It is a well known mathematical axiom that stock markets and other markets are “persistent” – in other words, trends in those markets continue for longer than they would if price movements were truly random. However it has become clear in recent months that trader psychology is even more “persistent” than the markets themselves. Thus markets become even more irrationally priced at turning points, and indeed irrational trader persistence is a valuable sign of an important turning point in progress.
The feedback loop between market persistence and trader persistence is almost certainly a two-way affair. Traders know that markets are persistent, therefore “follow the trend” even when other signals suggest that the trend has carried them too far. Conversely, trader persistence, or intellectual resistance to new contradictory information, is undoubtedly one of the factors causing markets to be persistent.
As a proof of the excessive persistence of traders, consider the behavior of the US stock market between the beginning of August 2007 and the middle of October. The significance of those dates is that in early August it became obvious that the subprime mortgage market had malfunctioned badly and was going to cause large losses not only for investors but also for a number of banks, including those who had had only a peripheral involvement in the mortgage market itself. It rapidly became obvious that this was the greatest credit crisis in 25 years, in which large portions of Wall Street’s gigantic financial edifice would come into question.
So what did the stock market do? It went UP – by about 6% on the Dow and 7% on the S&P500 Index between August and October. Traders believed that good old Ben Bernanke would come to the rescue of Wall Street once again, as his predecessor Alan Greenspan had done so often in the past, and would pump enough new money into the market to make the economy bound ahead. Yes, Bernanke’s rate cuts would worsen inflation, but inflation hadn’t been a problem since the 1980s and traders have notoriously short memories.
This was thus a classic example of trader persistence. Since 1995, the Fed had always appeared with rate cuts to bail out Wall Street when problems occurred, and stock prices had always benefited from the bailout. Yes, there had been that little unpleasantness in 2000-02, but even on that occasion the stock market turned round nicely once Greenspan really put his back into expanding the money supply and dropped short term rates to 1%. Hence traders had become completely accustomed to a reality in which interest rates were always low, asset prices were always rising, finance was always available for takeovers, private equity investments and real estate and the stock market trended generally upwards.
Even though it was clear to any competent analyst that August 2007 marked the beginning of a new era of tighter money, high uncertainty and declining asset prices, traders remained in denial as to the prospect, venting their fear by calling hysterically for immediate interest rate cuts (the Jim Cramer tirade will be played in college classes of investment and abnormal psychology for decades to come.)
In Japan, the opposite psychology has been in effect, both for Japanese traders and foreign analysts covering the Japanese market. Japan was in deep recession for 13 years after its bubble burst in 1990, so traders and analysts had grown used to discounting the government’s positive announcements as mere spin. When the subprime mortgage crisis occurred in August 2007, while US analysts ignored the problem, Japanese analysts decided it must be very bad news for Japan, even though no Japanese banks had more than minor exposure to the market.
Consequently, in the last year the Japanese market has fallen 23% compared with a fall of only 7% on the S&P500 Index – indeed Japan has been the world’s worst performing major stock market over that period. The market has discounted bad news that has not happened, and has ignored the continuing evidence of Japan’s fairly strong growth and negligible inflation. Even a housing problem, that has led analysts to forecast a huge drag on Japan’s economy similar to that in the United States, turned out to have resulted from new tighter housing permit regulations, which caused a dip in new construction that is already ending. There is no subprime mortgage problem in Japan – how could there be? The Japanese housing market had a catastrophic downturn in the early 1990s, when Tokyo house prices dropped in some cases by as much as 70%, so there was no possibility of a price spike or lending bubble against that background.
With the market sharply down, the economy continuing solid (fourth quarter GDP growth was 3.7% double the forecast) and analysts negative, Japan appears a safe haven in an uncomfortable world. Certainly it is likely to lead the world upwards at the end of the current unpleasantness.
Germany too suffers from a similar psychological malaise. All through the 1980s, when West German growth was slowing because of the excessive public spending increases and regulation of the previous decade, analysts’ opinion was that the West German economic miracle was imminently about to return. Then in the 1990s the reunification with East Germany was botched, so that the united Germany entered a decade of very slow growth and poor productivity. By 2000, analysts had reversed their opinion about Germany; it was now the sick man of Europe, requiring major if unspecified reforms before it could hope to perform adequately again.
That negativity still prevails, yet the reality is that German productivity has grown more rapidly than anywhere else in Europe since 2000, so the country is now highly competitive and is showing excellent economic growth prospects in spite of its continuing bloated government. After all, the reunification with East Germany was likely to be a finite problem; eventually all the workforce who had learned bad work habits under Communism would retire or die off. That now appears to have happened; the remaining costs of reunification are on a significantly declining trend. But analysts haven’t yet noticed.
The thoughtful investor will thus look for situations in which reality changes, but traders refuse to accept the change and continue irrationally positive or negative. Of course, that is easier said than done. In the middle 1980s, I like most other Britons refused to believe that sterling, which had been declining for 20 years, could have become a stable currency backed by a strong economy – thus sterling was allowed to drop to $1.03 against the dollar, in retrospect an irrational rate. Similarly in both 1995-96 and 2003, I missed the enormous bullish effect of excessive and artificial Fed creation of money, and so remained convinced that the stock market uplifts that began in those years would be short-lived. In both cases, reality changed before my perception of it.
Currently we have had a bull market in stocks that has effectively lasted 26 years and an economic recovery that has been almost uninterrupted for as long. Traders and pundits are thus convinced that any recession must be short-lived – hence the immediate credibility among the chattering and trading classes of Bernanke’s extraordinary assertion that the US economy would return to rapid growth in the second half of 2008.
Easy market conditions lasting over a generation have an obvious effect on traders and commentators – they make them persist far beyond rationality in believing that such conditions will continue. That is why commentators continue to forecast a recession lasting at most one or two quarters with a Gross Domestic Product decline of less than 1%. However, with many of the financial structures underpinning the market having come crashing to the ground, and with even the housing bust showing every sign of becoming far more serious than the tech bust of 2000-02, there can be little chance of this unduly favorable scenario playing out.
In reality the self-indulgences on Wall Street and throughout the world economy have been excessive and we can expect the subsequent hangover to be as pronounced as they were. In terms of the recession’s duration, it is likely that the $150bn stimulus plan recently passed will push its onset into the third quarter of 2008, after the stimulus payments have been spent. Thereafter however we will be lucky to escape with a recession of the severity of the relatively deep 1973-74 episode or the “double-dip” recession of 1979-82. What is more, by the end of the recession, the US budget deficit will exceed $1 trillion and inflation will be above 10% per annum. Both those problems will require to be solved, imposing considerable further economic pain in their solution.
Whoever is elected President this November had better accustom himself or herself to the idea that there is likely to be little economic recovery for his whole first term in office. The expectant candidate should not expect a Great Depression – unless his own policies are exceptionally inept as were those of Hoover and Roosevelt in the 1930s — but he should prepare for an experience like the unhappy second term of Grover Cleveland in 1893-97 or the miserable White House tenure of Martin van Buren in 1837-41. As Japan demonstrated in the 1990s, there is no reason that the recession that follows a period of vast excess should be over within a year or even two.
However, there is very little likelihood that market traders and economic commentators will expect such an unpleasant development before it arrives. It is also very likely that when vigorous recovery begins in say 2013 they will refuse to believe it, and will thus miss the first 50% price move in the stock market recovery.
Persistence of market trends can be profitable, but persistence in intellectual error is generally financially fatal.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)