This is an excerpt from The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future , by John Authers.
The 2009 rally was the most impressive in a century, but the signs of perverse synchronization were alarming-forex, equity, credit, and commodity markets moved in alignment, forcing some countries to try to push their currencies down, and leading to record gold prices. Many feared an incipient bubble.
The global stock market rally that started in March 2009 was the most impressive in more than a century. At its nadir, the S&P 500 hit the ominous level of 666, no higher than it had been in August 1996. From there, it gained 63.5 percent, getting back to 1120, and regaining in eight months exactly half its losses of the previous sixteen months. A "relief rally" is to be expected after a big sell-off, but after nine months, this rally was still greater than the rallies after the great bear markets of 1932, 1974, and 1982.
There was fuel for a rally because the global economy was recovering after its post-Lehman seizure and profits were stronger than expected, in large part because the downturn made it easier to cut costs by firing workers. Vocabulary shifted subtly. Pundits started talking about the "Great Panic" rather than the "Great Crash"-implying that the horrors of October 2008 were merely the result of a panic, rather than a reaction to fundamentals. If this were true, the market could indeed rebound as quickly as it had fallen, once investors got over their overwrought fears.
But it appears that the rally rested on exactly the same pathologies of herding behavior, moral hazard, and a simplistic faith in models, combined with synchronized and self-reinforcing trading, that created the super-bubble in the first place. And investors got over their panic only after truly extraordinary interventions by the U.S. and Chinese governments that must, at some point, be paid for. Rather than dismissing the entire correlated crash as a Great Panic, a more alarming and perhaps more persuasive interpretation is that the super-bubble never fully deflated before the behavior that inflated it the first time began to inflate it again.
History's great bull markets start when prices are irrationally cheap. Despite the fall that preceded it, it is hard to say that this was true in March 2009. Surveys of investors did show exceptional pessimism in March 2009, thanks to worries about a populist backlash against the bail-outs, or a choking off of free trade, and the arrival of the untried President Obama.
But stocks were much cheaper, and the economy in even greater trouble, before history's other great rallies began. A reliable long-term measure is the cyclically adjusted price/earnings ratio, first conceived by Ben Graham and more recently championed by Robert Shiller of Yale University. This metric compares share prices to average earnings over the previous ten years, and correctly identifies 1929 and 2000 as the two historical points when the U.S. stock market was most crazily overvalued. It also spots market lows. The cyclically adjusted price/earnings ratio fell to 5.5 before markets recovered in 1932, and almost fell to 7 before the rally of 1982.
Fund managers who do not want to look stupid and lose assets should rationally stay invested in the market, as the rally will continue until the bond market loses faith in the U.S. government's creditworthiness and forces up interest rates.
In 2009, the cyclically adjusted price/earnings ratio never fell below 13, suggesting stocks needed to be far cheaper before they presented a truly compelling buying opportunity; and by the end of the year it was back above 20, well above the historic average and almost identical to its level on the eve of the Lehman debacle (although, it must be stressed, still well below the levels that marked previous bubbles). That in turn implies that the desperate measures to save the banking system lifted the stock market before speculative excess had been squeezed out. And that is easy to believe. It is, after all, exactly what happened in 2003, when cheap money from the Fed arrested the decline in stocks and ignited the credit bubble, before the effects of the dot-com bubble had been squeezed from the system. The 2003 rebound came, otherwise incomprehensibly, when stocks were still historically expensive.
Next, the rise in stocks correlated almost perfectly with the decline in the dollar, precisely repeating the perverse pattern of the super-bubble years. As investors regained their appetite for risk, so they took their money out of the United States. The correlation weakened slightly but remained intact, with the dollar rising as stocks fell early in 2010. The parallels with Japan's crash of 1990 are eerie. It kept its banks alive while cutting interest rates to zero, and then the world used its currency to borrow cheap. In 2009, exactly the same thing happened to the dollar. The money flowing out of the United States was executing a kind of dollar carry trade, as investors looked for higher yields elsewhere.
Then there is the issue of correlation. According to MSCI, the correlation of the BRICs and the emerging markets with the developed world reached an all-time high in the summer of 2009. By then, the rolling annual correlation between them was above 0.8-so that a move in one was by far the strongest explanation for a move in the other.
In late 2009, correlations between the stock market and the carry trade were also stronger than at any point in 2007 or 2008-with the significant difference that the weak currency traders borrowed was the dollar, not the Japanese yen. The dollar and U.S. stocks were tightly linked. So, still, were the yen carry trade and the oil market. Calculations by Jamie Lee of pi Economics show that moves in the S&P 500 were by now sufficient to explain 60 percent of moves in the exchange rate of the Australian-dollar against the U.S. dollar. For commodity-backed carry trade currencies as a whole, the S&P explained about half their movements. And the link between the yen and the S&P was stronger than it had been in the weeks after the Shanghai Surprise almost three years earlier, when markets first lapsed into crisis.
Such strong correlations may merely be the result of the correlated crash that preceded them. If all these markets became undervalued together in a panic, then they might well be linked with each other on the way back up. But the pattern of the synchronicity between world markets makes this very hard to believe. Not only did markets take their cues from the falling dollar, but they took fresh orders almost every minute. Over a six-week period, the exchange rates of the dollar against the euro, the Australian dollar, and the price of gold all had a correlation of more than 0.5 with the U.S. stock market, every minute. Even in weeks when neither had a clear overall trend, they moved in the same direction as each other almost three times as often as they moved in opposite directions.
As the historical relationship between these markets is minimal, this suggested that all of them were priced inefficiently-bad news when the world economy was fighting to find equilibrium after a free fall. The relationship is so tight that it may be caused by computer-driven funds that have tracked the relationship in the past and are trading on the assumption that it will continue. If a computer-driven fund sees a gain in the S&P, it automatically buys the Australian dollar, for example.
Another explanation for 2009's resurgence is that markets entered a "rational bubble." On this view, the banks' recovery relied on co-opting, or abusing, the U.S. government's credit rating. In 2009, the United States stood as the ultimate guarantor of U.S. bank debt and issued much more debt to stimulate its economy. It could do this because its credit is rated higher than any other nation on the planet. To use an uncomfortable analogy, it is in the same position as the giant insurer AIG before the crash. AIG's AAA rating, although undeserved, allowed many securities to trade for more than they were worth. Its downgrade was a moment of truth for the market.
It may indeed be "rational" for investors to buy into the great rally of 2009-even if this involves inflating an incipient bubble.
Much the same would happen, although with no guarantor of last resort to step in, if the market were to lose its confidence in the United States and its AAA credit rating. But the U.S. government has tax-raising powers, and the likelihood of default remains remote. Therefore in the medium-term, fund managers who do not want to look stupid and lose assets should rationally stay invested in the market, as the rally will continue until the bond market loses faith in the U.S. government's creditworthiness and forces up interest rates. This is in line with history, as the U.S. bond market allowed the great bull market to start in 1982, when yields fell post-Volcker and later triggered the collapse of 2007 when yields rose.
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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