THE BEAR'S
LAIR The perils of
persistence By Martin
Hutchinson
It is a well known mathematical
axiom that stock markets and other markets are
"persistent" - in other words, trends in those
markets continue for longer than they would if
price movements were truly random. However it has
become clear in recent months that trader
psychology is even more persistent than the
markets themselves. Thus markets become even more
irrationally priced at turning points, and indeed
irrational trader persistence is a valuable sign
of an important turning point in progress.
The feedback loop between market
persistence and trader persistence is almost
certainly a two-way affair. Traders know that
markets are persistent, therefore "follow the
trend" even when other signals suggest that the
trend has carried them too far. Conversely, trader
persistence, or intellectual resistance to new
contradictory information, is
undoubtedly one of the factors causing markets to
be persistent.
As a proof of the excessive
persistence of traders, consider the behavior of
the US stock market between the beginning of
August 2007 and the middle of October. The
significance of those dates is that in early
August it became obvious that the subprime
mortgage market had malfunctioned badly and was
going to cause large losses not only for investors
but also for a number of banks, including those
that had had only a peripheral involvement in the
mortgage market itself. It rapidly became obvious
that this was the greatest credit crisis in 25
years, in which large portions of Wall Street’s
gigantic financial edifice would come into
question.
So what did the stock market do?
It went UP - by about 6% on the Dow and 7% on the
S&P500 Index between August and October.
Traders believed that good old Ben Bernanke would
come to the rescue of Wall Street once again, as
his predecessor Alan Greenspan had done so often
in the past, and would pump enough new money into
the market to make the economy bound ahead. Yes,
Bernanke’s rate cuts would worsen inflation, but
inflation hadn’t been a problem since the 1980s
and traders have notoriously short memories.
This was thus a classic example of trader
persistence. Since 1995, the Fed had always
appeared with rate cuts to bail out Wall Street
when problems occurred, and stock prices had
always benefited from the bailout. Yes, there had
been that little unpleasantness in 2000-02, but
even on that occasion the stock market turned
round nicely once Greenspan really put his back
into expanding the money supply and dropped short
term rates to 1%. Hence traders had become
completely accustomed to a reality in which
interest rates were always low, asset prices were
always rising, finance was always available for
takeovers, private equity investments and real
estate and the stock market trended generally
upwards.
Even though it was clear to any
competent analyst that August 2007 marked the
beginning of a new era of tighter money, high
uncertainty and declining asset prices, traders
remained in denial as to the prospect, venting
their fear by calling hysterically for immediate
interest rate cuts (the Jim Cramer tirade will be
played in college classes of investment and
abnormal psychology for decades to come.)
In Japan, the opposite psychology has been
in effect, both for Japanese traders and foreign
analysts covering the Japanese market. Japan was
in deep recession for 13 years after its bubble
burst in 1990, so traders and analysts had grown
used to discounting the government’s positive
announcements as mere spin. When the subprime
mortgage crisis occurred in August 2007, while US
analysts ignored the problem, Japanese analysts
decided it must be very bad news for Japan, even
though no Japanese banks had more than minor
exposure to the market.
Consequently, in
the last year the Japanese market has fallen 23%
compared with a fall of only 7% on the S&P500
Index - indeed Japan has been the world’s worst
performing major stock market over that period.
The market has discounted bad news that has not
happened and has ignored the continuing evidence
of Japan’s fairly strong growth and negligible
inflation. Even a housing problem that has led
analysts to forecast a huge drag on Japan’s
economy similar to that in the United States
turned out to have resulted from new tighter
housing permit regulations, which caused a dip in
new construction that is already ending.
There is no subprime mortgage problem in
Japan - how could there be? The Japanese housing
market had a catastrophic downturn in the early
1990s, when Tokyo house prices dropped in some
cases by as much as 70%, so there was no
possibility of a price spike or lending bubble
against that background.
Safe haven in
an uncomfortable world With the market
sharply down, the economy continuing solid (fourth
quarter GDP growth was 3.7%, double the forecast)
and analysts negative, Japan appears a safe haven
in an uncomfortable world. Certainly it is likely
to lead the world upwards at the end of the
current unpleasantness.
Germany too
suffers from a similar psychological malaise. All
through the 1980s, when West German growth was
slowing because of the excessive public spending
increases and regulation of the previous decade,
analysts’ opinion was that the West German
economic miracle was imminently about to return.
Then in the 1990s the reunification with East
Germany was botched, so that the united Germany
entered a decade of very slow growth and poor
productivity. By 2000, analysts had reversed their
opinion about Germany; it was now the sick man of
Europe, requiring major if unspecified reforms
before it could hope to perform adequately again.
That negativity still prevails, yet the
reality is that German productivity has grown more
rapidly than anywhere else in Europe since 2000,
so the country is now highly competitive and is
showing excellent economic growth prospects in
spite of its continuing bloated government. After
all, the reunification with East Germany was
likely to be a finite problem; eventually all the
workforce who had learned bad work habits under
Communism would retire or die off. That now
appears to have happened; the remaining costs of
reunification are on a significantly declining
trend. But analysts haven’t yet noticed.
The thoughtful investor will thus look for
situations in which reality changes, but traders
refuse to accept the change and continue
irrationally positive or negative. Of course, that
is easier said than done. In the middle 1980s, I
like most other Britons refused to believe that
sterling, which had been declining for 20 years,
could have become a stable currency backed by a
strong economy - thus sterling was allowed to drop
to $1.03 against the pound, in retrospect an
irrational rate. Similarly in both 1995-96 and
2003, I missed the enormous bullish effect of
excessive and artificial Fed creation of money,
and so remained convinced that the stock market
uplifts that began in those years would be
short-lived. In both cases, reality changed before
my perception of it.
Currently we have had
a bull market in stocks that has effectively
lasted 26 years and an economic recovery that has
been almost uninterrupted for as long. Traders and
pundits are thus convinced that any recession must
be short-lived - hence the immediate credibility
among the chattering and trading classes of
Bernanke’s extraordinary assertion that the US
economy would return to rapid growth in the second
half of 2008.
Persistence beyond
rationality Easy market conditions lasting
over a generation have an obvious effect on
traders and commentators - they make them persist
far beyond rationality in believing that such
conditions will continue. That is why commentators
continue to forecast a recession lasting at most
one or two quarters with a gross domestic product
decline of less than 1%. However, with many of the
financial structures underpinning the market
having come crashing to the ground, and with even
the housing bust showing every sign of becoming
far more serious than the tech bust of 2000-02,
there can be little chance of this unduly
favorable scenario playing out.
In
reality, the self-indulgences on Wall Street and
throughout the world economy have been excessive
and we can expect the subsequent hangover to be as
pronounced as they were. In terms of the
recession’s duration, it is likely that the $150
billion stimulus plan recently passed will push
its onset into the third quarter of 2008, after
the stimulus payments have been spent. Thereafter
however we will be lucky to escape with a
recession of the severity of the relatively deep
1973-74 episode or the "double-dip" recession of
1979-82. What is more, by the end of the
recession, the US budget deficit will exceed $1
trillion and inflation will be above 10% per
annum. Both those problems will require to be
solved, imposing considerable further economic
pain in their solution.
Whoever is elected
President this November had better accustom
himself or herself to the idea that there is
likely to be little economic recovery for his
whole first term in office. The expectant
candidate should not expect a Great Depression -
unless his own policies are exceptionally inept as
were those of Hoover and Roosevelt in the 1930s -
but he or she should prepare for an experience
like the unhappy second term of Grover Cleveland
in 1893-97 or the miserable White House tenure of
Martin van Buren in 1837-41. As Japan demonstrated
in the 1990s, there is no reason that the
recession that follows a period of vast excess
should be over within a year or even two.
However, there is very little likelihood
that market traders and economic commentators will
expect such an unpleasant development before it
arrives. It is also very likely that when vigorous
recovery begins in say 2013 they will refuse to
believe it, and will thus miss the first 50% price
move in the stock market recovery.
Persistence of market trends can be
profitable, but persistence in intellectual error
is generally financially fatal.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found at
www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
