By David Scott | Thursday 10 August 2017
Yesterday was the tenth anniversary of the start of the Great Financial Crisis, the banking implosion that changed the world as it did the way we think about economics, finance and money. Have we learned the right lessons from this earthquake, such that we can prevent variant forms of it happening again, and if we can’t prevent them, are we at least better equipped to mitigate their crippling costs? On both counts, I sadly say a resounding no.
Yesterday morning on BBC radio 4, Alistair Darling has revealed his “most scary moment” of the financial crisis, which began a decade ago. The former Labour chancellor of the exchequer said he received a shocking phone call from Royal Bank of Scotland in 2008, revealing a run on the bank. He told the BBC: “I had to go to one of these meetings of European finance ministers, and I was asked to come out and take a call from the then chairman of RBS [Tom McKillop], who said the bank was haemorrhaging money.
“Remember this was not only the biggest in the world, it was about the same size as the entire UK economy. “I said to him: ‘How long can you last?’ And what he said to me shook me to the core. He said: ‘Well we’re going to run out of money in the early afternoon.’” Lord Darling said there would have been “blind panic” had the government not intervened. RBS was bailed out by taxpayers later that year, and the government still owns a 71% stake in the bank. He added that the biggest danger regarding a future crisis was complacency.
On August 9, 2007, the first tremors began with the news that the French bank, BNP Paribas, had frozen three of its funds because of an inability to value the complex, mortgage-backed securities that were on their books. Over the next several months, a new world opened up as officials and the public scrambled to make sense of collateralised debt obligations, credit default swaps, conduits, capital buffers, liquidity ratios, lender of last resort facilities, and other toxic financial weapons is mass destruction. This was all stuff that previously had previously taken for granted or people didn’t know about at all. Worryingly the big macro-economic causes of the crisis, are still very much with us and in the case of borrowings, significantly bigger.
Making the situation worse. Since the crisis, we seem to have got permanently stuck in a low growth, low wage vortex, with negative real interest rates to match. Fighting the crisis with the same thing that caused it – debt – made some sense in its early stages, but that we are still taking the heroin ten years later only promises to create even greater levels of financial instability. When the next recession or crisis arrives, there is nothing left in either the fiscal or monetary armoury to throw at it. Globally Public debt is at record peacetime levels, and money could scarcely get any cheaper. Persistently low interest rates have generated further, risk taking by investors as they seek yield, making the world particularly vulnerable to renewed, speculative asset price booms and busts.
Below are the elements that typically form the foundation for a bull market, boom or bubble. A few will give us a bull market. All of them together will deliver a boom or bubble:
A benign environment – good results lull investors into complacency, as they get used to having their positive expectations rewarded. Gains in the recent past encourage the heated pursuit of further gains in the future (rather than suggest that past gains might have borrowed from future gains).
A grain of truth – the story supporting a boom isn’t created out of whole cloth; it generally coalesces around something real. The seed usually isn’t imaginary, just eventually overblown.
Early success – the gains enjoyed by the “wise man in the beginning” – the first to seize upon the grain of truth – tends to attract “the fool in the end” who jumps in too late.
More money than ideas – when capital is in oversupply, it is inevitable that risk aversion dries up, gullibility expands, and investment standards are relaxed.
Willing suspension of disbelief – the quest for gain overcomes prudence and deference to history. Everyone concludes “this time it’s different. “No story is too good to be true.
Rejection of valuation norms – all we hear is, “the asset is so great: there’s no price too high,“ Buying into a fad regardless of price is the absolute hallmark of a bubble.
The pursuit of the new – old timers fare worst in a boom, with the gains going disproportionately to those who are untainted by knowledge of the past and thus able to buy into an entirely new future.
The virtuous circle – no one can see any end to the potential of the underlying truth or how high it can push the prices of related assets. It’s broadly accepted that trees can grow to the sky: “It can only go up. Nothing can stop it. ”Certainly no one can picture things taking a turn for the worse.
Fear of missing out – when all the above becomes widespread, optimism prevails and no one can imagine a glitch. That causes most people to conclude that the greatest potential error lies in failing to participate in the current market darling.
The Current environment
The present level of uncertainties are unusual in terms of number, scale. They including stagnation of economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.
Pro-risk behaviour is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.
Most people can’t think of what might cause trouble anytime soon. But it’s precisely when people can’t see what it is that could make things turn down that risk is highest, since they tend not to price in risks they can’t see. With the negative catalyst so elusive and the return on cash at punishingly low levels, people worry more about being under invested or bearing too little risk (and thus earning too low a return in good markets) than they do about losing money.
This combination of elements presents today’s investors with a highly challenging environment. The result is a world in which assets have appreciated significantly, risk aversion is low, and propositions are accepted that would be questioned if investors were remotely wary.
The Bank of International Settlements warned on June 24 that markets have become “irrationally exuberant”, resulting in ever more risk-taking — fed on a diet of high liquidity, inflated asset prices and depressed market rates —causing investors to ignore rising debt ratios and political risks. In its latest Financial Stability Report, the Bank of England said “very low long-term interest rates make assets vulnerable to a re-pricing, whether through an increase in long-term interest rates, adjustments to growth expectations, or both”. Fed chair Janet Yellen has also hinted at an overextended financial cycle, noting rapid growth in stock market valuations that look “rich” by historical standards. European Central Bank President Mario Draghi also signalled that the balance of risks surrounding the Eurozone have shifted away from deflation, which leaves bonds looking expensive.
In response to the world economic slowdown after the GFC, China undertook a large debt-fuelled stimulus. In 2008, it had a non-financial sector debt-to-GDP ratio of 141% or $6.6 trillion; by 2016 that number was 257% or $27.5 trillion. Combined with wild real estate booms and overbuilding, plus an unhealthy addiction of corruption and severe neglect in "rule of law" infrastructure, a serious economic dislocation (or crash) is the obvious (but not necessarily correct) expectation based on the issues, the gearing, the interconnectivity and the likely quality of debt.
A Chinese financial market collapse would push the global economy into a deep recession and whether they will succeed or fail is completely unknown. But a reasonable conclusion about China is that it is foolish to ignore the signs of developing storm but also ill-advised to put a "clock" on it or deem it to be inevitable. Our instinct is that close to perfection will be required to avoid a very painful sequence of events in the global financial system and hence the world economy.
What is a stock market crash?
Simply, it is a sudden dramatic drop in stock prices across a significant cross-section of a stock market. While there is no specific threshold for stock market crashes, they are typically defined as a fall of more than 10pc in a stock index over the course of a day or two.
How does a crash differ from a ‘correction’?
The speed of the decline is what differentiates a crash from a stock market correction. While a crash occurs when markets experience a sudden double-digit drop in a couple of days, a correction occurs when prices fall by 10pc or more from the index’s 52-week high.
1929: The Great Depression
In the worst stock market crash in US history, the Dow Jones plunged 25pc in just four days, starting on October 24. It wiped out $30bn in market value. The Dow continued its descent until July 1932, when it bottomed out nearly 90pc lower from its 1929 highs.
People gather across the street from the New York Stock Exchange in New York Oct. 24, 1929. Thousands of investors lost their savings in the worst stock market crash in Wall Street history on Oct. 29, 1929, after a five-day frenzy of heavy trading. The Great Depression followed.
1987: Black Monday
The Dow Jones dropped 22.6pc in a single trading session. $500bn was lost in one day.
The benchmark US index rallied by almost 45pc in the run-up to the crash, stoking fears of an asset bubble.
2000: The Tech Bubble
The tech-heavy NASDAQ surrendered 78pc of its value. The US index surged in the mid-1990s fuelled by investments in internet-based companies, which investors hoped would one day turn a profit. Overconfidence, pure speculation and the failure of dotcom companies to perform caused the bubble to burst. Former Fed chair Alan Greenspan famously dismissed the stock market bubble as “irrational exuberance”.
2007/8: The Great Recession
A housing boom, rampant real estate speculation and excessive consumer spending categorised the most recent titanic moment. It came to a head on September 29, 2008 when the Dow Jones plunged 777.68 points in intraday trading after the US government rejected a $700bn financial rescue package designed to rescue the US economy and stabilise global stock markets. Two weeks earlier, the US government had allowed Lehman Brothers to go bankrupt.
Conventional financial theory suggests market players behave rationally, failing to account for investor sentiment, which can drive stock prices higher or lower. Greed, fear and expectations all contribute to investor sentiment. Periods of strong optimism among investors can artificially inflate stock prices, which creates a ‘bubble’ and subsequently has the potential to burst, causing share prices to plummet. A stock market crash is exacerbated by panic. Typically, investors who think the market is about to falter begin to dump stocks in an effort to avoid losing money. But as the speed of the share price slide accelerates, panic begins to grip the market causing others to follow suit. As everyone moves to offload stocks, supply exceeds demand causing prices to plunge across the entire stock market.
Research conducted by Nobel Prize-winning economist Robert Shiller on investor behaviour in the 1987 stock market crash found that there was “a great deal of investor talk and anxiety around October”. Using the metric developed by Professor Shiller and John Campbell, the cyclically adjusted price to earnings ratio or “Cape” - which compares a share price with the earnings of the company concerned over the past 10 years, adjusted for inflation - shows today’s valuations have been surpassed only during the build-up the dotcom bubble and 1929 Wall Street crash. Lofty valuations are a common theme before previous market crashes. Research conducted by Professor Shiller found that buyers and sellers generally thought the market was overvalued before the 1929 collapse.
History suggests that stock markets always rally strongly before a crash. While that it easy to recognise, other contributing factors can be harder to identify. Last month, Fed chair Janet Yellen said she believed we will not see another major financial crisis “in our lifetime” because banks are stronger. But not everyone is in agreement. Recently, Professor Shiller urged investors to tread cautiously because market valuations are at “unusual highs”. In a recent interview with CNBC, he said: “We are at a high level, and it's concerning,” highlighting that the only times valuations have been higher were in 1929 and 2000
Here is a recap of recent Fed warnings about asset prices, which have increased significantly since the presidential election:
Janet Yellen, July 12, 2017
So in looking at asset prices and valuations, we try not to opine on whether they are correct or not correct. But as you asked what the potential spill overs or impacts on financial stability could be of asset price revaluations — my assessment of that is that as assets prices have moved up, we have not seen a substantial increase in borrowing based on those asset price movements. We have a financial system and banking system that is well capitalized and strong and I believe it is resilient.
FOMC Minutes, July 5, 2017
...in the assessment of a few participants equity prices were high when judged against standard valuation measures... Some participants suggested that increased risk tolerance among investors might be contributing to elevated asset prices more broadly; a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a build-up of risks to financial stability... Several participants expressed concern that a substantial and sustained unemployment undershooting might make the economy more likely to experience financial instability or could lead to a sharp rise in inflation that would require a rapid policy tightening that, in turn, could raise the risk of an economic downturn.
Janet Yellen, June 27, 2017
Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn't try to comment on appropriate valuations, and those ratios out to depend on long-term interest rates.
John Williams, June 27, 2017
The stock market seems to be running pretty much on fumes... so something that clearly is a risk to the U S economy, some correction there, is something that we have to be prepared for and to respond to if it does happen. The U S economy still is doing — I think on fundamentals — is doing quite well. So I'm not worried about some kind of late- '90s, dot-corn bubble economy where a lot of the underpinnings were driven by the stock market.
Bill Dudley, June 23, 2017
Monetary policymakers need to take the evolution of financial conditions into consideration... For example. When financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease - as has been the case recently - this can provide additional impetus for the decision to continue to remove monetary policy accommodation.
Stanley Fischer, June 20, 2017
House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.
Janet Yellen, June 14, 2017
We're not targeting financial conditions. We're trying to set a path of the federal funds rate, but taking account of those factors and others that don't show up in a financial conditions index.
The concerted Central Bank policy message in the past couple of months has been to caution about complacency in global market valuations, as reflected in unusually low risk premia across assets and geographies.
The Bank of International Settlements warned on June 24 that markets have become “irrationally exuberant”, resulting in ever more risk-taking — fed on a diet of high liquidity, inflated asset prices and depressed market rates — causing investors to ignore rising debt ratios and political risks.
In its latest Financial Stability Report, the Bank of England said “very low long-term interest rates make assets vulnerable to a re-pricing, whether through an increase in long-term interest rates, adjustments to growth expectations, or both”.
Fed chair Janet Yellen has also hinted at an overextended financial cycle, noting rapid growth in stock market valuations that look “rich” by historical standards.
European Central Bank President Mario Draghi also signalled that the balance of risks surrounding the Eurozone have shifted away from deflation, which leaves bonds looking expensive. The risk premium on European high-yield bonds over German Bunds has fallen to the lowest since 2007, matching levels that preceded the global financial crisis.
The combination of central banker-applied brute force of buying everything in sight with money conjured up out of nowhere and central banker pronouncements issued with an authority of self-belief in their own magical like powers has dampened market volatility. In the short term this has suspended the lancing of the various bubbles and at the same time it has encouraged risk taking in market positioning, but not in business formation. I have thought, and still think, that confidence in central banks and policymakers has been unjustified and will erode or collapse at any time.
Since the major financial institutions which comprise the financial system are still heavily overheated and opaque (in fact with record amounts of debt and derivatives at present), such a break in confidence will happen abruptly and without warning. Investors should look at the historic evidence that most fiscal and monetary policymakers' knowledge of the world is somewhere between "close to nothing" and "way less than zero," in addition their authoritative delivered pronouncements and frequently amended policies and forecasts usually range from "silly but harmless" to "dumb and dangerous."
Markets will at some point correct in the face of rising credit losses and tightening credit conditions. No one knows exactly when it’ll happen, but the time to prepare is now. At 40% cash Warren Buffet is clearly taking a cautious approach presently. Once markets correct and reset it’ll be too late to act.
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