Irrational Exuberance II

“You can’t buy what is popular and do well.” – Warren Buffett.

Markets are often accused of being irrational, but the recent behaviour of equities points to a more urgent need for psychoanalysis than normal. After months of an interbank lending crisis, a US property market slowdown, mortgage default contagion, oil trading above $80, the failure or near failure of at least two banks (Northern Rock and the US’ Netbank), and $18 billion in bank losses – so far – the S&P 500 now stands at a record high. We should evidently have systemic financial emergencies more often.

While there are undoubtedly some pockets of genuine cheer in the markets (US exporters will benefit from a weaker dollar; most financial institutions will benefit from lower official rates and any steepening in the yield curve) one requires  heroic doses of wishful thinking to see more good than bad in the stock market as a whole. ‘The Times’ reckons that the world’s largest investment banks have announced more than 33,000 job losses this year. If that figure is even remotely accurate, it is not a terrific barometer of economic health. Unlike previous purges, Wall Street’s 2007 cull has involved major scalps, Merrill Lynch’s Osman Semerci and UBS’ Peter Wuffli and Huw Jenkins among them. Whether it makes sense to dismiss senior executives after a credit debacle that has visited itself upon pretty much everybody, and whether it makes sense voluntarily to pass up the experience of managing through, and enduring, such a crisis is another matter, but then investment banks have never claimed to have a monopoly on fairness, meritocracy or common sense. But the biggest irrationality is surely to interpret a 50 basis point cut from the Federal Reserve as a cause for optimism rather than a sign of just how awful US and for that matter global financial market conditions had become.

Nevertheless, equity markets are, to use the now common expression, partying like it’s 1999 (an appropriately ominous point of time), and the objective observer has to at least respect the price action even if he can’t rationalize it. Stocks appear to be pricing in a rapid recovery in the financial sector and no broader economic implications from a softening housing market. Is that really credible ? JP Morgan points out that Europe’s biggest banks will have £415 million less than expected in profits from asset-backed securities business in the second half of the year. That is just one part of their business. But there are plenty of areas where it is easy to believe that fragile confidence will be some time in returning. As systemic deleveraging rolls on, profit prospects for prime brokerage, equity and particularly debt underwriting, merger and advisory work, private equity lending, all look questionable. Indeed, the financial crisis of 2007 has blown another hole in the argument for ‘full service’ investment banks – having multiple business lines especially in fixed income trading hasn’t necessarily spared banks, it has merely led to more opportunities to lose money. But as mortgage-holders internationally come to terms with more punitive rates even as official interest rates fall – an uncomfortable coincidence that no amount of public relations will soothe – it is difficult to see an outcome for retailers, for example, that is anything other than worrisome. And there are early signs that a property slowdown that wrought such tremendous damage in the US has now crossed the Atlantic. Last week’s Halifax survey pointed to a 0.6% fall in UK house prices, while the Financial Times reported over the weekend that commercial property funds have just seen their first fall in total returns for 15 years. The FT’s Martin Wolf reminds the bulls that the UK could easily go the way of the US, in that our house price bubble has been more extreme than North America’s.

Doug Kass also articulates the bearish perspective well:

“non-traditional (and creative) credit originators are in intensive care and will not fuel growth anywhere near the degree to which they have in the past.. The credit unwind in the upcoming years can be expected to have a profoundly negative impact in the current down cycle of economic activity – possibly for years to come.”

Other factors Kass cites in the eventual unravelling of stock prices: lower business spending based on a weakening domestic economy; the economies of industrialized nations are beginning to weaken; emerging economies will not be entirely insulated from deceleration in the developed world; housing is replacing technology as the Achilles heel of future growth; the salutary inflation environment of the last decade is in the process of being reversed; slowing top-line growth, cost pressures and higher corporate tax rates augur poorly for profit margins; international savers and consumers might no longer be kind enough to underwrite US consumption and growth. A potentially toxic cocktail.

The unwarranted euphoria at play in the stock market is causing all sorts of tired investment mantras to be dragged out for a fresh airing: markets can remain irrational longer than you or I can remain solvent; the trend is your friend, until the end, when it bends.. There is a line in ‘1999’ that doesn’t get the attention in the investment media that it deserves:

“But life is just a party and parties weren’t meant to last”.

Comments

[Nick]

I was interested to read the other day that this last 5 year bull run is the only one since 1945 where PE ratios have actually contracted. Any thoughts?

[tim price]

It has been said that the market never capitalizes 'peak earnings' - in other words, that low p/e's are the norm as earnings reach cyclical highs. My own view is that there are pockets of value in the market but that there is tremendous momentum-driven buying which is not sustainable; also, that there is tremendous complacency out there in the face of weakening real estate markets globally.