Stock Markets – Calm for now

Following a rising stock market is an easy way to make money but share prices can only defy gravity for so long

Something strange is in the air among investors – a pervading sense of calm.  Volatility in financial markets has dropped off while stock prices are near record highs.  These conditions seem out of place at a time when there are a number of reasons to be jittery - the economic recovery is far from assured and central banks are set to raise interest rates.  The buoyancy of the financial markets says more about the habits of investors than the actual state of the economy. 

One defining feature of investing is that it can be easier to make money by following trends rather than fighting against market momentum.  The only problem is that the trends become a force in themselves and can push prices too far either up or down.  This effect can only be temporary as markets must revert back to normality at some point.  This leaves investors caught between making money when times are good and making a getaway before profits are wiped out.  This day is drawing closer.  Your Neighbourhood Economist can’t predict when it might happen, only that a reckoning is likely to be just around the corner.

It’s complicated

Financial markets are notoriously hard to read.  Theory tells us that the prices of shares are based on a combination of all available relevant information.  Yet one of the most pertinent reasons for buying or selling is the past price movements.  Financial assets are one of the few things that we buy more of as the price rises and are more likely to sell when the price falls.  This can often override other considerations such as whether a company is expected to see its profits grow in the future.  Base instincts such as greed and fear can also take over and distort our investment decisions.

The tech boom and bust just over a decade ago was a classic example of this.  Investors threw money into start-ups whose ability to generate revenue was questionable.  You did not even have to believe that the Internet would revolutionize business, just that others would and that these others would keep buying so that you could make a tidy profit and sell up.  Thus, prices often deviate from what shares in a company might actually be worth depending on the likelihood that someone else might be willing to pay more for the shares sometime in the future. 

This is not to say that money cannot be made by holding onto shares in profitable and well-managed firms.  Yet such an investment policy will only work out in the long term with the timing of when to buy and sell also being crucial.  The bulk of investors, however, are not trading in shares over the long term.  Professional investors looking after other peoples’ money tend to actively buy and sell to take advantage of short-term trends.  This proactive approach is also used justify (and amplify) their considerable fees despite often being unable to outperform market benchmarks.

Actually, it's even more complicated

Gauging where shares might be heading is further complicated by the current expansive monetary policy.  An abundance of cash in the financial system means that people wanting to buy financial assets are never far away.  Pushing share prices to unrealistic values is just one example of how monetary policy is creating problems.  Policy makers need consumers in an optimistic mood to get spending up and creating extra wealth through the stock market is one of the few ways of getting us in a more cheerful mood.  It can only provide a short-term boost and might work in the opposite direction when this policy is reversed.  The jolt from the inevitable interest rate hike which is likely to disrupt the market calm may result in more than just some investors losing their easy gains.

Economic Recovery – Reasons to be Pessimistic

The economy seems to be picking up so why are economists still so dour?

Economists are not known for being moody but many are depressed when it comes to the state of the global economy.  This seems out of place at a time when economic recoveries in some countries are showing signs of taking hold and stock markets are setting record highs.  The mood among economists was already negative after being caught out by the global financial crisis.  Are economists right to be worried or just hung up on past mistakes?

Why so glum?

My father inquired, after a recent post on my blog, why my views had to be so downbeat.  Given that much of the business cycle is driven by the sentiment of consumers and businesses, his line of thinking was that the economy would jump back to life if we could all just be more positive about the future.  People would spend more while companies would invest and take on more workers.  All we would need is economists to tell us that everything will be alright.

The problem is not that economists are always a grumpy bunch.  The problem is the opposite – that economists have been overenthusiastic in the past.  This optimism was fuelled by a belief that economic theory could provide a route to a steady rise in prosperity.  Instead, economists have been chastened as a result of their previous ideas being proved wrong by the global financial crisis.  The crisis has also focused minds on what can go wrong.  Now, even periods of prosperity are seen to have a darker side and to create the seeds for trouble in the future.

Grumpy for a reason

It may just be the case that economists are caught in a crisis of confidence.  There is a core belief among economists that markets have the ability to correct themselves.  This means that any periods of weak economic growth should only last until the economy gets back on its feet again.  There is much data on the economy to get excited about.  Consumer spending is up, buoyed by the job market recovering faster than expected.  The worst of the crisis seems to be behind us and stock markets reflect this new upbeat outlook.

Yet, economists have learnt their lessons and know better than to place too much trust in the data.  Behind the numbers lurks a less cheerful story.  Investment by companies is low with few businesses seeing opportunities to expand despite balance sheets laden with cash.  One reason for this is that labour productivity is weak.  This means that the extra earnings for companies from employing more workers are likely to be poor.  Low labour productivity also implies that wages are not likely to rise much which raises concerns about whether households will struggle to pay off rising levels of debt.  A lack of new innovations suggests that investment and productivity may not improve for a long time to come, prompting talk of prolonged stagnation.

When the markets are not functioning normally, it is typically the government that steps in to correct any problems.  However, the governments in many countries have been more hindrance than help.  Mismanagement of government finances, slow and timid responses to crises, and a lack of forward-looking policies are common complaints.  With voters lacking genuine alternative political parties, politicians have become engrossed in petty political positioning rather than constructive policy making.  Managing the economy has been left to central banks which has caused its own problems. 

This is why Your Neighbourhood Economist is one of many who struggle to find reasons for cheer.  It would be great to be caught up in the euphoria that has taken hold of the financial markets but economists have been burnt too badly to get carried away.  Only time will tell if the gloom among economists is warranted.

Economic Growth – Why good times never last

Central banks let the good times continue for too long and we are all paying a higher price as a result

Economic growth is like a party – the longer it continues, the more trouble is likely to ensue.  Investors, like partygoers, are likely to push the limits to make the most of the good times.  The longer this is allowed to continue, the greater the carnage that is likely to be left in the wake of the revelling.  Thus, it is not a coincidence that a period known as the “Great Moderation” has been followed by the “Great Recession”.  This is not the first cycle of boom and bust, but if it could have been predicted, why did central banks let things get so out of hand?

Theory behind boom and bust

The business cycle is a normal part of any economy.  The key driver of the cyclical nature of the economy is perceptions of how the economy will perform in the future.  Views about the economy change over time meaning that it is unlikely economic growth will continue at a steady rate.  This is because, when the economy is operating smoothly, confidence perks up.  Consumers will spend more and save less as worries about the future ease.  Greater spending by consumers will prompt companies to invest more due to expectations that their businesses will expand.

Optimism will also spill over into asset prices.  As prices for assets such as houses or stocks rise, the higher values attract more buying.  The hope of easy money lures in more and more buyers spurred on by the belief that prices will continue to rise.  Debt levels expand as consumers and businesses take out loans to take advantage of the economic growth.  Instead of this extra credit being put to productive use, it is easier to make money with speculative investments on property or stocks.  Thus, debt increases along with asset prices, each fuelling a rise in the other. 

This cycle inevitably gets out of hand as rising asset prices outpace the growth of the economy as a whole.  Prices reach unsustainable levels with the potential to trigger a financial crisis.  The cycle then goes into reverse with businesses slashing investment and consumers cutting back on spending.  The economy retrenches for a period as debt is repaid and asset prices fall back to more reasonable levels.  The harsher economic climate weeds out the weaker companies and business eventually picks up as the economy stabilizes again.  At this point, the party spirit returns and the business cycle begins afresh.

Economists make for bad students of history

The business cycle has been repeated throughout history but this is quickly forgotten when times are good.  Economists at central banks were patting themselves on the back for a decade or two of low inflation and steady economic growth which the previous head of the Federal Reserve Ben Bernanke labelled the Great Moderation.  Central banks thought they were keeping a lid on the economic boom time.  Interest rates were raised in an attempt to keep some semblance of order but hindsight has shown that this was insufficient.  

Everyone was getting too carried away with no one to rein in the revelry.  The indulgent ethos of the time was best captured by the head of Citibank who foolishly said in late 2007 that “as long as the music is playing, you've got to get up and dance”.  Central banks should have acted like police, stepping in to turn the music down, but were more like cheerleaders urging on the good times. Any Cassandras who prophesized the coming of the global financial crisis were marginalised as party poopers.

There was a line of thought that the financial markets knew best and central banks should just step in to clean up the mess when anything went wrong.  But letting the party go on for much longer than it should have done has only made the clean-up job that much bigger.  Even new tools are not proving much good in mopping up the aftermath.  If the partying had been cut short sooner, we would probably not be still suffering from the hangover.