Recent volatility in stock and bond markets globally do not make sense when viewed purely from the perspective of fundamentals. Indeed, pretty much nothing about current market levels, trends and money flows makes sense unless a pair of alternative prisms is employed: these are chaos and game theory. One posits the sheer randomness of events, while the other suggests a holistic framework for dealing with the same.
Let us first consider a few cases to get to the ideas behind this article:
Case 1: “Whatever it takes” – ECB edition
Mario Draghi who I crowned as 2012 Man of the Year back in January 2012, pulled the proverbial rabbit out of a hat with his speech about doing “whatever it takes” to keep the euro-bloc from failing or more specifically, requiring certain countries like Spain to actually exit the common currency. This was taken in conjunction with his statements to resorting to actual purchases of sovereign bonds to avoid failed auctions – a problem that had plagued Spain, Italy and Portugal last year – even though a closer reading of the European Central Bank law suggested that the institution lacked a mandate to do the same.
The act by the ECB president may have been out of tune with market expectations – even though many other “luminaries” around Europe ranging from Jean-Claude Juncker (prime minister of Luxembourg and generally considered the most stupid / least credible politician in Europe) to Spain’s Mariano Rajoy had in the past echoed very similar comments. What made this statement believable to some extent were the following two things (this is where the game theory aspect comes in):
1. Firstly, Draghi had coordinated beforehand with other central bank governors, and his statement about bond purchases followed comments and support from others including Federal Reserve chairman Ben Bernanke and Bank of England governor Mervyn King on the subject of extending quantitative easing to European government bonds.
2. Secondly, Draghi’s background as a former banker with Goldman Sachs was used by supporters to suggest that he was actually crazy (or courageous) enough to go against established law and German politicians to push through the bold proposals for direct bond purchases
With that, the line was drawn in the sand, and hedge funds beat a hasty retreat from shorting European government bonds, leaving the field wide open for buyers of all hues. The resulting compression in sovereign bond yields has been nothing short of dramatic.
Case 2: “Whatever it takes”: other central banks
It helped with the ECB that the actions of “whatever it takes” were also echoed by other central banks soon thereafter, thereby creating an “environment without safe havens”, ie everyone was acting crazy, so investors really had nowhere to run if trying to flee Keynesian madness.
Think of Japan: written off barely a few weeks ago (see “The end of Japan as we know it“, Asia Times Online, November 27, 2012) the country’s stock markets bounced back in January to a record month even as the currency tanked due mainly to the election of a new Liberal Democratic Party government that is actively pursuing all available options – “whatever it takes” – to unleash greater growth. Whilst eventually the fundamental aspects of such a recovery will falter at the altar of realism – witness the problems with Sony, Nikon and other household brands – for now the story is too big to ignore and so investors have bought into it.
The same goes with the new governor of the Bank of England, Mark Carney, who has basically suggested an abandonment of inflation targeting in favor of growth targeting as the key role of a central bank. What happens in Threadneedle Street eventually echoes around the world, so his actions will be closely watched and imitated elsewhere. Already, we have seen the Reserve Bank of Australia get much more aggressive on its rhetoric with respect to the dangers facing the Australian economy, and essentially loosening the purse strings.
Amongst the emerging markets, the central banks of both Brazil and India have gone from tightening towards monetary easing in the space of a few months, using currency trends and government efforts to cut deficits (respectively) as their justification for the policy turnarounds.
Case 3: The “scandal” in Spain
All this was going on nicely until a whiff of a scandal erupted in Spain, sending global stock markets into a tizzy on Monday (February 4) as fears grew of greater instability in Europe and all its attendant problems for the rest of the world.
Let’s think that through though: saying that a scandal in Spain (in this case about corruption between the construction industry and political parties) is like saying there is obesity in America or bad weather in England. In other words, this sort of stuff comfortably goes into the category of ‘not quite news, darling’. Therefore, what was important here was specifically what made it news: and that was the general levels of vertigo (see the section below on intrinsic value) that investors were feeling about valuations.
That was the volatility was vicious, but also short-lived. As we go into the Chinese New year holidays in Asia (ie removing most of the world’s investors with real rather than borrowed money from active trading in most of the key markets), another set of dynamics showed up namely to avoid further volatility by squaring off positions. Hence the subsequent recovery in markets as short positions were closed off.
Why nothing makes sense intrinsically
A long time ago, when I was interning in the dealing room of a large investment bank, the CEO of the bank – who fancied himself as a bit of an intellectual as well as a strong trader – walked down to the mere mortals on the “floor”. This was always painful for the traders because the CEO wasn’t as smart as he thought he was (no one ever is) but obviously wasn’t someone to be trifled with either so close to bonus time (in those days, people were still paid bonuses).
For context, what made these exchanges more painful was that the CEO would have stopped at a data terminal on the way to the dealing room, seen a couple of the headlines, and whenever anyone gave an explanation, he would counter with the usual “but I thought today’s PMI (or whatever other data) caused that move”. This jab was of course meant to remind traders that he knew everything that was going on, besides running the bank.
Pointing at a random currency pair that had moved a lot that particular day, he asked the dreaded question: “Hey, why is the US dollar off so much?”
The head trader, who had pretty much had enough of the pseudo-intellectual exchanges in the past, belted out a classic reply; and specially because it wasn’t one that the CEO could contradict: “More sellers than buyers.”
The chastened CEO walked off, and didn’t ask silly questions later; at least not when the head trader was around.
The point of the above story in the context of today’s markets is that from a pure fundamental perspective, pretty much nothing makes sense. Think of the following:
a. US Treasury 10-year yields at 1.96% vs running CPI (consumer price index) of 1.71%, which means a real yield of 0.25% for 10 years (not to mention the very likely increase in inflation meanwhile);
b. Dow Jones Industrial Index at close to 14,000, representing a 13.6 times multiple of earnings (15.2x before extraordinary items) and a price over book value of 2.8 times.
Just those two observations are enough to send most people into paroxysms of laughter about the sheer absurdity of it all. However, that isn’t to say that anyone wants to actually stand in front of the train, ie take active positions against the above (see “Bonds lack maturity“, Asia Times Online, March 17, 2012), because that would be very painful in the context of the following observations that are akin to the “more sellers than buyers” principle above:
1. The US Federal Reserve purchases 80% of all US Treasury bond issues;
2. Cash thus released to the banks (at a profit) helps to generate more lending towards portfolio acquisition of riskier assets;
3. It also helps that the Fed is specifically discussing the benefits of “wealth effects” on the economy; that’s usually short form for saying “Hey, we are watching the stock markets and we’ll only step back once they get to really high levels.”
Investors looking to partake of the benefits of what is essentially one of the most chaotic markets in recent history would do well to consider the following books: Understanding and calculating the odds by Catalin Barboniau, Chaos: Making a new science by James Gleick, and The (Mis)Behaviour of Markets by Hudson & Mandelbrot.
Alternatively, they could employ a simple two-word strategy to make money under these chaotic conditions: Buy Gold.
Understanding and Calculating the Odds: Probability Theory Basics and Calculus Guide for Beginners, with Applications in Games of Chance and Everyday Life by Catalin Barboniau. (INFAROM, 2006). US$29.
Chaos: Making a new science by James Gleick. (Penguin Books; Revised edition 2008). US$20.
The (Mis)Behaviour of Markets by Richard Hudson & Benoit Mandelbrot (Profile Books, 2005). US$12.