Recent volatility in stock and bond
markets globally do not make sense when viewed
purely from the perspective of fundamentals.
Indeed, pretty much nothing about current market
levels, trends and money flows makes sense unless
a pair of alternative prisms is employed: these
are chaos and game theory. One posits the sheer
randomness of events, while the other suggests a
holistic framework for dealing with the same.
Let us first consider a few cases to get
to the ideas behind this article:
Case 1: "Whatever it takes" - ECB
edition Mario Draghi who I crowned as
2012 Man of the Year back in January 2012, pulled
the proverbial rabbit out of a hat with his speech
about doing "whatever it takes" to keep the
euro-bloc from failing or more specifically,
requiring certain countries like Spain to actually
exit the common currency. This was taken in
conjunction with his
statements to resorting to actual purchases of
sovereign bonds to avoid failed auctions - a
problem that had plagued Spain, Italy and Portugal
last year - even though a closer reading of the
European Central Bank law suggested that the
institution lacked a mandate to do the same.
The act by the ECB president may have been
out of tune with market expectations - even though
many other "luminaries" around Europe ranging from
Jean-Claude Juncker (prime minister of Luxembourg
and generally considered the most stupid / least
credible politician in Europe) to Spain's Mariano
Rajoy had in the past echoed very similar
comments. What made this statement believable to
some extent were the following two things (this is
where the game theory aspect comes in): 1.
Firstly, Draghi had coordinated beforehand with
other central bank governors, and his statement
about bond purchases followed comments and support
from others including Federal Reserve chairman Ben
Bernanke and Bank of England governor Mervyn King
on the subject of extending quantitative easing to
European government bonds. 2. Secondly,
Draghi's background as a former banker with
Goldman Sachs was used by supporters to suggest
that he was actually crazy (or courageous) enough
to go against established law and German
politicians to push through the bold proposals for
direct bond purchases
With that, the line
was drawn in the sand, and hedge funds beat a
hasty retreat from shorting European government
bonds, leaving the field wide open for buyers of
all hues. The resulting compression in sovereign
bond yields has been nothing short of dramatic.
Case 2: "Whatever it takes": other
central banks It helped with the ECB
that the actions of "whatever it takes" were also
echoed by other central banks soon thereafter,
thereby creating an "environment without safe
havens", ie everyone was acting crazy, so
investors really had nowhere to run if trying to
flee Keynesian madness.
Think of Japan:
written off barely a few weeks ago (see "The
end of Japan as we know it", Asia Times
Online, November 27, 2012) the country's stock
markets bounced back in January to a record month
even as the currency tanked due mainly to the
election of a new Liberal Democratic Party
government that is actively pursuing all available
options - "whatever it takes" - to unleash greater
growth. Whilst eventually the fundamental aspects
of such a recovery will falter at the altar of
realism - witness the problems with Sony, Nikon
and other household brands - for now the story is
too big to ignore and so investors have bought
into it.
The same goes with the new
governor of the Bank of England, Mark Carney, who
has basically suggested an abandonment of
inflation targeting in favor of growth targeting
as the key role of a central bank. What happens in
Threadneedle Street eventually echoes around the
world, so his actions will be closely watched and
imitated elsewhere. Already, we have seen the
Reserve Bank of Australia get much more aggressive
on its rhetoric with respect to the dangers facing
the Australian economy, and essentially loosening
the purse strings.
Amongst the emerging
markets, the central banks of both Brazil and
India have gone from tightening towards monetary
easing in the space of a few months, using
currency trends and government efforts to cut
deficits (respectively) as their justification for
the policy turnarounds.
Case 3: The
"scandal" in Spain All this was going
on nicely until a whiff of a scandal erupted in
Spain, sending global stock markets into a tizzy
on Monday (February 4) as fears grew of greater
instability in Europe and all its attendant
problems for the rest of the world.
Lets
think that through though: saying that a scandal
in Spain (in this case about corruption between
the construction industry and political parties)
is like saying there is obesity in America or bad
weather in England. In other words, this sort of
stuff comfortably goes into the category of 'not
quite news, darling'. Therefore, what was
important here was specifically what made it news:
and that was the general levels of vertigo (see
the section below on intrinsic value) that
investors were feeling about valuations.
That was the volatility was vicious, but
also short lived. As we go into the Chinese New
year holidays in Asia (ie removing most of the
world's investors with real rather than borrowed
money from active trading in most of the key
markets), another set of dynamics showed up namely
to avoid further volatility by squaring off
positions. Hence the subsequent recovery in
markets as short positions were closed off.
Why nothing makes sense
intrinsically A long time ago, when I was
interning in the dealing room of a large
investment bank, the CEO of the bank - who fancied
himself as a bit of an intellectual as well as a
strong trader - walked down to the mere mortals on
the "floor". This was always painful for the
traders because the CEO wasn't as smart as he
thought he was (no one ever is) but obviously
wasn't someone to be trifled with either so close
to bonus time (in those days, people were still
paid bonuses).
For context, what made
these exchanges more painful was that the CEO
would have stopped at a data terminal on the way
to the dealing room, seen a couple of the
headlines, and whenever anyone gave an
explanation, he would counter with the usual "but
I thought today's PMI (or whatever other data)
caused that move". This jab was of course meant to
remind traders that he knew everything that was
going on, besides running the bank.
Pointing at a random currency pair that
had moved a lot that particular day, he asked the
dreaded question: "Hey, why is the US dollar off
so much?"
The head trader, who had pretty
much had enough of the pseudo-intellectual
exchanges in the past, belted out a classic reply;
and specially because it wasn't one that the CEO
could contradict: "More sellers than buyers."
The chastened CEO walked off, and didn't
ask silly questions later; at least not when the
head trader was around.
The point of the
above story in the context of today's markets is
that from a pure fundamental perspective, pretty
much nothing makes sense. Think of the following:
a. US Treasury 10-year yields at 1.96% vs
running CPI (consumer price index) of 1.71%, which
means a real yield of 0.25% for 10 years (not to
mention the very likely increase in inflation
meanwhile); b. Dow Jones Industrial Index at
close to 14,000, representing a 13.6 times
multiple of earnings (15.2x before extraordinary
items) and a price over book value of 2.8 times.
Just those two observations are enough to
send most people into paroxysms of laughter about
the sheer absurdity of it all. However, that isn't
to say that anyone wants to actually stand in
front of the train, ie take active positions
against the above (see "Bonds
lack maturity", Asia Times Online, March 17,
2012), because that would be very painful in the
context of the following observations that are
akin to the "more sellers than buyers" principle
above: 1. The US Federal Reserve purchases 80%
of all US Treasury bond issues; 2. Cash thus
released to the banks (at a profit) helps to
generate more lending towards portfolio
acquisition of riskier assets; 3. It also helps
that the Fed is specifically discussing the
benefits of "wealth effects" on the economy;
that's usually short form for saying "Hey, we are
watching the stock markets and we'll only step
back once they get to really high levels."
Investors looking to partake of the
benefits of what is essentially one of the most
chaotic markets in recent history would do well to
consider the following books: Understanding and
calculating the odds by Catalin Barboniau,
Chaos: Making a new science by James
Gleick, and The (Mis)Behaviour of Markets
by Hudson & Mandelbrot.
Alternatively,
they could employ a simple two-word strategy to
make money under these chaotic conditions: Buy
Gold.
Notes: Understanding
and Calculating the Odds: Probability Theory
Basics and Calculus Guide for Beginners, with
Applications in Games of Chance and Everyday
Life by Catalin Barboniau. (INFAROM, 2006).
US$29. Chaos: Making a new science by
James Gleick. (Penguin Books; Revised edition
2008). US$20. The (Mis)Behaviour of
Markets by Richard Hudson & Benoit
Mandelbrot (Profile Books, 2005). US$12.
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