The danger of anchoring the markets on shifting sands
What we’re seeing is a significant revaluation of equities against their fundamentals
The big freeze in Hong Kong has been reflected in the markets, with historical lows in the mercury matched by the city’s market having a record January fall of over 15 per cent.
The previous optimism of the markets is being humiliated as they have finally realised that economic growth and company earnings are not as they have been predicting. This cold north wind of realism has led to the sharp fall in the oil price being taken as an indicator of a slowing global economy. Last week’s avalanche was triggered by the 6.9 per cent Chinese economic growth figure which was roundly criticised as being inflated by international observers, who then panicked about the real figure. This column has previously estimated China’s true 2015 growth to be 3.2 per cent – still pretty darn good compared with the rest of the world.
The market’s response was to hit the Chinese stock market with a 23 per cent fall in January and more than the 13 per cent fall of oil exporter Brazil. The European index fell by 8 per cent, while the S&P 500 and India both dipped 6.5 per cent in sympathy. Yet while the fringe currencies like the aussie, kiwi and cable (sterling) were hit by around 4 per cent and the rouble was left frozen on the steppes (down 8 per cent), the safe haven US. dollar barely moved against the euro.
This is hardly the stuff of panic for the safe haven of gold barely moved, and the stock options volatility index (VIX) moved up to 28, half of what it reached last August. Normally the markets pick out weaknesses just as a shark smells blood; but while there was plenty of blood shed by asset prices, it was not reflected by the assets that measure worry. This indicates that this was not a real crisis although it was clearly a significant revaluation of equities against their fundamentals.
One of the very few shares to rise in the month was the current darling of the Dow Jones index, McDonald’s, which is up over 30 per cent in a year. Perhaps because they are about to be more frequented by bankers.
The fundamentals may well justify a fall of say 20 per cent but the danger is that any selling frenzy can take on a life of its own. Investors who are content suddenly take fright and start to sell, perpetuating the fall. In the old days, investors like long-term pension funds might buy a cheap market against the trend, but modern markets driven by computer technology, programmed by teenagers, and acting at the speed of light, don’t have time to think; if they hit a stop loss – they sell and sell against themselves.
Falling asset prices alone can lead to the collapse of the highly leveraged pack of cards that we call the financial system. Investors who have borrowed directly and indirectly to invest in the market may have to bail out of good assets to pay their debts. The oil exporters, for instance, have a black hole in their bloated public budgets this year and might need to fire sale assets. China has huge pressure on public funds, both domestically and to cover its global pledges for aid – so it might need to cash in some of its huge US dollar bond holdings. So a small slide in the markets could be the trigger for a death spiral that shouldn’t otherwise happen.
The oil slump and the Chinese GDP figures were the triggers for the current fall – the last grains of sand that caused the pile to slide – and they both demonstrate that the markets have been guilty of the behavioural bias of anchoring.
While markets have been flustered about US interest rates, growth and debt, they ignored an oil price anchored comfortably around the US$110 level – for four years. Only when the price broke from those levels did investors calculate a proper price based on supply and demand; and it was much lower. The S&P index traded for a year and a half above the 2,000 level. The Hang Seng Index was similarly anchored between 21,000 and 24,000 – the market was too high but no one thought to challenge it.
Big crashes occur when crazy things are happening – like AOL acquiring Time Warner in 2000, or in the future perhaps a Tesla buying Coke. The absence of craziness this time indicates that this is just a seasonable freeze to return the markets to their fundamentals. But the time will come when valuations and debt are high enough to trigger a death spiral, and then the financial system may have to cope with going back to the Ice Age.
Richard Harris is chief executive of Port Shelter Investment Management