``This pessimistic bias is a general-interest prop to political demagoguery of all kinds. It creates a presumption that matters, left uncontrolled, are spiraling to destruction, and that something has to be done, no matter how costly or ultimately counterproductive to wealth or freedom. This mind-set plays a role in almost every modern political controversy, from downsizing to immigration to global warming.” Bryan Caplan The 4 Boneheaded Biases of Stupid Voters
What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?
-The Pavlovian Response Stimulus Behavior
-Unlike The Bear Market Of 2007
-Posttraumatic Stress Disorder Revisited
-Economic Relativism And Zero Bound Rates
-Authorities Seem Clueless With Bubbles And Operate On Fear
Most of the global financial markets have ended the month mostly in the red. And with momentum appearing to falter, we are seeing marginally more price signal convergence than of a divergence over the past few weeks [both of the prospects we discussed in When Politics Ruled The Market: A Week Of Market Jitters]
By price signal convergence, I mean eerily somewhat similar shades that characterized the bear market of 2007-2008, namely, generally frail equity markets, feeble commodity markets, buoyant US dollar as foreign currencies fumble, lower treasury yields and rising credit default swap premiums, as shown in Figure 1, aside from a higher fear index.
Figure 1: Danske Bank: Negative Interest Rates In US and Resurgent CDS
US T-Bills turned negative for the first time since the Lehman episode in 2008 (left window). However, in spite of the spike in the credit default index of Europe’s most liquid investment grade companies, this has yet to even reach or top its most recent high in 2009 (about 75-right window).
The Pavlovian Response Stimulus Behavior
But does this mean a redux of bear market meltdown of 2007-2008? I don’t think so.
As we have earlier stated, markets appear to be acutely discordant or confused on what has truly been prompting for such apparent broad based weakness.
And as usual, media and mainstream analysts has repeatedly focused on any available current events to ascribe on the possible causal relations: the Chinese government enforcing a curb on bank credit, the Greece debt crisis and or the US proposed enhanced regulatory policies, aside from employment concerns.
Unfortunately, markets have not entirely been confirming such suppositions (see figure 2)
Figure 2: US Global Funds: S&P Weekly Performance
If read from the equity market activities in the US, aside from the Materials and Energy Index, which could be extrapolated as having been influenced by the China factor, it isn’t financials but the Info Tech index that has suffered the worst beating after the China factors this week.
Financials, consumer staples and consumer discretionary, or “economic sensitive” sectors declined marginally relative to its other contemporaries as the US economy registered a faster than expected 5.7% growth mainly due to inventory build up.
Yet following the outperformance of the Nasdaq (44%) and by the S&P 500 info tech (53%) in 2009, it should be natural that any correction should impact the biggest gainers most. The same force appears to have earlier influenced the financial sector, which accounted for last week’s biggest loser but this week’s least affected.
In other words, what we may have been witnessing could be an intrasector rotational profit taking process more than a rerun of the bear market.
And if we are to assess market sentiment (see figure 3) using the Fear index, following 3 successive weeks of decline, the financial markets doesn’t appear to be as apprehensive similar to the 2007-2008 experience…yet.
Figure 3: Fear Index: Not As Fearful
The Fear index has been on a relative downtrend compared to the 2007-2008 patterns where we saw massive contiguous spikes (blue ellipses).
While the surges in 2007 had little impact on the US dollar (USD) which then continued to decline, the recent upswing in the Fear index seems to somewhat replicate on the post Lehman syndrome October 2008 climatic drama, wherein the stock markets collapsed, the US dollar skyrocketed, US treasuries soared and commodities crumbled.
Like the famous experiment known as Pavlov’s dogs, where Nobel Laureate awardee Ivan Petrovich Pavlov successfully proved that dog’s behavior could be shaped by stimulus (ringing of bells)-response (bell ringing means food!), the markets appear to have assumed the same behavior by cognitively anchoring on the post Lehman syndrome as template for any correction: When the US dollar started edging up (or the perceived stimulus), markets have thus interpreted these as signals for “carry trade unwinds” and has equally responded by selling off in almost the same pattern as in the 2008.
In short, a morbid fear from the 2008 meltdown still seems fresh and deeply entrenched into the market’s mind. Yet with fear deeply-rooted into the market’s mindset (even policymakers are fretful of these), it is thus unlikely that the market should experience another bust, until complacency and overconfidence rules anew.
Of course, alternatively, a bust may occur only if the 2006 US housing mortgage crisis meltdown is seen as a continuous process extending until today, where the recent improvements in the markets and economies signify as merely bear market rallies or countercyclical trends.
Well our argument is if this should apply to the US then why should it also plague Asia or the rest of the world? Because the US is the world’s ONLY consumer and Asia is the world’s manufacturer? What nonsense.
Unless the global markets are inferred as sooooo hopelessly and incorrigibly stupid, static and rigid enough to fail to respond to the drastic and dramatic changes in the economic sphere, then this scenario should apply.
But in reality, the only thing rigid is NOT the market but the economic dogma espoused by mainstream analysts whose idée fixee is to resurrect past models and whose prisms of reality is as prisoners of the past. This month we discussed some of these subtle but highly material changes: Asia Goes For Free Trade, Asian Companies Go For Value Added Risk Ventures, Global Science and R&D: Asia Chips Away At US Edge, and Japan Exporters Rediscovers Evolving Market Realities.
The intense fixation on aggregates and on quantitative models which simultaneously ignores the human dimension to adapt to changes and respond to stimulus is the basic flaw for analysts who presuppose omniscience.
Unlike The Bear Market Of 2007
Well, sorry, but it’s not entirely like 2007-2008. Going back to the VIX and the European iTraxx index, both of the current surges haven’t undermined the dominant downtrend trends, and could reflect instead on normal countertrend cycles.
Moreover, while short term yields have admittedly shown some strains, these have not been reflected on the broad yield curve spectrum in the US and abroad.
Figure 4: stockcharts.com: US Yield Curve
The short term rates have indeed been falling but long term rates have held ground in spite of the recent pressures in the market. In short, it seems hardly like the 2007-8 chapter where yields have synchronically fallen.
True, the massive interventions of the US government has helped, but over the past 3 weeks the Federal Reserve has offloaded US treasuries in what some experts see as an experiment to rollback liquidity, aside from some FED activities that may have resulted to negative adjustments in November-December in US money supply (M1) and Adjusted Monetary Base.
But from our standpoint these actions could also be construed as insurance Ben Bernanke underwrote to extend his term [as discussed in Federal Reserve Tightening: Exit Experiment or Bernanke's Confirmation Insurance?].
Think of it, a market meltdown amidst the wrangling over Bernanke’s extended mandate would likely influence positively lawmakers to approve of his stay. That’s because the recent ‘successful’ market actions (money printing) have been correctly attributed to him. Yes, policymakers are not transcendental entities and are also human beings whom are subject to cognitive biases.
Yet, Mr. Bernanke epitomizes the public’s desire for inflationism, as Ludwig von Mises has been validated anew, ``In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”
So in effect, the US yield curve appears to have steepened and should incentivize the maturity transformation or conversion of short term liabilities (deposits) to long term assets (loans).
In addition, Asian sovereign yields have not substantially appreciated amidst the recent turmoil. In 2008, except for US treasuries all assets including sovereign debt yields of Asia fell.
Posttraumatic Stress Disorder Revisited
It would also be similarly foolish to assume that following a bust cycle or a recession, especially in the aftermath of a banking crisis, markets would automatically respond to a renewed borrowing spree or rapid revival of confidence, even if they have been supported by governments. (On the contrary, government support could even be the cause of uncertainty, since expectations would have been built on the continual dependency of the markets from government crutches)
Blind believers of the theory that markets operate on “animal spirits” think that this can happen, we don’t. It would take a bevy of spirits to bodily possess a significant segment of the population to enable these to happen. Unfortunately, the concept of animal spirits escapes the fact that people react based on incentives and NOT on some senseless randomness or mood based decisions.
So aside from the hackneyed arguments of overleveraged consumers and capital scarce banking system, the credit markets is likewise subject to Pavlov’s doggy experiment; children burned from touching a hot stove will refuse to touch it anew. Again it is a stimulus-response dynamic.
Airplane traffic fell (response) post 9/11 (stimulus) as people opted to travel in cars even if the latter mode of transportation has been statistically proven to be more fatal. In short, a person traumatized by a specific action (e.g. flying or swimming) due to a certain set of circumstances will most likely refrain from engaging the same activity, even if the circumstances that generated the trauma is absent.
Since markets are primarily psychologically driven then obviously prices reflects on human action based on people’s varied expectations.
So unless people buy or sell financial securities because their “dream” or a “fairy godmother” or their nanny instructs them to get ‘confident’ and buy up the market, we expect people to act on the markets with the expectations to profit or to hedge or to get entertained or to study or to get some needs or wants to be fulfilled from rationally related goals.
We have said this before and we’re saying it again-it’s called Posttraumatic Stress Disorder syndrome (PSTD). [we brought this up last February and has been validated, it’s time to refresh on the idea What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis]
Figure 5: IMF GFSR: Bank Credit to Private Sector In OECD and Emerging Markets
So it would be natural for markets to react negatively to the credit process, in the aftermath of a bust, which had been preceded by an inflationary boom, because the environment turned into a “proverbial hot stove”.
Let’s get some clues from the IMF on its latest Global Financial Stability Report on the state of bank credit to developed economies, ``Bank credit growth has yet to recover in mature markets, despite the recent improvement in the economic outlook. Bank lending officer surveys show that lending conditions continue to tighten in the euro area and the United States, though the extent of tightening has moderated substantially. Although credit supply factors play a role, presently weak credit demand appears to be the main factor in constraining overall lending activity.” (emphasis added)
Again the IMF on Emerging Markets, ``Outside of China, credit growth in many emerging markets has yet to recover appreciably. This suggests that leverage is not yet a key driver of the rise in asset prices. That said, policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.” (emphasis added)
We see TWO very important messages from the IMF outlook: one Asset Markets have NOT been supported by credit growth and most importantly FEAR.
This brings to my mind some questions:
If global asset prices haven’t been pushed up by the global credit expansion then how can asset prices materially fall (assuming they’ve been pushed up by savings)? Or how can a bust happen when there has been no preceding boom? Unless the global stock markets are ALL being manipulated by developed governments, which have taken most of the balance sheet expansion these days!
Another way to look at this is from the time delayed impact of the steep global yield curve which obviously hasn’t taken a footing yet.
As we have argued in What’s The Yield Curve Saying About Asia And The Bubble Cycle?, it takes some 2-3 years as in the case of 2003 to generate traction in the credit markets.
``Credit growth can be a powerful accelerator in expansions and usually kicks in strongly in later phases of upswing, but it rarely leads markets or real economy on the way up. Put simply, we do not need a pickup in bank lending to see an economic recovery or pickup in asset prices” comments Morgan Stanley’s Joachim Fels and Manoj Pradhan.
In short, the focus on credit, which is predicated on mainstream ideology, is actually a lagging indicator. Credit lags and not lead the economic cycle. This is perhaps due to the median expectations to see more concrete signs of stability, since everyone’s risk profile isn’t the same.
So while mainstream seems unduly focuses on the state of credit, little attention has been given to market’s ability to adjust based on existing the stock of savings, aside from the repercussions of money printing to the asset markets.
Hence if we go by the feedback mechanism from the previous credit cycle (2002-2006) then a more meaningful improvement could probably be expected by late this year and well into 2011. Yet the impact will be dissimilar.
Economic Relativism And Zero Bound Rates
But the mainstream would object, how about the overindebted consumers and the overleveraged banking and financial system, will they not affect the credit process?
Again the problem is to engage in heuristics or parse from angle of aggregates or oversimplifying problems or issues. For even in the economies that have seen the absorption of extraordinary or excessive leverage, debt assumption is largely a relative sectoral issue. Not all the industries have over expanded by taking up too much debt.
In the US, the technology and communications sectors bore the brunt of the dot.com boom bust cycle during the new millennium which spent the entire decade cleaning up their mess. The recent US boom bust phenomenon was largely a banking-real estate crisis and would likely spend years doing the same, unless government continues to socialize the losses, whereby taxpayers will shoulder the burden.
A similar relative effect should apply to the US households or even on the highly politicized issue of employment (By the way, the employment issue is being politicized as a way to shore up lost political capital following the electoral setbacks by the President and his party. On the other hand the pandering to the masses could also mean a diversionary strategy from a beleaguered political party whose goal is to secure the Senate majority this year).
Yet even if unemployment rate is at 10% or 17% on a broader scale last September, then still some 90% and 83% are presently employed and could possibly take up some form of credit but maybe to a lesser degree.
So the issue of absolutism is totally out of whack. So we may yet see some credit improvements in the future from the current levels (see chart again above) even if they are muted relative to the height of the previous boom.
The same dynamics should be applied to the world, where only some nations engorged on excessive credit. Many haven’t, such as Asians and the BRICs.
Figure 6: CLSA/Zero Hedge: Asia’s Loan To Deposit Ratio
In most of East and Southeast Asia bank loan to deposit ratios are under 100% which translates to generally underleverage in the system (more deposits than lending) except for Korea, Australia and India whose ratios are marginally above 100%.
Thus it would be foolhardy to argue that these economies won’t generate credit improvements when there is low systemic leverage, high savings rate, unimpaired banking system, current account surpluses, a trend towards deepening regionalization and integration with the world economy.
So the low leverage figures as shown by the IMF in figure 5 will likely see major improvements for as long as current policies are skewed towards favoring debtors at the expense of creditors.
Moreover I just can’t foresee a market meltdown given interest rates have been zero bound in major economies.
Figure 7: Japan’s Interest Rate and the Nikkei 225
Japan is a favorite for the mainstream peddling the deflation theme (which implies that money printing has no effect on consumer prices or the ‘liquidity trap’ which is disputed by the Austrian school as the money is neutral fallacy).
Although we believe that present conditions DON’T MEET anywhere near a Japan scenario, there seems no example of markets operating on near ZERO rates for comparison. So even if it is an apples to oranges comparison the point is to prove that a meltdown is unlikely at Zero bound, at current levels.
As you can see in figure 7, Japan’s stock market has basically shadowed the actions of its interest rate. In 2003, Japan’s zero bound rates hit the lowest level which apparently had been in coordination with the US, and these has been followed by a stock market rally. Interest rates then chimed, it moved higher. Today, Japan’s rates remain at near the lowest or near zero even while the Nikkei has modestly advanced. The interest rate chart in the lower window is only until 2005.
In other words, interest rates are pivotal factors in determining relative asset pricing, resource distribution and risk considerations.
In a bubble cycle, a credit boom will force interest rate higher as demand for resources will be artificially buttressed as investors compete with each other to invest in projects with long time horizon and also with consumers, whose consumption patterns will focus on the present. This hasn’t been the case yet.
Hence, ZERO bound interest rates amidst comparable yet depressed treasury yields or even cash will likely favor riskier assets as stocks and commodities.
In addition, major economies have been growing national leverage as the crisis erupted. National leverage comes in the form of government spending. And government spending has been backed by the issuance of these sovereign paper receipts, from which spending results to relative scarcity of goods and services. Hence the relative abundance of government paper receipts over goods and services implies prospective inflation.
And an upsurge of inflation likewise implies that given the loftily priced levels of sovereign instruments or paper receipts, risks appears titled more towards “risk free” instruments, particularly from nations which PIMCO’s Bill Gross calls the Ring of Fire [see Bill Gross: Beware The Ring Of (DEBT) Fire!]
So the risk reward tradeoff should benefit equity and commodity assets more than the conventional “risk free” instruments.
Authorities Seem Clueless With Bubbles And Operate On Fear
The second most important message conveyed by the IMF is Fear.
Again according to the IMF on emerging markets, ``policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.”
Even if the stock and commodity markets have gone substantially up, as we earlier pointed out, fear remains a dominant feature in the landscape.
Again the PTSD and or the Pavlov’s stimulus response behavior exhibits that not only many investors but most officials and policymakers have bubbles chronically embedded on their mindsets. The wound is apparently still fresh.
Yet this is one of a policy paradox, policymakers create bubbles by artificially lowering rates in order to boost the credit cycle, aside from other policies as manipulating the treasury and mortgage market via quantitative easing or providing assorted Fed as THE market via an alphabet soup of programs and other forms of fiscal or government spending.
Another implied goal is to see higher asset prices with the implicit aim to recharge confidence or the “animal spirits”.
However, rising asset prices is likewise seen as a bogeyman arising from the previous experience (anchoring) where such officials have excruciatingly learned that a bust follows a boom, ergo a bubble.
Yet, we’re quite sure authorities won’t be able to determine how to distinguish when high prices redound to a bubble. Why? Based on what metric? Who determines when it is a bubble? Since prices are subjective they will always arguable or debatable by some other officials. Besides market based politics will likely influence policymakers. Regulatory capture anyone?
We are seeing signs of such ambiguity or confusion today.
Here is International Monetary Fund chief Dominique Strauss-Kahn who recently warned against ``easing their stimulus programs "too early" before private demand becomes strong enough.”
From the Japan Times, ``"If countries exit too early (from stimulus), and if we have a new downturn in growth, then really I don't know what we can do," the IMF managing director said at the Foreign Correspondents' Club of Japan.
``Although the IMF does not forecast a double-dip recession, he said, "You never know. It may happen."
So the IMF chief wants easy policy to remain, while their GSFR is cautioning against higher asset prices (implying an intervention is required). Are they simply pretending caution? Or are they merely playing safe by offering a contingent clause?
Here is another contradiction, this time from a Chinese official who rebukes US authorities for low interest rates which he believes risks exacerbating a US dollar carry trade bubble. This was when the US dollar was falling last November.
From Marketnews.com ``Liu Mingkang, the director of the China Banking Regulatory Commission, warned a forum here at the weekend that a falling dollar and low U.S. interest rates are providing a vehicle for speculation worldwide, and are exposing risks for the emerging markets in particular as asset prices soar.
"The carry trade in U.S. dollars is huge because of U.S. dollar depreciation and the U.S. government's policy to keep interest rates unchanged and that has had a big impact on global asset prices, encouraging speculation in stock and property markets," he said. (emphasis added)
With the US dollar apparently rising today and where outflows from China’s swooning stock market reached an 18-week high, we see a reversal of sentiment.
From the Telegraph, ``China's deputy central bank chief Zhu Min warned that tighter US monetary policy could spark a sudden outflow of capital from emerging markets, evoking the 1990s Asian financial crisis.”
So China initially smacks the US for low interest rates, easy policies and a weak dollar policy and then currently China censures the US for tightening, which is which?
Have authorities been seeing their shadows (policies) as if it have been chasing them (boom bust cycles)? Or is it a case of a tail (policy errors) that wags the dog (unintended consequences vented on the marketplaces)?
Given the prevailing undertones which reflect on the heightened apprehensions of policymakers, it is doubtful if true tightening would ever take place in the near future. Instead, what would force up interest rates would be the same dynamics that haunt China now, market based inflation from a boom bust process.
At present, global stock markets don’t seem to clearly manifest signals on these yet. Moreover, the dissonance or the incoherence of the opinions of the experts appear to demonstrate a market undergoing a reprieve more than one suffering from a bout of depression based meltdown as alleged by some grizzly bears.
As we have been saying it’s seems mostly about poker bluffing.
