The stock market is normally a leading indicator, and has historically always tended to lead the real economy by approximately six months. In fact, in the construct of the series of leading economic indicators in the US, the stock market is one of the critical constituents of the leading indicator index. Even in this crisis, the markets broke down, before the crisis really began to eat into the real economy. The markets signalled early on that this is going to be much worse than a plain vanilla recession.
In the case of a traditional cycle, the economy overheats, inflation spikes, the Fed raises interest rates to cool the economy, growth slows and unemployment rises. Once enough of an output gap has opened up and inflation is tamed, the central bank will cut rates to stimulate growth and the cycle will continue. In this type of a classic recession cycle, brought on by central bank tightening ,markets always bottom about six months before the economy. The typical recession will last about 10 months and investors will always lead the economic recovery. Markets will start rising before the economic data conclusively turns, and some people will be left scratching their heads as to why have markets moved.
Given the unprecedented nature of this crisis, the normal equation stated above is unlikely to work. This crisis is far more globalised and structural in nature. This is the first time we have a simultaneous contraction in both global GDP and trade flows in at least 60 years. The global financial system has imploded, and the multinational banks are just a pale shadow of themselves. Central banks across the world have been forced into overdrive and a race to zero interest rates has begun. Risk appetite globally has been decimated and even the real money capital pools are short of liquidity. The reality is that we have limited visibility as to when we come out of this economic morass, and what will be the unintended economic consequences of all the unconventional fiscal and monetary actions being taken today. There are long-term concerns around the dollar, inflation, fiscal balances and the new regulatory structure governing large financial institutions. China is willing to publicly question the safety of US financial assets.
The destruction of wealth has been totally unprecedented (as a case in point, at the recent bottom of S&P 500 below 700, the combined wealth loss in equity and property in the US alone was over $11 trillion), and the near-collapse of the financial system has given investors a new appreciation of risk.
In the above context a big dilemma for investors is the extent to which they should lead a real economy revival. Can investors take on their normal role of being a leading indicator, and piling into risky assets before an economic revival is apparent in the data? Or should one recognise the unprecedented nature of this economic meltdown and be willing to wait for data to turn, before one gets fully invested? Do investors have enough confidence around the contours and trajectory of an economic revival to pre-empt it? If one believed in the normal lead/lag relationships, and agreed with the consensus view of a second half-2009 economic revival, then the time to buy is now. Valuations seem to be reasonable, though arguably, 15-20 per cent away from true historic long-term bottom levels and investor scepticism high.
Given the wealth destruction and new-found appreciation for risk, my sense is that investors will be less of a leading indicator than the past, and a market revival will be more of a coincident event with the real economy starting to revive than past history would indicate. There is nothing like a market down 50 per cent for everyone to relearn the lessons of capital preservation. Investors will, I think, be more willing to lose some initial upside, than wade in early. Investors’ capacity to bear further capital loss is very limited, naturally curtailing their willingness to be early. The question marks around the long-term impact of all the emergency fiscal and monetary policy action undertaken will also curtail any tendency to jump into markets at the first anecdotal signs of recovery. Investors will, I think, be in more of a “show me” mode, wanting to see clear sign of the economy recovering before they believe. The first green shoots of an economic recovery will most likely be treated with scepticism, rather than embraced as in more normal economic cycles.
The current rally, to the extent that it holds, seems to be more a normalisation of expectations and a pull back from extreme oversold conditions. Investors had gotten too bearish and priced in total collapse and nationalisation of critical financial institutions. Rumours were rampant of even senior debt holders having to take hair cuts on financial institution bonds. The Obama administration had also started losing credibility due to a continuing lack of concrete details around the toxic assets plan, and sentiment indicators were in panic territory. Some of the more extreme bearish outcomes for the banks now no longer seem on the table and we are getting more details around the Geithner plan.
While it is true that a series of economic data coming out of the US has surprised — with at least six or seven data points being better than expected, from the Philly Fed survey to new housing starts and new house sales etc —is this a case of expectations being too negative or a sustainable bottoming of the data? This is still a moot point.
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Emerging markets seem to have clearly begun a new cycle of at least relative outperformance vis-à-vis the OECD markets, and this will hopefully extend to India as well, after our elections.
Even if this current rally is sustainable, it is unlikely that the markets just gallop away. We may at best have tested how low markets will go in this cycle. Given the type and extent of economic, financial and psychological damage sustained, the markets will give you numerous opportunities to enter. One of the lessons of structural bear markets is that they tend to tire you out, lasting for years. It would seem foolhardy to chase markets at this stage, given too much is uncertain even now.