Resilience 1, policymakers zero.

Attention spans are short, particularly in newsrooms. The past is so stale, and outlets need exciting new click bait. So amidst the latest headlines it’s easy to lose track of larger patterns. Remember how worried everyone was back in January about the plunging stock market? It dominated the news agenda and it seemed how nobody could talk about anything else for weeks?

It gets little or no attention (at least from most journalists), but the market has of course come all the way back. The fear has dissipated. The panic that gripped everyone for weeks is gone. For now.

Of course that was statistically more likely, as I said at the time. It takes no great skill to say that:  serious 2008-style panics are also very rare. The deeper concern among markets, I suggested,  was more likely that policymakers were out of ammunition. But that might not matter so much, either. 

So consider this: it’s difficult to argue that the stock market recovery since January has anything to do with policymakers anywhere. No-one saved the day. There was no committee to save the world.  The recovery just happened, despite the fact that none of the problems people worried about – a fragile US recovery, slowdown in China, tension in the Middle East – have been resolved.  The risks are still there. Perhaps the ECB expanded QE – but there are doubts about its impact even on European bonds.  The panic subsided, the media found new breathless urgent stories, people moved on.

The conclusion? Financial markets and the wider economy do have some inherent stabilizing forces, at least in the short run. Not everything has to be planned or controlled by officials and ministers.  Control is less necessary than we think. But the more difficult corollary is we have less control than we usually think as well. The economy is a complex dynamic system which is only loosely coupled to our intentions.

There are limited situations where policy input is crucial, most especially bank runs or other liquidity problems. Bagehot laid out the heart of modern central banking in 1873; if you have a panic, lend freely on good collateral. The libertarian claim that markets are always optimal and right is therefore… wrong.  Intervention is sometimes needed.

But policymakers are usually not as important as they sometimes like to think, either. We sometimes like to think someone important is in charge and issuing orders (or at least open to blame later) but much of it is just theatrics. Often the most important things are not conscious deliberate choices, but underlying processes and feedback loops.  It helps to spot those at work. But it makes for a less vivid, personalized story.



2017-05-11T17:32:40+00:00 May 2, 2016|Assumptions, Central Banks, Equities|

Market Pessimism: Nothing left to shoot the bear?

So as we all dig ourselves out from the snow on the East Coast, the S&P is sliding again. There’s no sign of hibernation from the bears.  In fact, there seems to be an unusual amount of pessimism and angst out there among professional investors, and wider unease among the public which shows up in support for populist or socialist candidates in the Presidential race.

So how much should we worry? Is it time to plunge our head in a snowdrift and hope for the best? Let’s take the positive view first, and then go to the dark side.

So far the stock market slide is nothing out of the ordinary, of course, uncomfortable and morale-deflating as it is. We usually get a 10% correction in equity prices every two years or so, based on the historical record. So far it’s a bear cub, rather than a raging grizzly.

Let’s say it gets worse from here. 20% corrections are more lumpy in when they occur, but the long term average is they hit every 3 1/2 years or so. That’s a definite scrape from the bear, but not life-threatening. And we’re still very far away from that.

50% or more plunges, like 2008, are extremely rare, far out the tail of the probability distribution, occurring every generation. Or two. Or three.  But because we have painful memories of the most recent collapse, press stories about “worse than 2008” sell newspapers right now. Everything looks dangerous, but just like major earthquakes or hurricanes, it is likely to be decades before another hits us.

Putting this together, the most likely outcome, just in bare statistical terms, is a kind of regression to the mean and therefore recovery rather than another 2008-style catastrophe. That happens much more often in situations like this than a further slide to doom.

The trouble is frequency statistics can mislead. What if something more fundamental is broken? What if there’s cumulative damage?  There are always plenty of “This time it’s different” arguments for potential disaster when markets are weak.

So what is different right now?  What is so deep-seated and cumulative it could put us in 50% territory?

The main cause of recent market weakness appears to be the slide in oil prices, as well as concerns about a slowdown in China with knock-on effects on commodity producers. Add to those multiple pressures  on emerging markets the recent Fed rate rise, which may have disproportionate impact on the outer fringes of the dollar zone.

Yet oil and commodity price swings are anything but unusual. A decline in oil prices is bad for the energy sector but good for just about everyone else in the major western economies. The same applies to a first Fed rate rise in a cycle, even if it does tend to upset markets.

And it isn’t at all clear yet that China really has had a ‘hard landing’, as opposed to volatility on its equity markets. Many people have lost their shirts predicting collapse in the Chinese economy over the last ten or fifteen years.

There is clearly a massive debt hangover, and massive surplus capacity. Let’s affirm it: China has plenty of problems. But it could be a chronic gradual headache for years, rather than a spectacular meltdown which causes the whole world economy to crash. Or a painful temporary interlude, like the many spectacular crashes as the US nonetheless rose to the pinnacle of the world economy between 1865 and 1914.

The same applies to tension in the Middle East. There is obviously a heightened chance of serious conflict, as low oil prices cut budgets and the Saudis are increasingly fretful about Iranian resurgence. But that too could be a chronic, slow-moving problem rather than an immediate hot war. Sunni-Shia tensions date back to before 680AD, after all.  This is not unprecedented or unusual territory. “Trouble in the Middle East” is barely even news these days. And if a ship does get sunk or riots break out in a smaller Gulf state,  oil is likely to spike – offsetting other worries.

None of this is likely to derail the US economy. It’s compatible with a rotation in economic activity from emerging markets towards the US, rather than a collapse in the world economy. On this story, the US with its relatively minimal exposure to foreign weakness takes over its usual role as the  ‘locomotive’ pulling much of the rest of the world economy.  Safe-haven capital flows to the US, interest rates rise as the Fed normalizes, the dollar accordingly rises giving a boost to exporters in other countries, and the locomotive is on its way.

Sure enough, there are some reasons to doubt that it is happening just yet – American consumers may be saving some of the dollars they are not spending at the gas pump, or driving more miles than before.   But there is no reason to despair, or disbelieve altogether than the US is not going to gain significant impetus from lower energy prices before long.

There are other reasons many people worry about western economies,  most notably rising inequality  and technological threats to labor. There may be hidden bubbles after all the monetary liquidity we’ve had washing around.  I’ll look at those another time – but there’s no reason to think that markets have suddenly become much more concerned about these explanations  since New Year’s Day.

The deeper, different problem

Instead, the most interesting possibility is markets are concerned at a deeper level about what we can call the ammunition argument. Let’s say any of these potential threats materializes.  We don’t have to predict which one, or time it to the day. Then what?

The US recovery is still fragile. The EU is beset by problems of its own making. The central banks are already at or extremely near the zero lower bound for conventional policy. Fiscal policy is more constrained by the massive buildup of debt from the last major collapse. There is much more suspicion (especially in the US Congress) about bank rescues or lender-of-last resort functions, including more legal chains on Fed actions in a crisis.

So if something does go wrong – the Fed misjudges the strength of the recovery and raises rates too much, say, a Chinese credit crisis leads to emerging market commodity disasters which cause strains in European banks who have lent too much money to middle-income countries – there is no ammunition in the locker.

If we take out the rifle to defend ourselves agains the charging bear, we’ll just hear a muted empty “click” and the bear’s jaws will close on our throat. Unlike any other potential crisis in the last hundred years, we’re defenseless.

On this argument, no-one can really predict the stock market (or the Middle East). It’s not a matter of predicting specific outcomes. But if anything goes wrong, we’re bear food.  Talk to Murphy about his law.

And then? This is the deeper fear. Policymakers can’t do anything.  They may stage a few theatrics, write “bang” on a piece of paper and wave it at the bear, perhaps. And whatever they do, they’ll likely mess it up. (They’ll probably misspell “bang”).  It’s also linked to wider suspicions that elites don’t know what they’re doing.

This ammunition argument is the really important question, and deserves more consideration in the next post. It’s probably not true, but it’s a serious argument.


2017-05-11T17:32:40+00:00 January 25, 2016|Central Banks, Cyclical trends, Economics, Equities, Financial Crisis, Market Behavior|

Vaccination, Volatility and Caution at the Fed

A stew of different factors – Chinese data, time for a pullback in Japan's soaring equity market, algorithmic amplification of initial moves – influenced the sudden outbreak of market volatility in the last day. But one if the main factors was market confusion over Bernanke's testimony.

The reason for confusion is there are two opposite factors at work here.


The first is the Fed is well aware that the equity market is talking itself into a massive rout when QE ends, and the bond market could adjust with brutal speed to any drop-off on Fed purchases as well.

Vaccination is one strategy to try to minimize the agony of catching a serious disease. Small, benign doses may strengthen resistance to the life-threatening fever you might otherwise catch later on. Hence the Fed talk of tapering, of reversability of moves, and of pragmatic adjustment to data. A little bit of talk now may prepare the market for eventual actual tightening as the recovery proceeds.

Early inoculation may also reduce the chance of eventual financial instability caused by people complacently believing the Fed is stuck with its current policy for months or years to come. A little two-way risk is a good thing to prevent asset bubbles developing.

Of course, some of my friends believe the market is too binary for such nuance to work effectively. Maybe that is right. But it doesn't mean the Fed is not going to try to reduce that binary, manic-depressive aspect of market behavior if it can. The message is the first withdrawal of stimulus is going to happen before long, and it does not entail the end of the world.


The second, and opposite factor is Fed worry about premature tightening killing the recovery. In fact, the most important element in the testimony was Bernanke's specific link of QE to mitigating deflation risk.

In the current economic environment, monetary policy is providing significant benefits. Low real interest rates have helped support spending on durable goods, such as automobiles, and also contributed significantly to the recovery in housing sales, construction, and prices. Higher prices of houses and other assets, in turn, have increased household wealth and consumer confidence, spurring consumer spending and contributing to gains in production and employment. Importantly, accommodative monetary policy has also helped to offset incipient deflationary pressures and kept inflation from falling even further below the Committee's 2 percent longer-run objective.

Note he didn't use the euphemism of puppy “disinflation”, but a claim that the grown-up savage wolf of “incipient deflation” is kept from the door by current policy.

I talked about deflation here. The Fed will do virtually anything to stop deflation. That alone explains caution about premature tightening, regardless of any labor market thresholds. Even if there is a little more momentum in the domestic economy and a pick-up in the labor market, any sign of further falls in inflation (broadly defined) or unmoored inflation expectations would make the FOMC not just cautious but terrified.

Thankfully, the news in recent months is good in that department, which is why Fed officials can talk a little more about tapering.

So the FOMC has a difficult communication challenge: stop people doing stupid things because of expectations of prolonged low rates; prepare the way for tightening when the time is right by some tactical inoculation; but also reassure they will not undermine the real economy and anchored inflation expectations by tightening too soon. All parts of the message are necessary.

The most likely outcome is still a studied tiny slackening in QE purchases by late summer, perhaps couched as a technical experiment or one-off adjustment, in order to minimize the chances the market will panic and develop a serious fever.

But if the Fed is not sure the deflation monster is chained up, and the US economy is still fragile – and if Europe and China look weaker – then Bernanke and company are going to be cautious about any substantive withdrawal of monetary stimulus.



The Pain of Being a Bear

CNBC decided to name a “Dirty dozen” of the very worst actively managed mutual funds in the US, which offered horrible performance for high fees. One name stood out for me: the Federated Prudent Bear Fund (BEARX). It has returned -10.48% annualized in the last five years, and charged investors 2.5% for the privilege. It’s associated with the Prudent Bear website, which is actually well-argued and has considerable influence in financial markets. It’s like a pure distillation of a bearish approach to markets. This isn’t intended to knock the bear fund, though. The website and blog was required reading for several years during the crisis. It has a consistent and serious set of ideas. Instead, it shows how dangerous it can be to get locked into one persepective in markets. It is painful being a bear, even in the worst five years the economy has seen in four or five generations. How could you not make stacks of money as a bear when we’ve seen such economic catastrophe in recent years? There was a brief bear heaven in 2008-9, and it has been downhill ever since. This is BEARX against the S&P over the last five years.

Of course, stocks have rallied massively from the troughs and are setting new record highs. The trick is to know when to stop being a bear, as well. Bears are close relatives of hedgehogs, who know “one big thing” and who find it hard to switch perspectives. For sure, if we get a massive market meltdown soon, there will be a brief moment of ursine elation and vindication again and these performance figures will look very different. But there’s two things to conclude. First, the odds are stacked against you long-term as a bear. The base rate is the economy and equities grow over time. It’s usually two steps forward, one step back. Bears have to be nimble and dance, not sit in a corner and growl that Armageddon is always just around the corner. Second, it shows why markets just don’t price future crises effectively. Let’s say the bears really are right that we’re about to drop off a cliff again. Indeed, the smart money is getting increasingly fretful about asset bubbles building up from excess liquidity. Most of the market is convinced the end of QE could lead to massive turbulence in equities, and the potential for a huge sell-off in bonds. But most asset managers just can’t afford to miss rallies, either. Timing is everything in markets. With a performance chart like the one above, there’s not that many pure bears left. They’ve died or evolved into something else. We are almost certain to get major market reversals again in due course. Predicting that isn’t hard. But bears need to survive until that happens, and not get too excited when it does. The next rally will be right behind.

2017-05-11T17:32:56+00:00 May 21, 2013|Adaptation, Cyclical trends, Equities, Industry Trends, Investment, Market Behavior|

The Most Important Chart of the Week (#Fed)

And no, it’s not about Cyprus. There are plenty of people who worry that the S&P has become detached from reality, as it hit an all-time high on Thursday. I know several insightful people who are convinced the rise in equity markets is just a mirage caused by central bank money printing. If that’s true, we could have massive market declines when traders think the Fed is finished with quantitative easing before long.

The Fed is mostly puzzled by this view, and so here is an important counter-argument. It’s from Eric Rosengren’s speech on March 27. Rosengren is President of the Boston Fed, and tends to sit on the “dove” end of the aviary.

Some observers have noted that stock prices have risen quite substantially .. Of course our policy doesn’t specifically target a particular asset market, but encouraging investors and firms to take more of the responsible risks that contribute to economic activity and growth would normally mean a shift into assets such as stocks and investments with higher expected returns.


Make no mistake, this would pose a financial stability problem if stock prices had significantly outstripped likely earnings – particularly if those investing in stocks had become highly leveraged and were particularly susceptible to a reversal in share prices. Figure 4 shows the S&P stock index relative to composite operating earnings over the past 20 years. While share prices have risen, so have operating earnings. And while there has been some increase in the ratio, it remains well below the 20-year average.

Sure, there’s reason to monitor financial stability carefully, he says. But we’re not that worried about the stock market.

Of course, the Fed said that about the housing market in 2006 and 2007 as well. They argued some regions often suffer crashes, but aggregate crashes across the whole continental US were more or less unknown.

So what could be missing in this view now? The problem in 2007-2008 was not the housing market itself, the bricks and mortar. It was credit and the financial system. And if there is a risk to the stock market, it isn’t the basic liquidity “sugar rush” or corporate earnings. It’s that current policies may also be leading financial players to do foolish things. It isn’t so much a question of valuation as incentives.

2017-05-11T17:32:57+00:00 March 29, 2013|Central Banks, Equities, Market Behavior, Monetary Policy|

The half-life of joy

Well, that didn’t last long. We got a tremendous NFP number at 8.30am, with a fall in unemployment to 7.7%. After opening up in jubilation , the S&P500 has just turned negative, as people start worrying about the end of QE and Fed tightening again.  It is a sign that there is still extreme jitteriness out there about the consequences of any Fed tightening.

This NFP number is important, but not an immediate  game changer. Any sign of inflation would shift the Fed doves much faster than good news on employment, and there’s still no sign whatsoever of inflation. The doves will shift, but intentionally  only after the markets are screaming that the Fed is dangerously behind the curve. (I still expect that well before the end of the year).

I was in DC earlier this week talking to many people, and there is an acceptance among smarter policymakers that the exit from current Fed policy is going to be “choppy” in its effect on markets. That’s not a bad expectation for the market to absorb, however, as the right level of fear stops people doing stupid things.

And the fact that the real economy is looking better, including housing, is a sign that the recovery is more than just a Fed-induced sugar high. The equity rally isn’t only because of excess “liquidity” sloshing around that will collapse when the Fed hints at tightening.

The mood about the housing market seems to have shifted dramatically  towards optimism. Recovery in real estate is not as evident in the Northeast, where judicial review of foreclosures is slowing down the process of market clearing, but the housing market is normalizing elsewhere.

That has positive side-effects. One thing I learned this week from Kauffman Foundation and Citi research is that there is a  close relationship between company startups and home equity withdrawal. Most small businesses are not started with bank loans, which may be affected by monetary policy to some extent. Instead, entrepreneurs more often use mortgage loans. And as house prices recover those become easier to get again.

So a housing recovery indirectly boosts the creative destruction and entrepreneurial dynamism of the economy, a positive feedback loop that amplifies the direct boost from construction jobs or home improvement spending.

The Fed has just been trying to buy time for the underlying resilience of the economy to reassert itself. The animal spirits seem to be rousing – at least in the US.

2013-03-08T10:49:59+00:00 March 8, 2013|Bonds, Current Events, Economics, Equities|