Global Equity Markets: “Credit scare, what credit scare…where?”

``Economics is an evolving social science. About the only thing we know when we forecast is that the forecast is wrong. The idea is to get close to the trend if you can. Applying economics to financial markets is humbling. 35 years as a practitioner has taught me to be certain about nothing.”–David Kotok Cumberland Advisors

With the recent strength of the global equity markets one must be wondering; “Credit scare, what credit scare…where?”

Today’s environment certainly makes one feel that markets can ONLY MOVE UP, and that all downside actions be treated only as “ABERRATIONS” or as buying windows. Such dynamics only inflates on our risk taking appetite, fosters undue complacency and propagates overconfidence, the typical ingredients for most investor losses.

The recent credit scare provided the intrepid investor fabulous short term returns opportunities via a “masterful” bottom-picking prowess, where from the privilege of HINDSIGHT we get to see how the recent shocks turned out to be a buying opportunity instead.

But what if such “scare” evolved into a full-blown crisis? What appears to be “adept market timing” could translate to “catching a falling knife”…from bravado to foolishness. In other words, from a BACKWARD looking process since the events had already been perfected, it is then easy to pass conclusions…but, again what of the future? Will markets continue to rise amidst the present litany of risks?

As we have recently gathered, the average investor usually salivates on, or frequently applies “regrets” to such forfeited opportunities, without realizing that DECISION MAKING during these critical moments reflects economic or opportunity costs—cost of an alternative action that must be forgone in order to pursue a certain action (answers.com).

For instance, the credit drought, for us, signifies a SYSTEMIC risk, the first ever real threat to our secular bullmarket. These entanglements in the global financial system could have galvanized into a crisis from which markets could have fallen even more dramatically. Nevertheless, the concerted actions by global central banks appears to have successfully mitigated the present junctures but as to its sustainability remains to be seen.

Considering that effusive liquidity has been our perceived drivers of today’s financial markets, the reversal of such operative presents outsized risks relative to returns which we had been disinclined to underwrite. Hence, our opportunity cost was the supposed “bottom” portion of our valiant risk taker’s “fabulous” market returns in exchange for the relative safety of our capital.

While unlike depression advocates, we persistently argued that any extraneous shocks would affect the local markets in the same manner as it would affect its regional contemporaries, but whose effects could likely be ephemeral--given that the credit, financial market, monetary and economic structures are ostensibly nuanced compared to the epicenter of such shocks. In short, the degrees of functional leverage from which emerging markets and Asian economies have been exposed to are conspicuously distinct from its counterparts in the Anglo Saxon regions.

For us, forecasting depression by parsing trade, financial and economic linkages from HISTORICAL data or paradigms ignores the ever fluid dynamics of the tech-enabled “globalization” evolution quite evidently seen in the financial, economic, political, cultural and technological spheres. Such justification appears to reflect single dimensional thinking in a highly intricate world. Yet in a world where shocks have been mispriced, we simply wouldn’t discount of such possibilities.

Nonetheless, does the prevailing upbeat outlook in the world equity markets indicate that all is well and that potential shocks should be discounted?

Figure 1: New York Times: Sickly Credit Markets Heal a Little as Leveraged Loans Rebound

New York Times’ Floyd Norris gives us a great picture of the conditions of today’s credit market as shown in Figure 1 in his recent article ``Sickly Credit Markets Heal a Little as Leveraged Loans Rebound.”

Mr. Norris’ apropos opening statement (highlight mine), ``THERE are signs of life in credit markets that appeared to be dying only a few weeks ago. But those signs are limited. Few investors have returned, but in some cases banks have stepped in to replace them.”

While most of the credit markets appear to have shown marginally increasing signs of relative composure, they have been quite far from their normal post-credit crunch stance. In essence, these reflect on the continuing strains of investor anxiety.

The most apparent among the improvements had been on the account of leverage loans, where according to Mr. Norris volumes have risen “high enough to allow deals to get done.” This could be one of the factors which underpin today’s rallying US equity markets.

Another, loans have swelled for banks as financing deals which they guaranteed prior to the recent shock had been forcibly added to their books. On the hand, a record surge (fastest rate since early 1974) in the volume of commercial and industrial bank loans, reflects ``leveraged loans that could not be syndicated to foreign banks or investors, but most of it probably represents new loans that in previous months would have been done through the credit market”, according to Mr. Norris. Simply put, the confluences of the lack of diversification from the investors profile plus a recovering market help boosted these volumes of late.

So essentially, the credit markets have moved out of the Intensive Care Unit (ICU) but are still under strict surveillance from the Financial Authorities, given the seriousness of the conditions and the risks of regression. Yet relative to the performances of the equity markets, it appears that today’s market climate has severely underestimated the risks concerns.