Thursday, 30 August 2007

Recent market volatility

Time for a belated (sorry Simon...!) bit of rambling, ill-informed commentary on recent market volatility. As everyone one will be aware, stockmarkets around the world have been bouncing around in recent weeks in response to concerns about the crisis in the sub-prime market in the US. Lots of money has been lost, reputations have been battered (hedge funds, quant managers, ratings agencies), and central banks have been forced to intervene to steady market nerves. UK pension funds, which were just about heading back to surplus, have seen deficits re-emerge. It all looks rather bad.

But this time around I'm not actually that worried. The earliest crash I can remember was in 1987. Since then we have had some pretty serious follow-ups, including the Asian financial crisis, LTCM collapse, and the TMT bubble bursting post 2000. Each time it didn't turn out as bad as many expected and, thankfully, the underlying real economy didn't take too much of a battering.

That seems to be the case currently. The cheap debt binge was bound to come to an end sooner or later, but it's mistaken (I think) to view the fact that it happened as an entirely bad thing. If debt is cheap, it makes sense for companies (private equity) and people (mortgages) to take advantage of it. It is pretty rational. I have seen it argued on a Marxist (!) site somewhere recently that the growth of the use of debt could almost be described as a sort of private sector Keynesianism.

We are bound to go through a period of correction and capital markets, being what they are, will over-react and then get back to normal. I think capital markets, and the people in them, are far less important to the real economy than their cheerleaders think. Hence the FTSE can display a continuous downwards march in a period when the underlying companies whose value such indicies supposedly reflect, can continue to perform well.

If there is a problem it is that such volatility as we have seen lately can make it difficult for companies to invest. Here's a nicely written expression of this from The Soul Of Capitalism by William Greider:

“[M]odern finance theory employs the stock price in its fiendishly complex capital deals as an easy-to-read meter on corporate performance – and as a triggering mechanism for rewards or penalties. If the stock price rises smartly, it may liberalise credit terms for the company or allow its major lenders to convert their bonds into stock. When the stock price falls persistently, it will disturb – and may cut off – the company’s access to capital from the money market, bond borrowing and non-market sources. In the modern era, as financial value has become increasingly abstracted from a company’s real assets or everyday production, Wall Street has devised rarefied mathematical formulas to determine and predict corporate ‘value’ for investors. Despite continual errors of volatility, the stock price is a key anchoring fact for these calculations. Thus, as Keynes observed in simpler times, the short-term variations in stock price can perversely disrupt long-term plans for genuine investment…”

Also it's worth putting recent volatility in perspective. Look at the performance of say the FTSE100 over the past quarter, the normal period for fund managers to report returns to pension funds, and it looks pretty scary. Over a year it looks even worse - we are back to where we started. But over five years (reasonable period for a mandate?) and it starts looking fairly manageable. Maybe I'm being optimistic but it's notable that the official statement from the NAPF said much the same thing.

In addition, as the market over-reacts this will surely create opportunities for investors to spot seriously undervalued companies and start buying again. Already there is some of this sort of chatter going on.

The main issues that still do bother me are the role of the ratings agencies, and the apparent lack of knowledge amongst investors about exactly who is exposed to what. The latter one is important as financial "innovation" means that an increasingly small number of people understand how some of the investment instruments out there really work. Much of the panic in the market recently stemmed from this lack of understanding. As John Kay put it:

“If trading was motivated not by differences in attitudes and preferences but by differences in information and understanding, risk would gravitate not to those best able to bear it but to those least able to comprehend it."

But broadly, I'm not panicking. Yet.

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