(Photo: Neilson Barnard/Getty Images)The trading floor at the New York Stock Exchange in March.The Dow closed up 246 points on Thursday, ending a short week with a healthy rally before the Good Friday holiday. Since stocks bottomed out on March 9, the Standard & Poor’s 500 index has now risen more than 25 percent, one of its best runs since the Great Depression.
This run-up appears to be a classic bear market rally. Do such rallies indicate anything more than investors desperate to find good news anywhere? Or do they suggest a real return of confidence?
We asked two economists, Simon Johnson and Nicholas Bloom, and Barry Ritholtz, a market researcher, for their analysis.
This Rally Shows a Deeper Illness
Simon Johnson is a professor at the M.I.T. Sloan School of Management and co-founder of the global crisis Web siteBaselineScenario. He is a regular contributor to the Times’sEconomix blog.
Some stock market rallies are reassuring. Others provide at least temporary respite. And a third kind, more commonly seen in emerging markets, actually expose deeper underlying problems and contribute to a further downturn.
We seem to be experiencing this third kind of rally in the U.S. right now. Equity prices are up sharply, but the debt market continues to indicate a high probability of default. In particular, the level and recent trajectory of credit default swap spreads suggest that, as the financial system as a whole stabilizes, market participants expect increasing odds of failure (and failed bailout attempts) for the very largest banks.
The rally, paradoxically, creates conditions in which the government can consider letting a major bank default.
The equity market rally, paradoxically, creates conditions in which the government can consider letting a major bank default. Of course, this situation arises also because the administration is low on bailout money, and Congress has lost patience with all the “rescue” efforts since September and is not inclined to provide more.
Broader financial system risk would rise sharply if a major bank fails and there are large unexpected spillover effects, as after the Lehman collapse in September of last year. Instability may jump from the U.S. to the rest of the world, and then potentially back to us. And it remains unclear what the U.S. Treasury — by itself or working with the G-20 — has done to plan for the worst contingencies.
A Sign of Less Uncertainty
Nicholas Bloom is an economics professor at Stanford University and an associate at the Center for Economic Performance, London School of Economics.
Global stock markets have seen incredible volatility over the last six months. The turbulence in the stock market is at levels last seen during the Great Depression. This volatility reflects tremendous uncertainty over the future of the global economy. The world has changed so much that economists, policy makers and business people are unsure about what to expect next. So even the smallest piece of news can lead to panic-fueled dips and euphoria-driven rallies in the stock market.
The last couple of weeks have seen a rally because of two factors. First, some American banks have reported surprisingly decent results. Second, at the G-20 conference in London global leaders actually agreed on a common framework to address the crisis. Both factors have helped to reduce uncertainty over the course of global policy. The G-20 consensus also means the worst case scenario of global trade wars has been avoided.
Although the market is still volatile, a measure of the “financial fear factor” has fallen.
Normally, these events would lead to moderate changes in stock prices. But the recent rise in uncertainty means any news is big news, leading to wild swings in the stock market.
To put this in perspective, last year I wrote an article predicting a severe recession in 2009. Based on my analysis of 16 previous economic shocks I forecasted a 3 percent drop in G.D.P. and an increase of 3 million in the ranks of the unemployed. Unfortunately, that looks to be reasonably accurate. Fortunately, I was wrong about a far worse outcome – the world slipping into another Great Depression due to a damaging policy response to the crisis.
Much like today, the Great Depression began with a stock market crash and a meltdown of the financial system. Banks withdrew credit lines and the inter-bank lending market froze up. What turned this from a financial crisis into an economic disaster, however, was the compounding effect of terrible policy. The infamous Smoot-Hawley Tariff Act of 1930 was introduced as a way of blocking imports to protect domestic jobs. Instead of helping workers, this worsened the situation by freezing world trade.
In contrast, the G-20 leaders agreed to maintain free markets as well as sensible increases in financial regulation — which is radical, unprecedented stuff. As a result, stock market uncertainty — measured by implied volatility, commonly known as the “financial fear factor” — has fallen. A measure of uncertainty (tracking implied volatility of the S & P 500) shows a more than three fold jump after the collapse of Lehman in September 2008. But that measure has fallen back by 50 percent as political uncertainty has receded.
(Credit: Nicholas Bloom)Chart showing the financial “fear factor”: daily implied volatility in the U.S. stock market. View larger version here.Of course, there is still tremendous uncertainty about the extent of the damage to economy. We still don’t know the value of the toxic assets central to the banking crisis. Fear remains a factor, leading firms to postpone investment and hiring decisions. But we are moving past the big spike in uncertainty of last fall. And if uncertainty continues to decline, growth should start to rebound.
You Can’t Nail the Low
Barry Ritholtz is chief executive of Equity Research at Fusion IQ, an online quantitative research firm. He is the author of The Big Picture blog and the forthcoming book, “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
Is this a real shift in the market or just another bear market rally that will be subject to correction soon? Here are some things to keep in mind.
In a bull market, buy into the dips; selling will likely be disappointing, since prices will eventually go higher. For most investors, buy and hold is the simplest, most effective investment strategy. In bear markets, however, buy and hold is a losing strategy — trading what the market presents to you is the best risk management strategy. Sell during the rallies when equities might have a temporary premium.
Understand the difference between an economy that is improving versus one that “getting worse more slowly,” which is what we’re experiencing now. And remember that buying at the very bottom isn’t your goal, since you can’t know when the market has hit the bottom until after the fact. Even if you nail the low, you may not make any money.
Here’s an example: In 1966, the Dow first kissed 1,000. It did not top 1,000 on a permanent basis until 16 years later in 1982.
But if you managed to catch the exact low in December 1974, well, then, you would have had to accept an enormous level of volatility. That low was followed by a 75 percent rally, a 27 percent sell off, a 38 percent rally and a 24 percent sell off. But those are nominal numbers. Adjust the returns for inflation, and you actually lost about 75 percent of your money in real terms.
Instead, the goal should be to maximize returns on a risk-adjusted basis. This means being more conservative with your investments when risk levels are higher, and more aggressive when they are lower. For many investors, dollar cost averaging into broad index funds works well. If you want to be a bit aggressive, you can increase your contributions once the markets fall 30 percent or (like now) 50 percent. The time to throttle back? After a four- to seven-year bull market run.
from comments
Don’t listen to those who get a check from Wall St., including brokers and bankers. Clearly this is a bear market rally…things can only go down for so long before non-professional investors get a little optimistic, and professional investors sense a short-term trade opportunity.
And that’s the problem: We have yet to get to the “I hate the stock market and don’t want anything to do with it ever again” phase that traditionally signals capitulation by nonprofessional investors. Instead, these investors just “held on” because “it can’t get much worse.” That’s a bad sign: they will be suckered into believing that “the economy is getting less worse” is equal to “the economy is getting better.”
TIME is what we need. There is no rushing cycles. The economy must purge the weak, or let the strong pick up the weak at fire sale prices.
Remember, stock markets typically go in 16-20 year cycles of bear and bull. Our bear started in 2000…so, expect sideways and down moves for another 7-10 years.
— Marc Coan
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