidity injection in modern history.”
Hope is indeed springing eternal, and it is again unfashionable to be pessimistic. Brokers, analysts, and investment bankers are doing a roaring trade in peddling hope over reality, and it pays very well.
Such behaviour is a product of ignorance and, more importantly, the massively conflicted financial services industry. That industry has developed and grown throughout a 25 year bull market. It is an industry plagued by overcapacity, groupthink, and incurable optimism. It is hopelessly ill-equipped to deal with the prolonged bear market we are now entering into.
That may sound like a dumb statement considering the ASX has bounced by more than 50% from its March lows and the S&P500 has surged by around 60%. But bear market rallies tend to be very convincing, and this one appears to be convincing just about everyone. Global central bank induced liquidity is driving this rally, along with huge fiscal stimulus. The fundamentals remain terrible.
As Roach says in his FT commentary, the policy responses have done nothing to correct the global imbalances that caused the crisis in the first place. He writes that, “US authorities cannot resist opting for another dose of excess consumption – despite the fact that the consumption share of real gross domestic product remains at a record high of 71 per cent.
“Nor can the Chinese wean themselves off investment-led growth – even though the fixed investment share of their GDP appears to have surged beyond the already unprecedented reading of 45% in mid-2009. Far from rebalancing, an unbalanced world once again appears to be compounding existing imbalances.”
Why let sober reality get in the way of a good market rally? Instead of cautioning their clients to take money off the table as the market has surged from undervalued to overvalued, most market cheerleaders have become more delirious. The reasons to be bullish? The market has bottomed (for good, apparently) and there is still a huge amount of cash on the sidelines waiting to enter the great game (without needing substitution) the recession is over, and people are more confident.
There’s a term for such behaviour and it’s called “making hay while the sun shines.” The clouds have indeed broken over the past six months and the sun is shining through. The finance industry sees an opportunity…get that cash off the sidelines, put it to ‘work’ and clip the ticket on the way through. All is normal again.
But is it? Normal for whom? For the industry, or for the people the industry is meant to serve. I have a number of questions I’d like to ask the optimists.
What does cash on the sidelines mean? If you’re referring to money market instruments, like bank bills, short term commercial paper and short term government debt, why are these interest rates not rising around the world, signifying the flight from ‘cash’ to higher risk equities? Could it be that freshly minted central bank stimulus is flowing into risk assets, while the ‘cash on the sidelines’ is displaying more inertia that initially thought?
I would also ask the optimists what has changed in the global economy over the past year to make them so…optimistic. How does a huge increase in government debt do anything but provide a short term boost, masking long term structural problems? How can more debt solve problems caused by too much debt? How do they expect ultra low interest rates – which encourage consumption and discourage saving – to correct the imbalances?
I’m guessing the answers would have something to do with faith in governments and policy makers to get us out of this mess. The fact that they didn’t see the mess coming doesn’t seem to register.
Roach’s analysis is far more realistic. He writes that, “This [government attempts to ‘fix’ things] is the same dubious script the world followed in the aftermath of the bursting of the equity bubble in the early part of this decade. And look how that ended. With far more excess liquidity currently sloshing over into asset markets, there is great temptation to erase the memories of the Great Crisis. Therein lies a pitfall for the markets – as well as for a still unbalanced post-crisis world.
After a 50% fall on the ASX, which occurred from the 2007 peak to the low back in March, many market pundits were ‘cautiously optimistic’, the correct call given the significant amount of value opportunities. Now, after a 50% rise from the March low, and the absence of any attractively priced companies, the correct call is to be cautiously pessimistic.
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