A client emailed me a question this weekend about what might be around the corner based on the last week's extreme market volatility. Here is my response, with a few enhancements and additions:
Q: Does this market volatility suggest something around the corner, either up or down?
A: I've been stewing on that question since last week, as have many, I'm sure, and am not sure there's a compelling answer there -- and given the market's extremely bi-polar performance last week, it would seem to agree. My guess is that volatility, like markets in all things, probably exhibits a momentum effect, so that a high volatility period is a little more likely to be followed by a subsequently high period of volatility (until it's not). That said, though, I think there are (obviously) a few things going on here.
- The debt crisis in Europe is a serious issue, and it's made more complicated by the single-currency Euro Money Zone (EMZ), with only one currency among all members. In times gone by, a single country could devalue its currency and inflate its way out from under its debt problems. This wasn't without risks, as its future borrowing costs would skyrocket, but it was a way out none-the-less. That's not possible for the EMZ members since they are all locked into the Euro and no member has control over the currency itself. Ultimately, the big concern on this front is that many European banks own a lot of the government debt of the countries in trouble (Portugal, Ireland, Italy, Greece and Spain -- the "PIIGS", as they've collectively been called), and no one wants to see a replay of 2008 where European credit flows stop due to bank insolvency caused by sovereign debt defaults. The thing we have going for us this time is that, unlike 2007 and early 2008, when there was (in hindsight) a lot of denial about what was and wasn't possible, everyone knows how serious an issue this is, and the European Central Bank (ECB) and the EMZ members look to be pursing the issues much more aggressively. On Thursday and Friday, European markets were up very sharply on optimism about the ECB's response. Because this is somewhat of a binary outcome (world ends / world doesn't end kind of thing), markets have been vacillating between extremes.
- Because of a well-known psychological bias, the recency bias, people are probably hyper-tuned-in to the possibility of another 2008. "The crowd/market", while it usually gets thing right in the long-term, is notoriously manic-depressive in the short term, and with 2008 so close in the rear view mirror, people are probably a little overly tuned into that scenario and are overlaying that image on top of today's, which is almost assuredly increasing the tendency to panic.
- What has been holding the market up is that the economic data has been very mixed -- as it was in the late spring of 2009. Retail sales, some housing start numbers, auto sales, etc., have continued to be better than people expected, against all odds and all predictions, and unemployment numbers, while barely improving, have not gotten materially worse either. Additionally, while GDP numbers have been slower than hoped for the first half of this year, a not insignificant portion of that slowness can arguably be pinned to the Japanese earthquake and resulting supply chain slowdowns. Because of that dynamic, this may end up pushing some of what would have been 2nd quarter GDP activity into quarters 3 and 4 this year, but we'll see.
Making the tea leaves even more difficult to read is that the economic data has been VERY noisy this year: it's good, it's bad -- no, wait a minute, it's ok; oh, no it's not. Hard to ascertain a compelling pattern there. What is true is that the economic data has been much more resilient than a lot of pessimists would have believed possible.
So -- and I realize this is not a terribly helpful observation relative to the question, the outcome in the medium term (1 - 2 years) is going to probably hinge on two things: 1) how effectively the ECB crafts a solution to their problems, and 2) the ever-changing weather vane that is US and global economic data, and on that, despite the myriad of opinions and predictions I read every day -- any prediction wouldn't really be worth much. I personally think that the ECB will likely find some workable, long-term solution to their problems (what's the alternative?), and hopefully sooner (next 12 months) than later.
First, consumer confidence last week reached a low not seen since 1980 at the depths of another very serious recession, although we came very close the this consumer confidence low point in the early spring of 2009. I sent out a chart back then showing an inverse correlation between consumer confidence and subsequent stock market performance - that is to say that historically low consumer confidence ratings have, on average, been followed by better than average stock market returns . . . for whatever that is worth.
Second, in theory, one of the concerns of last week's S&P downgrade of long-term US debt was that our borrowing costs would rise due to it's now lower quality. As reality turns out, this past week's first auction of US public debt since the downgrade, demand was so high for US Treasury debt that the auction yielded the highest prices ever (meaning the lowest yields / interest rate ever) saving the government almost $650 million in interest cost this auction alone. We'll see what the longer term holds, but file that under "who would've thought?"
Finally, four articles worth a quick look:
From last weekend's WSJ (the weekend immediately after the S&P downgrade of US Debt), from professor emeritus Burton Malkeil at Princeton, Don't Panic About the Stock Market. A little after-the-fact at this point, but still worth reading in retrospect - perhaps especially in retrospect!For some perspective on America's first debt crisis (circa. 1790) and the compromise that came out of it, here's an article by Harvard Law professor, Mark Roe, published in the economics blog, Project Syndicate: America's First Debt Crisis
From Mark Hulbert, who has been tracking subscription-based investment newsletters since 1980, here's an article (Insiders Are Buying) about the bullish 1.68-to-1 sell-to-buy ratio of corporate insiders. The long-term "normal" ratio is more like 2-to-1 or 2.5-to-1.
Lastly, from the Washington Post, a short blog post (Maple Leaf Miracle) about how Canada regained its triple-A debt rating after having lost it in 1993.
As always, I'd be happy to talk this over or answer any questions you may have, so please don't hesitate to call or email.