The Key to the Crash


The stock market remains remarkably unpredictable. The ABC described yesterday’s fall as ‘carnage’. That’s a word usually reserved for horrific events, such as war or plane crashes, and it signals just how seriously this process is being received (as well as signalling an appalling tabloid trend in ABC news). How big the fall is remains uncertain, but it is already big enough to begin reflections.

First, some mechanics. Economists like to believe in something called ‘fundamental value’ – that shares, or any form of asset, will gravitate towards a price that reflects their capacity to generate profit. That’s how ‘rational’ traders will price them. There is some debate about how exactly to measure ‘fundamental value’ – is it price/earnings ratio, or some valuation on company assets, such as would be calculated for a private equity buyout – but there’s one thing we can be sure of: shares have been trading above this price for some time.

So from the perspective of ‘fundamental value’ analysis, a crash has been due. And shares have been overpriced for a few possible reasons.

One, as the fundamental value analysts would have it, is that traders have been ‘irrational’ – remember that Alan Greenspan, US Federal Reserve boss for so long, introduced us to the term ‘irrational exuberance‘ about a decade ago. Perhaps, but it doesn’t explain much. If the term ‘rational’ means all-knowing and all-seeing, irrationality is the human condition, not a phenomenon of the 2007 stock market.

A second reason is that it may be ‘rational’ to stay in a bull market so long as everyone else stays in. You can ride the increasing prices, so long as you know when to get out. This is the bubble scenario, and when bubbles burst, prices tumble rapidly. This spiral downwards gets faster when people have borrowed to buy shares, for when the loan is made against the value of the shares, and the value of the shares falls, the lender starts to get worried. They make a ‘margin call’ – they call in more collateral to support the loan, and the implication is that many speculators have to sell shares to meet margin calls. It was the key to the crash of the Thai baht that precipitated the Asian financial crisis a decade ago – a small fall led to margin calls that required borrowers to sell baht, which caused the baht to fall faster.

A third reason is that people got carried away with stories of Indian and Chinese growth, and the profits that would flow from riding on the coattails of those booms. So people bought shares (especially resource and bank stocks) in expectation of future profits associated with India and China. The basic argument here is probably right – there will be profits to be had – but the question is ‘how right?’ The optimism may be premature. And there was need to factor in the opposite trend in the US.

So the fourth factor is this US recession. There has been evidence for some time that the US economy has ‘past its peak’ in a long term sense. This can be overstated. After all, US companies have spread across the world, and the profitability of the big US companies is still pretty robust: their ‘fundamental value’ looks better than the ‘fundamental value’ of the US itself, and it is companies, not nations, that get priced in the stock market.

But there is the US debt question looming here, and the willingness of the rest of the world to hold US dollars and dollar-denominated bonds. Was this credit-driven growth a latent crash waiting to happen? Perhaps, but people have been saying that for 20 years (last year was the twentieth anniversary of the publication of Susan Strange’s Casino Capitalism – and the system keeps expanding!).

What did happen was the crash in the sub-prime market. Again, this is not necessarily a disaster for the global economy. It’s shocking for the (generally black) working class people in the US who have lost their houses, and a blow to some big financial institutions that have lost billions (but not before they made billions), and, across the world, some ordinary punters now find that their superannuation accumulation had declined a bit. Of itself, it’s not the profile of a generalised crash.

But if you line up these factors, there’s a fragility. Share traders in a bubble get twitchy, wanting to know when to jump. Some long-term scenario about US decline is tolerable, but add to that a sub-prime crisis that keeps growing in dimension, and the twitching exaggerates. And when people say they don’t know how big the costs of the sub-prime crisis will be – not just the direct effects, but the indirect ones too – then the twitching becomes intolerable. It’s time to sell. And fast.

So how do we interpret recent events? Here, a diatribe could start about the evils of greed and speculation, and how they are nurtured by capitalist economic and social relations. We can put it on the record without need for elaboration.

So let’s look at some narrower issues, related to the spread of information – for it is clear that what happens in these markets is all about information and impressions. A couple of points.

First, advocates of the virtues of financial market processes always talk about transparency (or the need for more transparency) so that traders know the ‘real’ situation (and ‘fundamental value’), and can trade accordingly. What we have seen with the sub-prime crisis is just how ‘untransparent’ financial markets can be – with organisations taking many months to find that they have a financial exposure, and still longer to determine its extent. The way the subprime crisis has unfolded on a drip feed, perhaps more than the actual losses themselves, has given markets the jitters. Best to get out before the next bit of bad news comes through.

Second, the information we are currently getting about the stock market is similarly limited. You can get raw data form the various stock exchange web sites, but when it comes to commentary on its meaning, you’ll notice that it’s all being done by central bankers and private bank economists. The problem here is that these bank economists are always going to talk up the market – a standard comment is: a) we don’t know what will happen, but b) there are now some bargains out there in the market and we should see some new buying as those who got out at the peak re-enter the market. The word ‘bounce’ will soon return to the commentators’ lexicon.

Why do they talk up the market? In part because of a code of social and professional responsibility – predictions of crashes by a central banker, or even by a private analyst on behalf of a large bank, will more than likely be self-fulfilling. But in part, too, we should note that most of the commentators are employed by banks whose own share price may be dropping 6 per cent per day. They need the slump to end – and that’s different from whether it will.

Where will it go? It’s standard to answer that no one knows. But beyond that, a couple of pointers. One is that the predicted US recession, which is driving sentiment in the markets even if it is not profoundly driving ‘fundamental value’ analysis, is an unknown quantum. Those who talk of huge levels of debt (individual and national) are predicting the BIG CRASH. Yet it can also be argued that debt means something different now from what it did before – people don’t mind being in debt, in fact they gravitate towards it.

Another big issue is what happens to the US dollar. It is remarkable how well it has held up in recent weeks despite recession talk and the cut in interest rates (which make it less attractive to hold as an interest-earning asset). And finally, and slightly longer term, we need to find out to what extent Chinese and Indian industrialisation hold up even if the US falls as a source of demand.

Finally, it warrants noting, there is a conspicuous floor under the stock market, especially in Australia. The superannuation funds have oodles of money (and it just keeps growing) that they have to invest in the stock market. They can shift between particular shares, although they effectively have to invest in all the big companies. Superannuation has, no doubt, been pushing up demand for shares in the past, and impacting on share prices. This demand will not disappear with a bursting bubble.

So we all watch with interest. If I were a punter, I’d be saying that the downturn will not take too long to recover. In the meantime, had I sold out at the peak, I’d now be putting my money in New Zealand dollars (because the interest rate gap between the US and New Zealand dollars is now huge) and gold – for some primitive reason, it is seen as ‘real value’. And also I’d put some early money on Hawthorn in the AFL grand final. But I’m not a punter, and my tips are always wrong. Except sometimes.

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