Global Equity Markets: A Complete Recovery or A False Dawn?

``But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by "backing" them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm's income and assets, not debts backed by dubious assets.”-Jeremy Siegel, Wharton University of Pennsylvania, Why Bernanke’s Critics Have it All Wrong

My apologies for initially posting the wrong chart, I'd like to thank reader Melvin for bringing this up...

The Phisix ballooned by nearly 5% this week, accounting for a dramatic 15% advance in only two successive weeks since it hit new lows last August 17^th.

Many had been seen cheering in the assumption that perhaps the ‘bottom had been found, the crisis had been averted and we are on our way to glory’, as it had been during the past 4 years.

As the previous corrections served as “windows of opportunity” to reenter the market, such occasions proved to be profitable engagements and thus had been programmed into the mindsets of our average investors that history is due bound to repeat itself.

Perhaps they could be right. But we simply couldn’t go along with such views because we understand that past performances does not always produce similar outcomes or we simply can’t be lulled into simplistic generalizations.

As proven by the recent turmoil, today’s financial markets have been closely intertwined. Imagine the woes of some real estate speculators in New York or elsewhere in the US similarly affects the security prices at Philippine Stock Exchange or even potentially the financial conditions of the “real economy” in the form of lending conditions to our entrepreneurs or farmers.

True enough the Phisix recovered a substantial segment of its lost ground as global equities appeared to have “stabilized” as shown in Figure1.

Divergences in Bond Markets and Equity Markets: Who’s right?

But beyond the horizon of the equity markets. the strains from the recent bouts of liquidity seizure or credit squeeze still has not been “normalized”--the very essence that has buttressed the financial markets in its entirety.

Figure 1: Stockchart.com: Recovery or Pause from Bloodbath?

As shown in the chart, world markets, represented by the Dow Jones World Index, at the lowest pane, alongside with the US S&P 500 (main window) manifesting some indications of recovery. Yet, just as global stocks initiated some convalescence, panic buying towards short term 3 month T-Bill US treasuries resulted to a PLUNGE in its discount rate last August 20^th, marked by the circle at the topmost pane.

Today, the short-term US treasury has like stocks, equally recovered some lost footing but still drifts below the breakdown levels.

Mr. Ambrose Evans-Pritchard of UK’s Telegraph has an interesting dramatized commentary last August 23^rd (highlight mine),

``Ben Bernanke is looking hawkish to me, given the shock of what happened on Monday when yields on 3-month US Treasury notes plunged at the fastest pace ever recorded, a panic flight to safety that no living trader had ever seen before.

``Why? Because trust had collapsed to such a degree that players with a lot of cash no longer believed it safe to leave wealth in bank accounts, or the money market funds of brokerage companies - (exposed as they are to short-term commercial paper and subprime CDOs). This did not occur after 9/11, or in the heat of the October 1987 crash. Nor did was there such a banking panic in October 1929. (it hit in August 1931). If you think this is of no importance, or that this will pass swiftly, you have a strong nerve.”

Of course, this “flight-to-safety” can also be noted in the US 10-year treasury (seen in pane below the 3-month T-bills) whose yields have been on a DECLINING TREND even as global stock markets remained buoyant (Could the bond markets have presaged the decline in stocks?).

The yields of the 10 year instrument have traditionally been benchmarks of mortgage rates. But in today’s setting, mortgage rates remained high as a consequence to the growing risk aversion towards mortgage-related instruments and the tightening of lending conditions in the mortgage markets, while the 10-year benchmark yields has collapsed.

According to the Shobhana Chandra of Bloomberg, ``The average rate on a one-year adjustable mortgage surged to 6.51 percent, the highest since January 2001, from 5.84 percent the prior week. The rate also surpassed the cost of a 30-year fixed loan for the first time.”

The stampede towards the treasury markets are indications relayed by the bond investors that they expect a SIGNIFICANT SLOWDOWN or at worst a RECESSION.

Professor Gary North explains in his article “RECESSIONS ARE GREAT OPPORTUNITIES” last December why such market reactions are likely to be indicators of such events,

``This oddity appears before every recession. It exists because bond investors are generally a lot wiser than stock investors. They are mainly institutional buyers and rich buyers. They see what is coming earlier than stock investors do. When they see recession coming, they are willing to lock in their money for 30 years rather than get paid a higher rate for money tied up for 90 days. They think rates are coming down. They want to lock in high rates.

``Why should interest rates come down? Because rates fall during recessions. There is reduced demand for loans: fear of debt. There is also money flowing out of the stock market into CD's, T-bills, and simple bank accounts: fear of capital losses. People care more about the return of their capital more than the return on their capital.”

Equity Markets: Walking on Government Crutches

In addition, for last week, the gains from the US broadmarket bellwether the S & P 500 seems to have been bolstered by government led initiatives. Aside from the provision of contingent liquidity by global Central banks, there had been a barrage of jawboning from US authorities (see two arrows in Figure 1).

On Wednesday, following a hefty decline, Fed Chairman Bernanke announced that the FED would “act AS NEEDED to ease the impact of the credit squeeze” and the market almost virtually erased the losses overnight.

Friday was a follow through, but this time with US President Bush promising to respond to the unfolding crisis by helping those “affected” (proposed loosening up on standards from GSEs and allow for refinancing) saying this was not to benefit the speculators but aimed at helping the low income home-owners.

Meanwhile, at the annual FED symposium at Jacksonville Arkansas, its Chairman Ben Bernanke reiterated what it said Wednesday that the Fed ``will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets”.

Notice that under today’s circumstances, the global financial markets appear to be TOTALLY DEPENDENT on the actions of Global Central banks. Everyday the market looks for guidance from authorities, without which the market undergoes selling pressure. For instance, the Bush-Bernanke tandem has temporarily provided relief or the cushion required to sustain the US equity markets at present levels.

But financial markets ACT as a discounting mechanism, from which the present messages by authorities UNLESS TRANSFORMED INTO ACTIONS will likely become stale, discounted or ignored from where the risks of a selloff becomes of a larger probability.

In short, the markets expect the authorities to ACT on their promises to resolve the impasse otherwise a selloff becomes imminent!

Put under the previous analogy we used; like drug addicts, today’s market have been anxiously awaiting for requisite substance for them to continue with the party.

In another perspective, it is quite ironic why authorities would have to react to the present turmoil with utmost urgency, when the equity markets have taken a small impact. Consider, despite the present selloffs, the US equity markets remain positive year-to-date; the Dow Jones Industrial up 7.2%, the S & P 500 3.93%, Nasdaq 7.5% and Russell 3000 3.75%.

The answer appears to be premised on the chain of leverage embedded in the present financial system.

Many of the non-banking financial institutions like hedge funds have taken enormous amounts of leverage by as much as 10 times or more for every dollar of capital exposed. For example, a $100,000 position geared 10 times would translate to $1,000,000 in investment exposure--where a 5% gain is magnified into 50% return. That’s when the going was good.

Conversely, when the going gets tough, a 5% loss wipes out 50% off the capital or simply a 10% loss eviscerates all capital from those institutions with a 10 to 1 or more in gearing. Small moves get amplified with margin positions.

Subsequently, losses emanating from such levered positions impair the capability of such institutions to pay or settle with their creditors, who essentially takes a hit through a forcible expansion of the lending institutions’ liabilities and where operational losses mount. To paraphrase a saying, if you borrow 100,000 pesos from a bank, the loan is your problem. But if you borrow 100 million pesos from a bank, the loan becomes the bank’s problem.

In today’s landscape, an overdose of credit is the problem of the financial system.

This is could be ONE possible major reason why regulators have been overly alarmed by the losses from other markets which threatens to diffuse to an equivalent streak of losses in the equity markets.