Jonathan Davies: Bank on sure hands, and luck

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The Independent Online

After such a big fall in stock markets around the world over the past 18 months, it would be comforting to think there is an obvious floor below which share prices will not now fall. Maybe, many investors are thinking, the recovery in prices we have seen in the past three weeks is the start of a return to more normal times. After all, central banks are pumping liquidity into the system, the shock of the New York attacks has been taken on board and priced into the markets, and it is at least possible to start looking beyond the now inevitable recession to sunnier times. With markets having fallen by 40 per cent in real terms over the past 18 months (and by more in some countries), there must be a case for thinking we have at last seen the back of the bear market.

After such a big fall in stock markets around the world over the past 18 months, it would be comforting to think there is an obvious floor below which share prices will not now fall. Maybe, many investors are thinking, the recovery in prices we have seen in the past three weeks is the start of a return to more normal times. After all, central banks are pumping liquidity into the system, the shock of the New York attacks has been taken on board and priced into the markets, and it is at least possible to start looking beyond the now inevitable recession to sunnier times. With markets having fallen by 40 per cent in real terms over the past 18 months (and by more in some countries), there must be a case for thinking we have at last seen the back of the bear market.

Well, it's a point of view. But I wouldn't rush to that conclusion, at least if you are one of those who believe that there are lessons to be drawn from a careful reading of financial history. At a conference last week organised by the Stewart Ivory Foundation in Edinburgh, a distinguished group of investment professionals and visiting experts addressed the issue of what historical lessons might best be taught to new fund managers entering the investment business. A critical sub-text was: what will be the enduring impact of the great internet bubble that peaked in March 2000?

The near-unanimous opinion of those speaking was that even with markets off 40 per cent from their peak, financial history provides naught, or very little, for our comfort. There is nothing that says share prices cannot continue to decline and stay down for years. Clearly the cost of clearing up after the party we all enjoyed during the bubble years is likely to be much greater than investors (including many professionals) have yet appreciated.

The fundamental problem is, as the longtime bearish fund manager Tony Dye put it: "This is a bear market that is priced like a bull market." In other words, share prices today have only returned to a level that are in historical terms you would typically expect to see near the top of a bull market. That is why measures such as Tobin's q, which measures the value of the stock market against the replacement cost of its component corporate entities, suggest that even now the US market is 40 per cent above its historical average. Another speaker, Professor Richard Sylla, from New York University, was careful not to make specific forecasts of what would happen to the stock market over the next few years but showed a graph of the past 200 years of market experience, expressed as 10-year rolling average returns (after inflation). This demonstrates that the stock market can often take a long time – 20 or 30 years – to recover its previous top-of-the-cycle peaks.

Professor Sylla looked at where the market would be on this scale if you project forward 10 years of 0 per cent real returns (in other words, if you assume that the market does nothing more than maintain its value after inflation for the next decade). His conclusion: such an outcome would not be unusual or unprecedented when set against experience. In fact, it might even be an underestimate.

But surely, you might counter, at least now we know how to handle recessions and stock market bubbles? After Keynes, nobody is going to make the same mistake as the Federal Reserve made in the 1930s, when (so conventional wisdom has it) the central bankers failed to open the monetary spigots to keep the economy moving forward. Has not Alan Greenspan kept the bull market going? Will he not do so again?

Historians are less convinced about this than many professional fund managers. Edward Chancellor, author of an outstanding history of financial speculation published two years ago, argued persuasively that history's verdict on Mr Greenspan's tenure as chairman of the Federal Reserve will be less favourable than the laudatory press to which he has become accustomed

What he and Tony Dye and many other speakers seemed united on was that Mr Greenspan has to take a full share of responsibility for creating the stock market bubble whose after- effects we are living through. Like every asset price bubble before it, the one that ended in March 2000 has helped to create a massive overcommitment of capital, not just in telecoms and technology, but in many other sectors. Marconi is just a more gruesome example of how damaging such episodes can be. They must inevitably lead to retrenchment and falling profitability, which, at its worst, can lead to the recent Japanese experience of deflation, economic stagnation and consumer paralysis. The full cost and implications of the bubble, says Mr Chancellor, will take time to emerge, but the outlines are predictable.

There will be more scandals and a search for scapegoats. Politicians will try to talk up the markets, but to little avail. The historian's verdict is that today's central bankers will need a sure hand, and a dose of luck, if they are to steer the economy through its next phase. So, all investors, need to recognise that this market downturn is different in scale and scope to others we have experienced in recent years. History's verdict is clear: there will be no going back to the "glad, confident morning" of the 1995-2000 period for some time.

Davisbiz@aol.com

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