Fund managers who wanted to keep their jobs had even stronger reasons to buy. Once the market turned, they desperately needed to be a part of the action to avoid embarrassment. The weight of money programmed to follow the herd also increased. Index funds and exchange-traded funds gained ground. By the end of 2009, ETFs of both commodities and stocks, on both sides of the Atlantic, had more assets than at their peak before the crisis. An ever larger chunk of the market automatically chased prices higher. Hence it may indeed be "rational" for investors to buy into the great rally of 2009-even if this involves inflating an incipient bubble.
A final concern is that traders were playing chicken with the Fed once more and betting that central banks would not dare exit their cheap money policies. After the disastrous United States attempt to beat moral hazard by letting Lehman Brothers go bankrupt, the market assumed that the government would not follow through on any threat to raise rates.
This was a key difference from the bear market lows of 1932 and 1982. On these occasions, financial pain had squeezed moral hazard out of the system. Investors were humbled. In 2009, despite the disasters of 2007 and 2008, politicians made a conscious decision to reignite risk-taking, to jump-start the market. The alternative of revisiting the worst depths of 1932 seemed too dangerous given the populist sentiment around the world, with attacks on the homes of bankers and riots in the streets. But the option they chose is also a dangerous game. The more commodity prices rise and the dollar weakens, the greater the risk of inflation, and hence the greater the incentive for the Fed to swerve and raise rates to choke it off. Bastille Day of 2008, when the oil price collapsed, warns what could happen.
The word "bubble" can itself be devalued. By the end of 2009, stocks were still far below their highs, and were nowhere near as overvalued as they were before previous crashes. There was still time to stave off a new bubble.
But it was remarkable that stocks were more expensive than the historical norm with the financial system still on life support. All of the perverse incentives and instabilities that had marked the investment industry as it grew up over the preceding half century remained embedded in global markets' DNA. The most absurd and debased financial instruments of the subprime debacle were gone and were never to return, but the incentives that had allowed synthetic collateralized debt obligations and the like to flourish remained in place. The danger is that another, more severe financial dislocation will be needed finally to purge the markets of these distortions.
The forces driving the great 2009 rally were moral hazard and the herding mentality of the modern investment industry.
Tight correlations suggest markets were priced inefficiently, even if prices remained below bubble territory.
Reform is needed to change incentives on fund managers and reduce moral hazard before new super-bubbles form.
Reprinted with permission of FT Press, an imprint of Pearson. Copyright 2010 by John Authers.
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