copyandpaste

THE HANDSTAND

OCTOBER 2007

Bubbles leave a residue that can take years to shift

By Tony Jackson

Published: September 23 2007 19:49 | Last updated: September 23 2007 19:49

Say what you like about punters, they have staying power. No sooner have they burst the bubble in credit than they start new ones – in gold, in emerging markets and, most strikingly, in mainstream equities.

When the US Federal Reserve slashed interest rates last week, the immediate response was to push the Dow and the FTSE 100 higher than they had been in early August. So equities are now thought to be worth more than before the credit markets tanked.

If that seems unexpected, consider a theory on emotional finance advanced by Professors Richard Taffler and David Tuckett. Investors, they say, are in a “paranoid-schizoid” state, characterised by “distrust and constant jittery activity”.

This, they believe, explains the credit bubble. It also explains a lot about Northern Rock. Consider how the British public, having brought the bank to its knees by withdrawing their deposits, have promptly flocked to buy its devalued stock – only to be clubbed down in their turn by short-selling hedge funds.

But professional investors, you will say, are different. Their stance on equities is based on logic. So how might that logic run? First, you might argue the credit crunch was priced into equities in advance. In that case, we might expect it to have been priced into the credit markets as well, which it plainly was not. Indeed, people in the credit world – a senior figure told me last week – have been eyeing the equity markets in recent weeks with disbelief.

Next, you might say, investors are working on the reasoned assumption that the credit debacle will not affect the real economy. Well, let us test that on the UK market. Since August 8 – the day before the credit markets finally seized up – the FTSE 100 has risen slightly. But within that, the worst performers – the banks, of course, excepted – have been those exposed to a downturn in consumer spending. Persimmon, the nation’s biggest housebuilder, is down by nearly a quarter. The pub group Mitchells and Butler is down around 12 per cent.

Which have risen most? Copper miners Kazakhmys and Antofagasta are up 16 per cent and 14 per cent respectively. The copper price, meanwhile, has gone nowhere. There could be some rationale behind that, but it is probably not worth inspecting.

Next comes a familiar line: don’t fight the Fed. Chairman Bernanke will do whatever it takes to save us.

This rather assumes today’s markets are amenable to central bank control. In credit especially, that looks an antiquated notion. Nor should we forget that the markets fought the Fed perfectly successfully on the way up. As Alan Greenspan has reminded us recently, in his time as chairman of the US Federal Reserve he tried to prick asset bubbles by raising rates, then gave up when he found it wasn’t working.

At the beginning of August, I wrote that the looming credit crunch would be good for equities. My argument was that, other things being equal, corporations would benefit from the fact that they had not succumbed to the credit mania by leveraging themselves to destruction.

But other things, it turns out, are not equal. It no longer seems plausible that the credit epidemic can be fenced off from the real world.

For a start, as Northern Rock has forcibly reminded us in the UK, taxpayers are ultimately on the hook for the follies of the banks. The reaction is now underway, and an era of unregulated credit is over.

Banks will be forced into more candour about the risks they are running and to put up capital accordingly. Accounting rules will change. Risk will be made more expensive and credit will contract. As for the markets, they will swing – in the professors’ terminology – from a paranoid-schizoid state to a depressive one. Investors will now “recognise [that] investments have both attractive and unattractive characteristics, and judgments are imperfect”. They will balance risk and return, rather than swinging between extremes.

Let me put a similar point in a different way. There are some events which are simply too big to grasp at once. The ostensible reality may be clear enough – the collapse of the Soviet Union, say, or 9/11 – but it can take years for the full significance to emerge. In its more modest way, the credit crunch fits that description.

The crisis is not over yet, and there is no saying how long its implications will take to sink in. But when they do, investors will have more to think about than chasing the next bubble.