The stock market is always so easy with hindsight

FT 2011

People often say these days, oh, it was so easy to invest in stocks in 2009 or 2010 and then just wait, do nothing and make loads of money by now (August 2017). It was just so easy and it did not require any wits or guts, you just had to do the obvious – buy stocks back then. But was it so obvious back then?

Let’s take a look at the Financial Times of 22/23 January 2011. In a column Merryn Somerset Webb published in that issue, she wrote about an investor called Ken Fisher who thought that the stock market was hugely overvalued (S&P 500 stood at around 1280) due to QE. Mr Fisher considered himself a savvy investor (and probably he is) holding 17% in cash just in case. Moreover,  he thought the market is going nowhere and that it will only do “big ups and downs that amount to zero”.

What should one make of this?

For starters Mr Fisher could very well say that he was an amazing prophet. The S&P 500 indeed hardly moved in 2011. So if he was speaking of the year that lay ahead he turned out to be exactly right.

However, my feeling is that he had a much broader time-horizon in mind. And his words to me are indicative of the broader market scepticism back then and indeed all the way up until now. To me, Mr Fisher’s words are the epitome of the broader syndrome of the market players being constantly worried when the market is poised to go up. And then tragically investors are usually least worried when the market is about to crash. Like the enthusiasm for stocks in early 2007.

But hey, it was damn “easy” to invest in stocks in 2010 and make loads of money! It was nothing like the situation now with all that uncertainty lurking everywhere.

Should we be worried about the flattening yield curve in the US? Not too much

My short answer is not too much.

While I am not arguing for complacency, the worries that the yield curve in the US signals an impending recession are overdone. The bond yields movements of this week seem to clearly confirm that: Mario Draghi’s comments pushed long-term European yields up and this spilled over to the US treasury yields which also went sharply up.  This is the clearest sign that the real picture of growth and inflation expectations in the US is different from what the flattening yield curve was suggesting. It also shows that that the distortion in the US yield curve is at least partly caused by the ultra low yields on European bonds and the resulting chase for yield.

Since the Fed started raising the overnight interest rates, the yields on longer dated bonds have been falling, thus causing the yield curve to flatten. Ever since the Second World War this has been a reliable signal that a recession is coming. The fears were compounded by the fact that the current cycle of expansion has been the third longest on record since at least the start of the 20th century, implying that it is high time for a recession.

However, whether the flattening yield curve signifies a recession hinges a lot on whether the long-term interest rates correctly reflect market participants’ expectations for the future path of the inflation and economic growth. Many observers have opined that huge capital is flowing from Europe and Japan into US treasuries in an attempt to avoid super low interest rate environment, thus distorting the long-end of the yield curve, making it flatter than it otherwise would have been.

This argument got a strong boost this week. The mere hint from Mario Draghi that Europe is moving away from deflation and a bit closer to reflation caused a sudden repricing of European debt. This spilled over to the US, where the 10-year treasury yield jumped from as low as 2.1% to 2.3% in a matter of days, showing that demand for US treasuries is indeed sensitive to the changing (expectations for) yields in Europe from super low to slightly higher and, by extension, depends on the capital inflow from the old Continent into the US.

In other words, there are very clear signs that the yields on US longer-dated treasuries have been kept artificially low because of foreign inflows and thus those yields did not accurately reflect market expectations for the future path of the US economic growth and long-term interest rates. It is therefore doubful that one can rely on the flattening yield curve as an indicator of an imminent recession. Investors in US equities can take a breath.

Deutsche Bank and the herd mentality on capital adequacy

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About a month ago Deutsche Bank experienced one of its most difficult moments since the financial crisis of 2008-2009. In a matter of days, its share price dropped precipitously, nearly 30% down, rumours sprung that the German lender was in dire financial condition (given the threat of a large fine in the US) and some big instiutional clients started fleeing threating to trigger  a run on the bank.

The heart of the problem was whether Deutsche had enough capital.

It is remarkable that while many observers opined that Deutsche Banks’s capital was inadequate, still many others, including Deutsche’s own management, claimed that the run that was about to start was irrational since the bank had considerably more capital than a decade ago. FT’s , even quantified it at around three to four times as much capital as what the bank previously had.

Yet investors remained unconvinced. They compared Deutsche’s capital to that of other similar European banks, noted that Dutsche was the laggard and reached the conclusion that capital was insufficient under realistic scenarios, given the impending DoJ fine and despite the large legal provisions made by Deutsche.

Why did the market react that way? Couldn’t market simply say, oh ah, despite all adversities Deutsche Bank has way more capital than it ever had in the last ten years, even assuming a large fine from the SEC, so why worry too much?

Apparently not, as the market instead panicked, albeit for a brief period. The underlying question here is what is adequate capital for a bank. As Marcia Stigum very aptly explains, “since the whole question of capital adequacy boils down to asking how much capital a bank needs to ensure its survival under unknown future conditions” it is not surprising that neither regulators nor banks themselves have ever found a definitive answer to that question. We live in a world of radical uncertainty so who can confidently predict what condition would prevail in financial markets in future or how a specific portfolio of loans and securities will fare.

In those circumstances what banks do is they stay with the herd. In other words each bank compares its position to that of the other banks and aims to stay in line with its peers. This behaviour is rational from banks’ point of view given that both regulators, investors and clients are ready penalise a bank that steps too much out of line.

So to come back to the question about Deutsche, the reason for the panic was not necessarily the objective lack of sufficient capital buffers but rather the tendency of the investors to penalise banks when they deviate from the herd.

Just as with many other issues in the economics of bubbles and panics, the question of Deutsche’s capital adequacy and the panic surrounding it, all boiled down to herd mentality and self-fulfilling behaviour.

Money and Credit, how does it work?

Money can be confusing. In the past it used to be in the form of gold. But what is money nowadays? It is more like very liquid and abstract credit. And since it is credit, it is also debt. This is very confusing because we are used ot think of money as “something”. To think that every unit of money is somebody’s asset and at the same time somebody else’s liability is not easy for the untrained observer.

Here is a “fairy-tale” attempt to explain this in a way that can build intuition on how this works and how money is linked to the underlying concrete transactions which we like to call the “real” economy. This fairy tale is based on chapter 6 of John Hicks’ book “A Market Theory of Money” and is inspired by Professor Mehrling’s Money and Banking course at Coursera.

The Tale of Money and the roots of the Money Alchemy
We could imagine a pre-money society. I am a producer of apples and you want to buy some in exchange of pears. But you expect your pears to ripen two months from now. We could agree that you get the apples now and I wait for the pears to be delivered later. That would be inter-temporal trade with a normal contractual relations. But you could also offer me a paper which says “[Your name] promises to deliver 10kg of pears to the bearer of this note on [date]”. That would be something like a negotiable instrument. I am not sure these kind of things ever existed. The point is that once I get this paper I could trade with it. I accepted it because I trust you will deliver. I could pass it on to anybody else who equally trusts you.

How can I use the paper to trade with people who don’t trust you? I have to use the services of a third party that is “universally” trusted. That party should be willing to take my paper and issue its own liability, again let’s imagine in the form of paper. Here we better introduce some measure of value and say that the third party issues a paper worth 10 Guldens (the name has nothing to do with gold). This third party will have, of course, discounted my “pear paper” (i.e. with those 10 guldens I will be able to buy less than 10kg of pears). Now that I have the liability of the third party I can trade with anybody in the community, or at least with a wider circle of people than with the “pear paper”.

The third party is trusted “universally” because it is doing this transformation of debts professionally and is supposed to pick up the good promises that are unlikely to go unfulfilled. It’s trusted also because it holds a portfolio of these. So even if one of the “papers” remains unpaid the others will be and given that it discounts them at the appropriate rate all should be fine.

We can call this third party a bank…

Comment
Although this is not representing accurately what banks do, or have ever done, they do something close to that. And what central banks do is similar too. Instead of promises to pay apples/pears they usually obtain short-term government debt (but also other things like MBS recently in the US) and issue central bank reserves or banknotes in exchange.

Europe’s QE: will it work, what the market thinks?

This week James Mackintosh of the Financial Times wrote that the market reaction to the prospects of QE in Europe suggests that QE will happen but it will not work. Mackintosh’s arguments run along the following lines. In the US quantitative easing worked mostly as a confidence boost. When the Fed started bond purchases the bond yields went up. On a purely demand and supply level of analysis this made no sense. Increased demand should have brought the bonds’ prices up and their yields down. But because QE did work its miracle in the US (i.e. it did boost investor confidence) money flowed into stocks and other assets and bond prices decreased.

In Europe, however, as Mackintosh points out, German bond prices were going up while yields dropped on 27 November to a record low of 0.7%. Mackintosh reasoned that this implies that the market believes there will be QE in the eurozone but it will fail to boost confidence, and therefore the simple demand and supply logic is playing out. Hence German bonds price went up and yield reached lower.

Two things contradict this theory.

First, the short term market reaction is almost certainly driven by traders front running of the asset purchases. Mackintosh did acknowledge this effect and he even mentioned that this also initially happened in the US. What he seemed to have missed is that the traders cannot be equated to the market. Traders react quickly to news of economic significance or to changes in supply and demand. But traders’ moves are not necessarily indicative of the broad market’s perception of the fundamentals that drive the economy. Traders have a short-term outlook. To be sure they do react to the moves by the longer-term minded big institutional investors. But “fundamental” investors’ reaction may be slower than the daily volatility created by traders. The transmission mechanism between the “fundamental” investors and the traders can take some time. Ultimately it is the slower reaction of the big “fundamental” investors that will shift the market and show whether QE worked. At this stage we are yet to see the “fundamental” investors’ reactions. From this perspective it is premature to judge whether the market “believes” that QE will work in Europe. (One of the weird things here is that QE will work if investors believe that it will work. But this is another story to be examined separately.)

Second, Mackintosh only focused on the reaction of the price of yields of German 10-year bonds. On the exact same day, 27 November, when German bond yields were reaching record low, the German DAX index was rising for an 11th day in a row, telling another story – investors’ confidence was on the rise.

The two points above do not clearly point to any conclusion on whether the prospective QE in Europe will inspire market confidence. But they show that it is premature to reliably gauge the market sentiment on QE’s fortunes. We still need to see more data as the events unfold.