Friday, May 08, 2009
This week's Buttonwood column in The Economist looks at the global stock market rally that is now entering its third month, raising the possibility that some investors will begin looking at their neckties for signs of trouble.
Happy days are here againThis has really been something to behold. As this is written, U.S. markets are now up almost 40 percent from their March lows with some emerging markets up over 50 percent.
Investors' optimism has returned very quickly. Too quickly
MOST students suffer from pre-exam nerves. But the financial markets were remarkably sanguine ahead of the results of the stress tests of American banks (published after The Economist went to press). By the close of trading on May 4th, the S&P 500 index had regained all the losses it suffered earlier in the year.
Financial stocks have in fact been rallying ever since March, when Citigroup hinted that its trading performance in the first quarter had been better than expected. That optimism was borne out in other banks, albeit with the help of some one-off factors that may have overstated the underlying recovery in their finances. Big losses on commercial property and consumer debt are still to come. Nevertheless, the system has come a long way since the meltdown of last autumn.
What could go wrong?
The trouble with this picture is that it all seems too neat. Bear markets are normally pitted with some vigorous rallies, as investors in Japan have discovered over the past 20 years. Often these rallies result from the technical position of investors, and this may be another example. After their battering in 2008, many hedge funds entered the year either betting against the market (going short) or holding large cash positions. As the market has rallied, those funds have had to chase it higher, thereby giving the rebound stronger impetus.Most investors, especially those who have been buying stocks in the last few weeks, would surely like to think that they know more about equity markets than Luigi Galvani knew about dead frog legs, which, surprisingly, is an interesting story.
The economic data may have improved, but only from some terrible lows. It would have been amazing, given the amount of stimulus thrown at the economy in the form of lower oil prices and interest rates, quantitative easing and fiscal deficits, if there had not been some kind of rebound.
Companies are still defaulting on their debts at a steady rate; 40 issuers did so in April and Moody’s expects the default rate to reach 14.3% by next March. Even the results season has been mixed. Andrew Lapthorne at Société Générale points out that 62% of American companies have missed expectations for sales. That implies the profit improvement is coming from higher margins, something that it is hard to believe can persist given the economic backdrop.
The danger is that sentiment has flickered higher rather as a dissected frog’s leg will twitch when an electric current is applied. The world is still drowning in debt, unemployment is still rising, wages are stagnant and the threat of higher taxes hangs over consumers. This was not a conventional downturn; it is unlikely to herald a conventional recovery.
In 1786, according to popular version of the story, Galvani dissected a frog at a table where he had been conducting experiments with static electricity. Galvani's assistant touched an exposed sciatic nerve of the frog with a metal scalpel, which had picked up a charge. At that moment, they saw sparks and the dead frog's leg kick as if in life. The observation made Galvani the first investigator to appreciate the relationship between electricity and animation — or life. This finding provided the basis for the current understanding that electrical energy (carried by ions), and not air or fluid as in earlier balloonist theories, is the impetus behind muscle movement. He is poorly credited with the discovery of bioelectricity.Maybe it's "animal electricity" that drives investor sentiment today.
Galvani called the term animal electricity to describe whatever it was that activated the muscles of his specimens. Along with contemporaries, he regarded their activation as being generated by an electrical fluid that is carried to the muscles by the nerves. The phenomenon was dubbed "galvanism", after Galvani, on the suggestion of his peer and sometime intellectual adversary Alessandro Volta. Galvanisim is electricity by a medical reaction.