Just time for a quickie. The stock markets, not just the U.S., but worldwide, had another very bad day. The major indices in the U.S., Dow Jones Industrials, Standard & Poor’s 500, NASDAQ, were all down from 4-4.6%. This is on top of 6% decline on Monday and more declines in the last two weeks. In fact, the last three weeks have seen the stock markets fall over 17%.
So what’s happening? A lot of things. But as I’ve said before, it’s not worry about the U.S. defaulting on debt or having too large of a deficit. If that were true, then bond prices would drop and interest rates rise. Instead, we’ve seen almost as dramatic moves in the U.S. bond market. Tonight the U.S. 10 year bond is trading with a 2.1% yield. A 2.1% interest rate! It was 2.6% as recently as last Friday. We’re starting to see interest rates on government bonds move into the territory we say in 2008.
Yes, it’s fear. And it’s uncertainty. But it’s fear over growth prospects in both the U.S. and Europe. It’s also fear over financial system stability. In the U.S., Bank of America, the second largest bank has been hit with a series of judgements, lawsuits, and other problems dating back it’s sub-prime mortgage days that it’s looking pretty dodgy. In Europe, the slow-motion train wreck that is the Euro and government bonds there is a serious concern. The debt crisis contagion that started in Greece and spread to Ireland and Portugal, now seems to include Italy and maybe Spain. Today, news came out that France’s debt rating might also be downgraded (remember, unlike the U.S. they don’t have their own central bank). That set concerns for the health of the largest French banks.
On the uncertainty front, what the debt-ceiling debate and “deal” told us is that we’re on our own. The politicians have no plans for helping the economy. Instead they’re in a rush to cut spending which will only make it worse.
So what to do when all looks frightful and uncertain? Go to cash. Or what’s essentially the same thing – U.S. bonds. I’m not trying to recommend this or any strategy. I’m not an investment advisor. But that’s what’s happening.
It’s Monday, Aug 9. The stock markets are declining significantly, although anybody who says it’s panic doesn’t remember 2008. Anyway, lots of market commentators, you know the types on cable TV news networks, are all claiming the decline is due to the S&P downgrade. They’re wrong. Completely wrong as I pointed out already. But just to reinforce my point, here’s Paul Krugman just minutes ago:
Carnage in stock markets as I write — and all of the headlines I see attribute it to S&P’s downgrade.
They really are trying to make my head explode, aren’t they?
Once again: S&P declared that US debt is no longer a safe investment; yet investors are piling into US debt, not out of it, driving the 10-year interest ratebelow 2.4%. This amounts to a massive market rejection of S&P’s concerns.
The “signature” of debt concerns should be stock and bond prices both falling; what we actually see is those prices moving in opposite directions. And that’s normally the signature of concerns about a weak economy and deflation risk (see Japan, decline of).
What triggered economy fears? To some extent I think this is a Wile E. Coyote moment, with investors suddenly noticing just how weak the fundamentals are. Also, the mess in Europe.
And maybe, maybe there is an S&P story — but not the one you think. Arguably, that downgrade will bully policy makers into even more deflationary, contractionary policies than they would have undertaken otherwise, which has the perverse effect of making US debt more attractive, since the alternatives are worse.
But all the Very Serious People, having totally misdiagnosed our problems so far, will probably double down on that wrong diagnosis as markets fall.
Oh by the way. The 10 year bond rate is now down to 2.38% from 2.6% on Friday. The 3 month and 6 month rates are less than 0.01% – essentially zero interest rate.
One of the economic theories that dominated a mainstream economic theory during the last few decades is Efficient Markets Hypothesis. Essentially, an important part of the concept is that asset prices, such as stock prices on the stock exchange, accurately reflect all available information about the future earnings of the firm. Further, it implies that stock price movements reflect changes in these perceptions. There’s a lot wrong with the theory as is explained quite well in Zombie Economics by John Quiggin. But let’s add this little bit from Washington’s blog and Naked Capitalism.
→ Washington’s Blog
The Fourteenth Banker writes today:
In the stock market, program trading dominates volume. I heard recently that 70% of trade positions are held for an average of 11 seconds.
As the New York Times dealbook noted in May:
These are short-term bets. Very short. The founder of Tradebot, in Kansas City, Mo., told students in 2008 that his firm typically held stocks for 11 seconds. Tradebot, one of the biggest high-frequency traders around, had not had a losing day in four years, he said
Similarly, FT’s Martin Wheatley pointed out last month:
I know of one HFT firm operated out of the west coast of the US that boasts its average holding period for US equities is 11 seconds
And market analyst Peter Cohan writes at AOL’s Daily Finance:
70% of trading volume on the major exchanges is conducted by high-frequency traders who hold a stock for an average of 11 seconds.
The fact that the vast majority of stock market trades are held for 11 seconds shows that the stock market is not a real market with real traders governed by the law of supply and demand, and with no real price discovery.
One of the enduring myths of 20th century American capitalism is that “anyone can do it”. Anyone can get rich, that is. And one of the ways people are encourage to “get rich” is by wisely gambling investing in the stock market. Unfortunately for countless numbers of people hoping to retire soon, it just isn’t true. Yes, it’s possible to maybe hit or guess a stock that rises dramatically. You just might get Microsoft in 1984, but it’s not likely. You were probably just as likely to get Digital Research in 1984.
Here’s an interesting graph (one of many) from James Hamilton, one of the better econometricians of our time.
Figure 2. Green line: Ratio of real value (in 2010 dollars) of S&P composite index to the arithmetic average value of real earnings over the previous decade, January 1880 to Aug 2010. Red line: historical average (16). Blue line: average compounded nominal rate of return on stocks purchased at the indicated date and held for ten years from that date. Data source: Robert Shiller.
Even at today’s supposedly “low” prices following the 2008 crash, PE ratios are still higher than normal. No values here. Note also that 10-year returns on stocks are now negative. If you’re planning on retirement or saving for a child’s college education, don’t assume you’ll earn the 8-12%’s that the stock brokers and investment advisors claim.
It’s well worth the short amount of time required to read the full article at: http://www.econbrowser.com/archives/2010/08/longterm_perspe.html
Popular media like to point to the stock market as a real-time measure of the health of the economy. They particularly like the Dow Industrials average. It makes quick, easy news for lazy journalists. Occasionally they do it right, but it’s rare. CNN gets it right here:
Don’t trust Dow 10,000
The stock market is supposed to be a leading indicator, predicting what happens next. But the rally doesn’t mean the nation’s economic woes are over…
…said Rich Yamarone, director of economic research at Argus Research. “But I think there’s a bubble-like atmosphere going on here in the rush back to 10,000. Caution should rule the day. We’re not out of the woods yet.”
Several experts point out than many of the relatively strong earnings reports helping to lift the markets in recent days are being driven by cost cuts, rather than strong revenue growth that would be a better indicator of consumers and businesses being willing to spend again. If businesses keep cutting costs to make the numbers that Wall Street wants to see, that can only put more downward pressure on jobs and wages, and result in weaker economic growth or another downturn.
“The companies are cutting fat, and in many cases cutting bone and muscle. There’s no organic economic growth there,” said Yamarone.
Barry Ritholtz, CEO and director of equity research at Fusion IQ, said that despite their reputation as a leading indicator, the stock markets do a terrible job forecasting the economy.
“Beware of economists pointing to the stock market,” he said. “The rallies tend to be false starts because it’s a reaction to what came before. The sell-offs tend to be overdone because, as they gain momentum, they lead to panics.”
Steven Pearlstein of the The Washington Post explains via this story in the Hamilton Spectator why the run-up in the stock exchange of the last 6 months isn’ t necessarily a good thing. Instead of being a predictor of good times to come, the run-up in the stock market is more likely the latest in a series of financial bubbles. We started with real estate & S&L’s in the 80’s, then it was dot-com’s and tech stocks in the nineties, then back to real estate and houses until 2006, then oil and commodities in 2007-8 (remember $130 barrel oil?). We still aren’t reforming our financial system and we’re still letting speculators, bubble-blowers, and Wall St drive our policies.
Less encouraging is what’s happening on Wall Street. It turns out that all those bold and necessary steps by the Federal Reserve to prevent the financial system from collapsing wound up creating so much liquidity that it has now spawned another financial bubble.
Let’s start with the $1.45 trillion that the Fed has committed to propping up the mortgage market – money that, for the most part, was simply printed. Effectively, most of that has been used to buy up bonds issued by Fannie Mae and Freddie Mac from investors, who turned around and used the proceeds to buy “safer” U.S. Treasury bonds. At the same time, the Fed used an additional $300 billion to buy Treasurys directly. With all that money pouring into the market, you begin to understand why Treasury prices have risen, and interest rates have fallen, even at a time when the government is borrowing record amounts of new money.
At the same time it was printing all that money, the Fed was also lowering the interest rate at which banks borrow from the Fed and each other, to pretty close to zero. What didn’t change was the interest rate banks charged for everyone else. As a result, “spreads” between what banks pay for money and what they charge are near record highs.So who is doing the borrowing? By and large, it’s not households and businesses, which are reluctant to borrow during a recession. Rather, it’s hedge funds and other investors, who have been using the money to buy stocks, corporate bonds and commodities, driving prices to levels unsupported by the business and economic fundamentals.
I recommend reading the full story at the link.
From the Comrade Swan on the comments on Calculated Risk, who says it better and funnier than I possibly could:
PICTURE the Black Knight scene from Monty Python & Holy Grail, but the script as follows below the fold: Continue reading