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Market commentary: September 2013

By September 6, 2013No Comments

SUMMARY. Beware the tendency to optimism.We fail to see a crisis in advance, but when we look back it falls into the “bleeding obvious” category. Here we consider how this manifests itself now, and how history guides us.

What is wrong with us?  We fail to see a crisis in advance, but when we look back it falls into the “bleeding obvious” category.  This is one of many inherent limitations with which the vast majority of investors labour.  It is called “optimism bias”.

As economist Stephen King points out, this problem extends to institutions such as the Federal Reserve.  It has pumped extraordinary amounts of money into the global economy (not just the US), always optimistic that it will trigger escape velocity for the US economy, always confident that this process can be easily reversed once all is well.

QE, a dangerous invisibility cloak

The truth is that despite QE and historic lows in interest rates, this is the worst US economic recovery ever (similarly in the UK).  And the first mention on 22nd May of QE being gradually withdrawn (tapered) caused sharp market reactions.  So far the worst damage has been in certain emerging markets.  This volatility is highly unlikely to be contained in emerging markets.

QE, beyond preventing a deeper recession in 2009, did little other than buy time.  The global imbalances which led to the crash and recession of 2008/9 have not been tackled.  QE anaesthetized central bankers and governments around the globe, investors believed happy days were here to stay, and the optimism bias served as an invisibility cloak over the (growing) shadow of future crises.

Central bankers given up?

The world’s central bankers had their annual jolly in Jackson Hole a few days ago.  The FT feedback was that, despite a feeling that the world’s economic problems were getting worse (ignore the cheerleaders on tweaks of GDP figures), they had given up trying to deal with the global imbalances.  The world is doomed to an endless cycle of bubbles, crises, and currency collapses, the FT reported.

What QE did achieve, with dramatic success, was major market distortions, in equities and bonds.  In fact if markets were functioning normally they would already be obviously adjusting to mounting risks.  They aren’t, at least not yet.

History advices caution

Economic numbers out of the US in recent weeks have been mixed to poor, ranging across manufacturing, housing, and consumer spending.  Emerging economies are now also under pressure.

For how much longer can investors ignore the over-valuation of the US stock market, which is pivotal for global equity investors?  The Shiller PE ratio, a measure of over-valuation, is now at the same level (24) as August 1929, higher than August 1987, and just below the October 2007 level. (A market low would see this ratio no higher than 10).

Of course there is an alternative precedent, 1998-2000, the biggest stock market bubble of all time.  Global central banks could take the current unique experiment to a new level, flooding the world with even more cash.  The FTSE 100 index wouldn’t just hit a new all time high above 7,000, but go north of 12,000.  Hmmm. It would be like betting the house on a toss of the coin.

As we enter the traditionally stormy Autumn period for markets, don’t be too heavily invested in equities.

Dennehy Wealth