Bad Omens
We’re in the middle of one of the most dramatic experiments financial markets have ever seen. Central banks, across the world, have bet your house and mine on a gamble of extreme proportions yet, such is the unpredictability of markets, we’ll only know the outcome of this with hindsight, a notoriously unhelpful bedfellow.
The problem is that changes in monetary and market liquidity can trigger outbreaks of investor insanity and by pumping the world full of cheap money central bankers are gambling that they can manipulate markets to beat behavioural biases. The omens are not especially good for them getting this right.
Untradeable Assets
At a simple level significant market movements can be explained in terms of a combination of liquidity and stupidity. Liquidity comes in many different forms, mutating just about as soon as economists think they've nailed it down. They spend lots of time arguing over definitions of liquidity but we can roughly think about it as the available money in the system.
Cash in the bank account is part of it but so's the credit card limit and the overdraft limit and that huge secured loan we took out against the garden shed where we store our limited edition garden gnome collection. Which is fine, just as long as no one comes to actually value the desirable bijou detached timber-framed residence at the bottom of the yard. Were they to do so then the liquidity in the system may drop suddenly, along with the clearing price of gnomes as the market's flooded with the things.
Liquidity helps drive markets – when there’s more money entering the market than leaving it then stocks will, on average, go up. When the reverse is true they’ll go down. Large flows of liquidity then drive human fear and greed, depending on the overall market direction, causing over and under-reactions.
The Liquidity Trap
This is a trivially laughable description of the way markets operate. Yet there are times when “trivially laughable” comes uncomfortably close to the truth in our sophisticated modern markets. Such an occasion was the backend of 2007. As the Bank of England's Paul Tucker puts it:
The Downward Spiral
Basically many of these assets – far too many – had been bought with borrowed money which suddenly needed to be repaid pretty damn quickly when fearful and stressed lenders called in their dues. Unable to sell mark to model assets, on account of – as we discussed in Quibbles with Quants – no one believing the model valuations, institutions started selling whatever they could – primarily assets traded on open markets with guaranteed counterparties – stuff like quoted stocks. So thus we came to our very own Minsky Moment:
Exit the Greater Fool, followed by bear market.
The Last Resort
Rather late in the day governments and central bankers decided that the foundations of the world’s financial system were really crumbling and, as is invariably the case under these situations, stepped in as the lender of last resort to provide liquidity to financial institutions at incredibly low rates of interest. In doing so they're following the dictum of the nineteenth century English journalist Walter Bagehot, whose advice under these conditions was expressed by Tucker, thus:
All this is typical of most major financial crises – as we saw in Panic! in the end governments nearly always step in as the lender of last resort for fear of something far worse. However, this time not only have governments underwritten the savings of retail investors they've also implicitly guaranteed the continued existence of many of the investment institutions responsible for this mess by allowing them to borrow our money at knock-down prices against assets that are little better than my garden gnome-house. The calculation, presumably, is that the global financial system is too weak to survive on its own and the early removal of massive financial support risks a worse problem than the alternative.
To be fair, as Tucker points out, for central banks to stick to a policy of lending only against the soundest assets when the very lack of those assets is causing the crisis is stupid:
Investor Behaviour
The trouble with this calculation is that it requires extremely fine judgement as to the psychological behaviour of investors. Cheap money is seeping out into real-world assets – stockmarkets are booming, property markets are showing signs of tentative recovery too. The return of liquidity is encouraging investors back into markets, as they operate under the illusion that uncertainty has been banished.
Of course, some recovery should be expected. In the depths of 2008 and early 2009 the withdrawal of liquidity saw many assets being driven down to valuations that were clearly stupid. Their recovery as cash, and some sense of proportion, returns is simply an elastic rebound. However, as we can see from the net flows of money into investment funds an element of exuberance is returning to investors: from a global net outflow of $41 billion in the first quarter of 2009 to a net inflow of $93 billion in the second quarter. Meanwhile net flows into overpriced government bonds soared to $165 billion, another behavioural bubble waiting to burst.
As we would expect, at the very point markets reached their low points, when rational investors should have been throwing funds at the market like there was no yesterday, they were, in fact, pulling it out in record amounts in the apparent belief that tomorrow would never come. This was all entirely predictable to anyone with even a basic knowledge of stockmarket history: yet, as Charlie Munger recently said, anyone not willing to temporarily lose 50% of the value of their stock portfolio deserves everything they get.
Exuberance and Uncertainty
The problem is that there can be little or no guarantee that investors will behave as expected from now on. We’ve moved on from the obvious irrational lows to the intermediate indeterminacy of a market recovery. Yet while there’s cheap money washing around the system you’ll likely see prices climb and more and more investors come off the sidelines, bringing yet more money with them. People are irresistibly drawn to where the action is. As Uri Simonsohn and Dan Ariely have shown in When Rational Sellers Face Non-Rational Buyers, using EBay as a test bed, people much prefer to bid on auctions where there are more bids. As prices rise, more people will join the game.
Quite how governments and regulators intend to control this behavioural spiral is, at the moment, unknown. The levers of excess liquidity – so-called quantitative easing – and interest rates take time to work. Calming the irrational exuberance of the masses without causing another recessionary plunge will take considerable skill and judgement. Recent regulatory history doesn’t promote optimism in this regard.
Spin the Wheel
Investors whose approach is essentially activist and short-term face a period of more than normally difficult decision making. In truth the future is never really predictable, but the current forecasts are even more than usually opaque. The alternative, taking a long view, is anathema to many investors despite the abundant evidence that it works, if you’re smart enough to avoid most of the obvious bear-pits.
Trying to second-guess how this will all turn out is impossible. In essence the central bankers are betting that they can use the levers of liquidity to control human stupidity. To pull this off and spring the liquidity trap will require one of the greatest finesses ever. History is not on their side.
Short-term investors need to place their bets. The rest of us should settle down in the viewing gallery to watch. It promises to be a lot of fun.
Related Articles: Quibbles With Quants, Get An Emotional Margin Of Safety, Is Intrinsic Value Real?
We’re in the middle of one of the most dramatic experiments financial markets have ever seen. Central banks, across the world, have bet your house and mine on a gamble of extreme proportions yet, such is the unpredictability of markets, we’ll only know the outcome of this with hindsight, a notoriously unhelpful bedfellow.
The problem is that changes in monetary and market liquidity can trigger outbreaks of investor insanity and by pumping the world full of cheap money central bankers are gambling that they can manipulate markets to beat behavioural biases. The omens are not especially good for them getting this right.
Untradeable Assets
At a simple level significant market movements can be explained in terms of a combination of liquidity and stupidity. Liquidity comes in many different forms, mutating just about as soon as economists think they've nailed it down. They spend lots of time arguing over definitions of liquidity but we can roughly think about it as the available money in the system.
Cash in the bank account is part of it but so's the credit card limit and the overdraft limit and that huge secured loan we took out against the garden shed where we store our limited edition garden gnome collection. Which is fine, just as long as no one comes to actually value the desirable bijou detached timber-framed residence at the bottom of the yard. Were they to do so then the liquidity in the system may drop suddenly, along with the clearing price of gnomes as the market's flooded with the things.
Liquidity helps drive markets – when there’s more money entering the market than leaving it then stocks will, on average, go up. When the reverse is true they’ll go down. Large flows of liquidity then drive human fear and greed, depending on the overall market direction, causing over and under-reactions.
The Liquidity Trap
This is a trivially laughable description of the way markets operate. Yet there are times when “trivially laughable” comes uncomfortably close to the truth in our sophisticated modern markets. Such an occasion was the backend of 2007. As the Bank of England's Paul Tucker puts it:
"... the current crisis has illustrated just what a mess can result from liquidity draining out of [capital] markets. Market liquidity is endogenous: participants thinking that it might dry up can contribute to its doing so. In the early phases of this crisis, by virtue of holding large ‘trading’ books that were marked to market, banks and other traders found themselves having to make very large portfolio write downs in the face of sharp rises in liquidity premia in asset markets. As highly-levered institutions, those markdowns depleted their net worth to the point of imperilling solvency. That caused a retrenchment in the availability of credit, helping to plunge the world economy into recession, and so impairing the value of more traditional loan books, in a vicious spiral."Yeah, what he said.
The Downward Spiral
Basically many of these assets – far too many – had been bought with borrowed money which suddenly needed to be repaid pretty damn quickly when fearful and stressed lenders called in their dues. Unable to sell mark to model assets, on account of – as we discussed in Quibbles with Quants – no one believing the model valuations, institutions started selling whatever they could – primarily assets traded on open markets with guaranteed counterparties – stuff like quoted stocks. So thus we came to our very own Minsky Moment:
"Minsky rejected conventional economic ideas such as the efficient market hypothesis. His financial instability hypothesis holds that the structure of a capitalist economy becomes more fragile over a period of prosperity ... The expansionary phase of the financial instability hypothesis leads to a Minsky moment. Without intervention in the form of collective action, usually by the central bank, a Minsky moment can engender an economic meltdown (i.e., plummeting asset values and credit, falling investment and output, and rising unemployment)."As institutions withdrew liquidity from markets to shore up their balance sheets stocks fell even more, sometimes to dramatically low levels. This effect was exacerbated by the realisation that even sound companies might not be able to roll over their debts due to the lack of money in the system. A combination of declining stock prices and ever increasing volatility triggered all the standard behavioural biases: many investors panicked and also sold, pulling yet more liquidity out of the markets.
Exit the Greater Fool, followed by bear market.
The Last Resort
Rather late in the day governments and central bankers decided that the foundations of the world’s financial system were really crumbling and, as is invariably the case under these situations, stepped in as the lender of last resort to provide liquidity to financial institutions at incredibly low rates of interest. In doing so they're following the dictum of the nineteenth century English journalist Walter Bagehot, whose advice under these conditions was expressed by Tucker, thus:
"Bagehot’s famous dictum, in Lombard Street, was that, to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates’."The panic eased as the market participants realised that debts would be repaid, albeit with government money, and the desperate round of beggar-thy-neighbour behaviour finally slowed, stopped and then grindingly went into reverse.
All this is typical of most major financial crises – as we saw in Panic! in the end governments nearly always step in as the lender of last resort for fear of something far worse. However, this time not only have governments underwritten the savings of retail investors they've also implicitly guaranteed the continued existence of many of the investment institutions responsible for this mess by allowing them to borrow our money at knock-down prices against assets that are little better than my garden gnome-house. The calculation, presumably, is that the global financial system is too weak to survive on its own and the early removal of massive financial support risks a worse problem than the alternative.
To be fair, as Tucker points out, for central banks to stick to a policy of lending only against the soundest assets when the very lack of those assets is causing the crisis is stupid:
"In other words, a central bank policy of lending against only the best assets is likely to prove time inconsistent when it comes to the crunch ... This is not an ivory tower problem. It is a real problem."This scenario, frankly, isn’t very attractive either. However, letting the free market sort the problems out on its own would lead to millions of otherwise innocent people becoming victims of a scandal that’s nothing to do with them. So moral hazard has to go hang, at least temporarily.
Investor Behaviour
The trouble with this calculation is that it requires extremely fine judgement as to the psychological behaviour of investors. Cheap money is seeping out into real-world assets – stockmarkets are booming, property markets are showing signs of tentative recovery too. The return of liquidity is encouraging investors back into markets, as they operate under the illusion that uncertainty has been banished.
Of course, some recovery should be expected. In the depths of 2008 and early 2009 the withdrawal of liquidity saw many assets being driven down to valuations that were clearly stupid. Their recovery as cash, and some sense of proportion, returns is simply an elastic rebound. However, as we can see from the net flows of money into investment funds an element of exuberance is returning to investors: from a global net outflow of $41 billion in the first quarter of 2009 to a net inflow of $93 billion in the second quarter. Meanwhile net flows into overpriced government bonds soared to $165 billion, another behavioural bubble waiting to burst.
As we would expect, at the very point markets reached their low points, when rational investors should have been throwing funds at the market like there was no yesterday, they were, in fact, pulling it out in record amounts in the apparent belief that tomorrow would never come. This was all entirely predictable to anyone with even a basic knowledge of stockmarket history: yet, as Charlie Munger recently said, anyone not willing to temporarily lose 50% of the value of their stock portfolio deserves everything they get.
Exuberance and Uncertainty
The problem is that there can be little or no guarantee that investors will behave as expected from now on. We’ve moved on from the obvious irrational lows to the intermediate indeterminacy of a market recovery. Yet while there’s cheap money washing around the system you’ll likely see prices climb and more and more investors come off the sidelines, bringing yet more money with them. People are irresistibly drawn to where the action is. As Uri Simonsohn and Dan Ariely have shown in When Rational Sellers Face Non-Rational Buyers, using EBay as a test bed, people much prefer to bid on auctions where there are more bids. As prices rise, more people will join the game.
Quite how governments and regulators intend to control this behavioural spiral is, at the moment, unknown. The levers of excess liquidity – so-called quantitative easing – and interest rates take time to work. Calming the irrational exuberance of the masses without causing another recessionary plunge will take considerable skill and judgement. Recent regulatory history doesn’t promote optimism in this regard.
Spin the Wheel
Investors whose approach is essentially activist and short-term face a period of more than normally difficult decision making. In truth the future is never really predictable, but the current forecasts are even more than usually opaque. The alternative, taking a long view, is anathema to many investors despite the abundant evidence that it works, if you’re smart enough to avoid most of the obvious bear-pits.
Trying to second-guess how this will all turn out is impossible. In essence the central bankers are betting that they can use the levers of liquidity to control human stupidity. To pull this off and spring the liquidity trap will require one of the greatest finesses ever. History is not on their side.
Short-term investors need to place their bets. The rest of us should settle down in the viewing gallery to watch. It promises to be a lot of fun.
Related Articles: Quibbles With Quants, Get An Emotional Margin Of Safety, Is Intrinsic Value Real?
You got the paper title wrong.
ReplyDeleteIt's:
When Rational Sellers Face Non-Rational Buyers
I did, I've fired the proofreader :)
ReplyDeleteThanks.
As always, you provide great background on the problem, Tim.
ReplyDeleteThe "Minsky Moment" idea is key, in my assessment. But I don't agree with the idea that a government solution can work without investor cooperation. I believe that the answer is letting investors know how stock investing works and drilling the right strategies into people's heads over and over and over again. Instead of telling people "Buy and Hold, Buy and Hold, Buy and Hold," we should be telling people "Price Matters, Price Matters, Price Matters."
Oops.
It's not dark yet.
But it's getting there.
Rob
As usual, you provide great background on the problem, Tim.
ReplyDeleteI think "the Minsky moment" is key. But I don't think a government solution can work without investor cooperation. We need to be telling people the realities of stock investing. Instead of saying "Buy and Hold, Buy and Hold, Buy and Hold," we should be saying "Price Matters, Price Matters, Price Matters."
Oops.
It's not dark yet.
But it's getting there.
Rob