27/08/2010: When the only surprise would be no surprise at all

Many people will recall the stirring words of Franklin Delano Roosevelt during the dark days of the Great Depression: "The only thing we have to fear is fear itself." This was a rallying call to sentiment in 1933, not a rational policy argument. Perhaps that's why we remember it today.

Indeed, Roosevelt's words contradict efficient market theory, which sees investors as thoroughly rational actors. We think FDR had a point: experience teaches that investors are driven at least as much by sentiments, fads and fears as by fundamentals.

And investor sentiment has plummeted lately. Despite an earning season that, on paper, looks solid enough, trading volumes on the equity markets have shriveled, as has risk appetite. After a ripple of relief following the worst of the European sovereign debt crisis, a sense of dread has returned to the markets as summer ends. And this is worrisome.

Macroeconomic developments are again the center of investors' focus, and the picture, especially for the US, is fairly grim. Between fears of a double dip, or even a slide into depression – which at least would justify the excessively low interest rates – and the prospect of reliving the 1994 bond market crash, a range of worse-case scenarios are competing for fulfillment.

And now many technical analysts are pointing to the formation of a "Hindenburg Omen," which is not an Expressionist movie from Fritz Lang, unfortunately, although the name alone makes one shudder. Nor does the term refer to the Prussian field marshal with the walrus moustache, spiked helmet and a most unloved place in history. It's worse than that, actually.

In fact, the technical analysts are referring to the Hindenburg disaster, the spectacular fire aboard a German dirigible that killed 36 people in Lakehurst, New Jersey, in 1937. The event was captured on film and reported live on radio to a shocked world. Today, when technical analysts note the emergence of several particular patterns, they use the Hindenburg Omen as a metaphor for a stock market bursting into flames.

Declaring the formation of a Hindenburg Omen relies on several arcane technical parameters and the designation is not without its critics. Market fundamentalists would dismiss it as yet more "chartist rubbish." They would argue that, given the good valuation that equities currently enjoy, investors should ignore the esoteric mumbo-jumbo of the techies. But if we have learned one thing lately, it is that investors as a whole are seldom coldly rational.

Some statisticians will grant that, yes, Hindenburg Omens have been spotted ahead of every major market correction over the past thirty years. However, the sample is too small to support an ironclad rule. And while many big market corrections may have been preceded by a Hindenburg Omen, not every Omen was followed by a sell-off. Skeptics will also accuse Hindenburg advocates of "data mining:" They spot a pattern and then, after the fact, they seek out only the numbers that confirm their hypothesis. And finally, the fundamentalists assert that the Hindenburg Omen cannot be explained theoretically, making it utterly useless for predictive purpose.

In my view, though, it would be unwise to simply dismiss such signs, however questionable they might be. Whether the Hindenburg Omen can be read in the charts or not, it is the stuff of real market nightmares. Tales of Hindenburg sightings, plus a little more bad macroeconomic news, could very well spark a market fireball. After all, irrational behavior is not only evident in rising markets; it is also at work when markets tumble.

So, doom-and-gloom seems again ready to guide market sentiment. Don’t get me wrong: I do not belittle the growing pessimism. While it may indeed be fed by technical smoke and mirrors, at least some investors may be prepared for the worst, which would be a welcome change from the recent past.

It is possible that, like the many "reasons" so freely cited to feed market exuberance, the phantasms of a Hindenburg Omen may evaporate in the cold light of experience. We sincerely hope they remain merely the feverish figments of a technical analyst's imagination.

At this stage in our hyperactive financial world, the biggest surprise this year could turn out to be the absence of any surprises at all.

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22/08/2010: Forget decoupling, this is fragmentation

Decoupling – the idea that some countries prosper while others flounder – has entered a new phase. After slowly gaining credibility between 2005 and 2007, the term was swept aside by the jitters of 2008, reappearing in mid-2009. Now, a new word describes global economic developments: fragmentation. It has disturbing implications for the Eurozone.

Decoupling refers to asynchronous business cycles across regions – in other words, when one economy grows while another stumbles. Early in the 2000s, the US appeared to set the rhythm for the global economy. As its growth rate moved, whether up or down, so did that of the rest of the world. Late in 2007, signs of US weakness started to emerge.

At first, both Europe and Southeast Asia seemed immune to America’s woes and the concept of “decoupling” was born. The term’s usefulness quickly faded when the 2008 financial crisis taught us that we’re all in this together. The clear message of the crisis was the interconnectedness in the global economy. No major country could escape the shock waves from an extreme event in the world’s largest economy. But decoupling returned in 2009, applied first to Southeast Asia, led by China, then to the commodity- exporting countries, and finally to the other export-oriented countries.

Now, with the first half year of 2010 behind us, decoupling has reached a new level altogether. While US growth faltered in the second quarter, fuelling worries about a possible double-dip and prompting calls for more government stimulus, Germany grew at a rather astonishing annualized rate of 9%, almost outpacing China. What’s going on here?

Decoupling, it seems, has advanced to a stage perhaps better called “fragmentation.” First, decoupling took place between regions; now it is taking place within them. In the Eurozone, Germany is currently clearly the outlier, with some other northern European countries – for example, the Netherlands and Finland – also faring well. France and Italy have had decent, if not outstanding, growth, while Spain, Portugal, and especially Greece – the triggers of the European sovereign debt crisis – are in recession or very close to it.

Most economists agree that Germany’s remarkable second-quarter growth will not be matched in the second half of the year. Nevertheless, we think fragmentation will only increase, with some worrisome consequences. Germany’s growth is export-driven, as is the case in some other northern European countries. Meanwhile, in France, Italy and southern Europe as a whole, growth, however modest, has been much more domestically driven. This does not bode at all well for the future of the Eurozone. The larger the disparities, the more the tensions among the different members will grow, further exposing the impotence of the European Central Bank’s monetary policy.

Just imagine that Germany continues to post robust growth numbers through year-end, raising inflation pressures in Europe’s core. How will the ECB tackle this issue if, at the same time, Europe’s periphery is mired in recession or even depression?

As admirable as Germany’s growth might be, it could sow the seeds of deepening discontent in all of Europe.

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13/08/2010: Houses have long shadows

Real estate may be one of the oldest assets around. It has a long history of manias and crashes and surely was at the core of the recent financial crisis. If another property bubble is building in China, it will have consequences for us all.

The bursting of the recent housing bubbles in the US, the UK and Spain is still being felt today, four years after markets peaked. For most of these recent victims, the markets haven’t even started to recover. Remembering Japan’s long hangover after its housing and real estate bubble burst in the late 1980s, we have to face facts: this latest crash could take decades to undo.

When they burst, real estate bubbles inflict particularly vicious damage to a country’s economy, gutting broad swathes of the population. Since they are often fueled by dramatic credit and monetary expansion, when prices do collapse and liquidity dries up, seemingly overnight, it can lead to widespread bankruptcies and crippled financial intermediaries. Nasty deflationary tendencies lurk in the wings, waiting to strike while the patient swoons. This is the big, ugly fear of many economists for the US today. A replay of Japan’s deflationary stagnation in the world’s largest economy is not a pretty picture to contemplate.

But if they are so dangerous, then why do housing bubbles occur in the first place? Why don’t government officials combat them in the early stages? A straightforward answer is that they are surprisingly difficult to spot. The current Federal Reserve president and his predecessor, Messrs. Bernanke and Greenspan, are highly accomplished economists and they both failed to spot the US housing bubble, even in late 2005, when prices were skyrocketing. Some would say they didn’t miss the house price bubble; rather, they willingly ignored it because it didn’t match their policies and worldviews. Other, more conspiratorial minds might suggest that they saw the bubble but naively assumed the costs of the cleanup, once it burst, were manageable.

We would argue that despite extreme price movements a real estate bubble can be hard to recognize. Consider China. A recent paper from the US National Bureau of Economic Research notes that Chinese house prices “increased by 140% since the first quarter of 2007 and by a record 41% (annualized) during the first quarter of 2010.” This is obviously an extreme increase. But there are some crucial differences between the housing bubble that inflated in the US (and elsewhere) earlier in the decade and China’s current housing market dynamic.

The price evolution in China’s property market stems from a shortage of supply rather than from excessive demand due to cheap credit, that is, leverage. While housing prices have risen substantially in the past years, so has average urban income. Moreover, according to the International Monetary Fund, the value of outstanding mortgages is only around 14% of GDP in China. This needs to be compared with 76% in the US or almost 90% in Australia. Most Chinese economists acknowledge pockets of excesses, especially in the fashionable cities like Beijing and Shanghai, but they usually also point to the fact that, in aggregate on a national level, property prices have moved in sync with the national income.

And there is another significant difference between the laissez-faire US during the past decade and China today: The Chinese government has so far been relatively vigilant, openly expressing concern about a potential property bubble and taking measures to reduce precisely the kind of credit growth that could fuel such a bubble.

Whether China will ultimately face a burst real estate bubble, with all its dreadful consequences; or whether the current price rally, which has lately slowed, merely reflects fundamentals, cannot yet be known. However, given our experiences with similar real estate market developments, we should at least monitor the situation closely and acknowledge it as yet another risk in our post-financial-crisis world.

Let’s be clear: if it were to transpire, a burst Chinese house price bubble would have serious global consequences that could threaten recovery in the still unsteady developed economies. The world has indeed become one big house, with many interconnected rooms. It casts some very long shadows.