Sunday, 1 December 2013

Are we in 2007?

If I could revisit 2008 in 2011, why not turning back time even more and returning to 2007? If you look at the S&P chart below, showing some period of 12 months from December to November, your guess should be that it dates back to good, pre-crisis times, while in fact it illustrates recent 12 months. No major correction, low volatility and over 30% return over the year is what stockholders on average experienced in 2013.

Such patterns are typical, but for the late expansion phase, in which GDP growth is high, unemployment runs low, inflationary pressures intensify and have to be dampened by monetary tightening. Such chart could also come from a period of early economic recovery, when stock prices bounce back after a dismal bear market. But the bear market actually has not occurred since early 2009. Since late winter of 2009, stock markets have been in the bullish phase, with some major corrections: in spring 2010 when bankruptcy of Greece was a real threat, in summer 2011 when US sovereign rating was downgraded, in spring 2012 (was there a profound reason for the downward movement?), but since then most markets have been rising without a deeper break to take a breath.

Is the incline sustainable?

Every why has a wherefore. Sound bull markets the history has witnessed were grounded in economic fundamentals – economies were expanding, fewer people were jobless, taxpayers paid more in taxes and governments ran nearly balanced budgets, wheels in the economic machines were oiled property and central banks kept interest rates on moderately high level to prevent economies from overheating and preclude inflation from going up. Now the economic growth rate in USA stays below 3%, Western Europe economies are rebounding after deep slowdown. Unemployment rate in the USA is above 7% (which is very higher given the flexibility of labour market there), in the eurozone it is above 10%. To combat adverse economic conditions, tremendously loose monetary policy has been pursued over last five year. Not only have the interest rates in the biggest economies have been cut to near zero, but many central banks have been carrying out quantitative easing programmes, or in plain English, increased money supply in financial system.

Normally when if money supply goes up, everything else held constant, price level should increase by the same rate, to keep the financial system in balance. To many economists’ surprise, ultra-loose monetary policy has not sent overall price level rising. The reason for it is simple – the money intended to prop up the real economy through the financial system have not flowed out of banks and drove up asset prices.

Long ago it has been discovered that low interest rates distort economic decisions. The upshots are now visible on stock and property markets in many countries. House prices in the United States and in Great Britain have seen double-digit increases over the last year. Is this trend sustainable?

I keep asking myself a question: “why so good, if so bad?” Why are the markets red-hot if the economy is still fragile? The only plausible explanation is that market participant are buying the prospects of bright future. But can the next years be rose-coloured, if financial markets rely on drip of cheap money provided by central bankers? Near-zero interest rates cannot be kept forever. One day central bankers will have to bite a bullet on it and what then? The biggest corrections in the recent months on the stock market have been brought about by rumours of QE being tapered or petering out in near future. Central bankers realise the scale of pathological reliance of markets on monetary easing and the difficulty they have to get to grips with is how to pull out of the egregious practice of printing money without harming the markets, as the shock suffered by them would be transmitted into real economy. This dilemma niftily depicts the abnormality of current situation. In ‘normal’ environment raising the cost of credit above certain level just stifles economic activity and dampens enthusiasm of financial markets’ participants. At the present, leaving cost of credit on historically low levels, but only curtailing pumping money may wreak bigger havoc to financial system than unexpected jacking up interest rates by 100 points in a healthy economy.

Quite frequently you can hear of economists arguing, whether the recent unfettered stock market rally is a full-blown bubble, or it only has all makings of a bubble. Federal Reserve has already received a warning. Many indicators (P/E > 25, margin debt, bullish sentiment, low volatility, technical indicators) point at existence of a bubble, while other (business cycle phase, low participation of individuals in the market) may disprove the bubble theory. I only wish to stress the presence of the word “bubble” in the media and in the search engines might be a misleading gauge and should be interpreted with caution.

According to the scenario in the paper linked above, the crash is very likely to occur in 2014. If so, I foresee it will not strike out of the blue, but the show will go on in the ordinary way. At some point stock market reaches its peak, then retreats, attempts of bullish speculators to drive prices up go in vain, then ensues the waterfall (shape of a price chart when prices plummet), then a rebound, then a gradual decline and at the end the tsunami strikes… This pattern is similar to what was observed in 2008 (peak in 2007, retreat, waterfall in early 2008, decline till the early days of September 2008 and then the Lehman earthquake). The first and foremost argument against such scenario is that financial system is not full of toxic assets as it was before the crisis. On the other hand, central banks and government have run out of tools the used to rescue financial institutions and economies in 2008 and 2009. Fhe frail economies cannot endlessly underlie exorbitant stock market valuations and the sooner market participant realise it, the better for everyone.

These musings take me back to the last semester of my studies, when in late 2010 I took a course “Financial crises and financial stability”, delivered by prof. Mieczysław Puławski. I recall well the lecturer mentioning a crisis model devised in 2009, according to which a much more wrathful crisis will hit in 2H2014. Time will tell, if the prophets’ of doom prediction was right.

A few paragraphs above I stated “financial markets rely on drip of cheap money” and laid my thought out very precisely – financial markets, not real economies. Real economies are capable of bearing the burden of higher cost of credit, it may bend them, but will not knock them down and in the long run sound monetary policy will lay foundations for returning to the path of sustainable economic growth.

Compared to developed markets, Poland comes out impressively safe. The property market has been on decline since 2008. In 3Q2013 property prices nudged up, yet it is too early to judge, whether the trend has reversed, or the rebound is just a correction in a downward trend. Unquestionably, the increased demand for properties is the effect of lower interest rates and constricting regulation regarding buyer’s equity for property purchase (min. 5% in 2014, this one hastened many buyers finance the planned transactions with 100% mortgage this year). One swallow does not make a summer and it will be the summer of 2014 when with hindsight the mid-term trend on Polish property market can be observed.

The Polish stock market has been consistently underperforming developed markets. While S&P 500 and DAX indices are well above their 2007 peaks, WIG (broad market total return index) and WIG20 (blue chip price index) are not only below their 2007 peaks, but also below their highs recorded in first half of 2011. Market analyst put it down to insecurity over future of pension system in Poland. If this is indeed the case, it only bears out the reform is a step in the right direction. Despite not beating ever-time records, the stock market in Poland is red-hot, judging by IPO frequency and successfulness. 4Q2013 already saw privatisation of PKP Cargo, which was priced quite high and debuted at absurdly high price. I subscribed for shares of PKP Cargo, took the 19% profit and made off. Recently I subscribed for Newag, just for fun I signed up for 50 shares, 19 PLN each. On Friday I discovered I had been allocated mere 4 shares, as individual investors’ demand surpassed supply over 25 times, which resulted in 93% haircut in share allocation… Demand for Energa among individual investors is also record-high and over-subscription is expected. I will subscribe for those shares as well, hoping to find the greater fool to buy them from it on secondary market. I realise this has become a fad and market sentiment clearly indicates I should rush to escape.

My strategy is to liquidate my stocks portfolio in first weeks of 2014. I last bought stocks in early September 2013, when pension reform announcement triggered a short-lasting sell-off, which turned out to be a superb mid-term investment opportunity. The only reason why I have not pulled out of the stock market recently is the sizeable loss from hapless 2011 which is carried forward into next years. According to Polish tax regulations, no more than 50% of a loss from a specific year may be used as tax shield in any of next following year, so this year (in 2012 my profit was very small) I cannot use it up and sale of securities in 2014 offers a chance to reduce capital gains tax payable. And after I scram, may it all collapse. By all accounts, Poland’s economy will not be severely impacted by the downturn on financial markets and subsequent bear market might offer interesting long-term investment opportunities.

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