Irrational exuberance

SMARTSHARE

A common argument that is heard from permabulls on either side of the Atlantic is that the regime of low interest rates is just round the corner. And there is no stopping the markets after that. The rising of the markets after the first rate cut happens is almost explained as a natural corollary.

The geo-political situation has lit a fire under the crude pot and the next hurricane season is just two months away. Even if the Iranian genie was to be pushed back into the bottle, how the hurricane season (which begins from June) will pan out is anybody's guess. Last year's hurricane season was a tame affair, but who knows what havoc Erin and Melissa, which are just waiting to be formed, will cause this year.

The recovery in the world equity markets post-July last year was built on one single premise "" falling crude. As crude tumbled from the highs of $77.95 a barrel in July 2006, inflation suddenly became surmountable. But with crude flexing its muscles, inflation could be a raging issue once again.

One of the better-known brains on Dalal Street recently cited the rise in Japanese property prices as a reason to feel buoyant about the global equity markets. While there is no doubt that it shows the economy in a better light, it could also push inflation higher as consumption could rise. Japanese officials were almost apologetic of the 0.1 per cent rise in land prices in 2006.

If the officials had to clarify that this 0.1 per cent rise was not a bubble, imagine what effect this could have on spending by consumers, who have only seen land prices depreciating for the past 14 years. Land prices have, in fact, been halved from their peak in 1993.

Rising land prices could make them feel rich, and there may not be the necessity to save as much as before, which means more consumption "" which in turn would mean higher inflation, which then could result into higher interest rates. And we all know too well what effect an appreciating yen could have on the markets.

Back home in India, the finance minister has said that we would need to apply the brakes a bit harder. Converting it into non-driver parlance, what it effectively means is tightening the nuts further on liquidity or higher interest rates or both.

And mind you, this was said before crude became an issue.

Let's now come to the second argument, the theory of markets going up in a low-interest regime. I do not fault the theory. But I would severely oppose any hurriedly arrived conclusion that the markets start rising immediately.

In recent history, the Dow peaked at 11,750 in January 2000 and the interest rates peaked at 6.5 per cent in May 2000. The Dow continued to fall and reached a bottom of 7,197 in October 2002. The Fed by then had cut rates 11 times to reach 1.75 per cent. So it wasn't before 29 months that the Fed first started cutting rates and the Dow started rising. Alan Greenspan, the then Fed chief, went on to cut rates twice more to a 43-year low of 1 per cent.

It may not be out of place to revisit the US housing conundrum, which the markets have only recently woken up to. But before that, we must look at what powers the world's largest economy, to whose apron strings is tied the fate of our markets.

Retail spending accounts for some thing like two-thirds of the US economy. According to Federal Reserve data, consumers have taken about $3 trillion in equity out of their homes in the past five years, adding about 7 per cent to disposable incomes every year. That boost kept the economy humming and has driven the personal savings rate below zero for the first time since the Great Depression.

To get some insight on what lies ahead, it might be a good idea to see what Yale economist Robert Shiller, the author of Irrational Exuberance, has to say. Not only did Shiller predict the impending stock bear market of 2000, but he also added chapters to the version released in 2005, forecasting a similar fate for US home prices. Shiller still holds that home prices could continue to fall by a round 2 per cent over the next 10 years.

If home prices fall, consumers's ability to spend more based on home equity would be curtailed. Even consumers who didn't take out any equity increased their spending during the housing boom, and they'll probably slow their spending as prices flatten out.

Another bomb that is ticking is that housing EMIs on a third of the housing loans are likely to be reset higher. More than 1 million families will lose their homes in the next few years, by one estimate. A 2 per cent fall in house prices would push some 1.5 million more homes into foreclosure, leading to a vicious cycle of further fall in home prices.

An upward revision in the Q4 GDP growth rate in the US, end of the financial year pressures in India, the upcoming result season or an amicable end to the Iran imbroglio may give the bulls an extended lease of life. Any rise in the Index in April may be seen by the fattening bears as a ski-lift to begin skiing again from a higher altitude.