Some argue that the stock market downturn was too shallowby Edward Chancellor / February 20, 2004 / Leave a comment
Published in February 2004 issue of Prospect Magazine
Just under four years ago, in the first spring of the new millennium, the longest bull market in history came to an end. For three years, as the stock market endured a stuttering decline, the Cassandras enjoyed their triumph. However, over the last nine months of last year, shares recovered much of their lost ground. Furthermore, the US economy grew at a startling pace, spreading prosperity to the rest of the world. Despite this good news, most bears have not turned coat and joined the bulls. Now they look a rather beleaguered lot – but their views should not be dismissed. Economic growth in the US surged last year. In the third quarter of 2003, US GDP climbed by over 8 per cent – its best performance since 1984. A recent survey of US manufacturing showed new orders rising at their fastest rate for half a century. The British economy also produced good news, with manufacturing growing at its strongest rate for four years. Even Germany reported that its manufacturers had enjoyed the biggest increase in orders in three years. Stock markets too have been looking a lot more buoyant. In the spring of 2003 the decline of the stock market came to an end. For the rest of the year shares rallied. The gains were accompanied by strong corporate earnings growth. The Financial Times has declared the bear market officially over. Those commentators who had remained optimistic about the prospects for recovery during the bear market were elated by this good news. "The stock market crash of April 2000," wrote Anatole Kaletsky, "has not turned into a thirties-style recession, a profitless recovery, nor even a jobless recovery. It has just turned into a mild, but otherwise perfectly normal, investment-led business cycle." Alan Greenspan, the veteran chairman of the Federal Reserve Board, has long been scorned by the bears. It was he, in their view, who allowed the bubble to inflate. However, when the bubble began letting out air in the first years of the decade, Greenspan did not stand by. The Fed slashed interest rates from 6.5 per cent in early 2000 to 1 per cent by June 2003. Many bears had predicted that monetary policy would fail to arrest the decline of the stock market. At first, they appeared to be correct. But after the rally of 2003 the Dow Jones regained the talismanic 10,000 mark, not far short of its peak. Thus in early 2004 the bears find themselves in a difficult position. They had anticipated a stock market decline even greater than that which occurred and many had predicted a "hard landing" for the economy. Many must have felt like Stephen Roach, the chief economist of Morgan Stanley, renowned for his prediction of a "double-dip" recession in early 2002. Roach confessed in a piece of new year breast-beating that "there are times when you think you have it all figured out and there are times when you feel almost clueless." But most bears are not prepared to retreat from their position, or even to admit to past errors of analysis. On the contrary, they maintain that the bear market is far from over. There are two strands to their argument: first, they maintain that the stock market is still in speculative territory and second, that the economy is not in such good shape as Greenspan, Kaletsky and others would have you believe. Although the recent bear market lasted three years, it failed to perform even its primary function, that of driving equity valuations back to fair value. According to Andrew Smithers of Smithers & co, the US stock market remains between 60 and 80 per cent overvalued. Many people maintain, Smithers says, that bear markets are short affairs. But after the US stock market peaked in 1968, it didn’t reach its bottom until 1974. Japan has yet to recover from the collapse of the bubble economy back in 1990. Smithers predicts that the medium term outlook for equity investors is extremely poor. Another leading bear, Jeremy Grantham of Grantham, Mayo, Van Otterloo & co in Boston, characterises the stock market rebound as the "greatest suckers’ rally in history." Grantham argues that a bear market rally has four typical characteristics. First, it starts from a position where values are not particularly low. Second, leadership of the market reverts to the favoured stocks of the bull market. Third, the rally is sharp and has a speculative flavour. Fourth, investors are overconfident because their hearts have not been broken by the previous market low. In Grantham’s view, the stock market rally which began last March meets all of these conditions. Leaving aside issues of valuation, there are other grounds for investors to be wary. James Montier, of Dresdner Kleinwort Wasserstein, claims that investors continue to be entranced with the meaningless pro forma earnings figures (otherwise known as "profits before the bad stuff"), which are put out by compliant brokerage analysts. He also believes that despite the Enron scandal and subsequent legislation, many large US companies are still manipulating their earnings. If one of the functions of the bear market is to dampen the animal spirits of investors, this recent bear market has been a flop. The speculative spirit is still alive: margin loans to buy technology stocks on the Nasdaq market are at record levels, while the average holding period for shares listed on the larger New York stock exchange is less than one year. Another cause for concern are the high levels of share sales by corporate insiders in the US, which rose last year to $30bn. Insider purchases, by contrast, were a measly $1bn, the lowest amount since 1995. In the past, such high levels of sales have presaged a market decline. If stock market valuations were to collapse again there would be severe repercussions. Insurance companies and pension funds would once more face the threat of insolvency (in fact, despite the recent market rebound, it is estimated that US corporate pension funds still face a deficit of $300bn). Another big decline in the stock market might finally shake investors’ confidence. They would then respond by raising their savings rate, which in both Britain and the US are at near all-time lows, and reducing consumption. If that happens, the double-dip recession will finally be upon us. In fact, the extraordinary resilience of consumer spending in the Anglo-Saxon economies over recent years was the main reason why the collapse of the stock market bubble had such a minimal impact on the economy at large. The bears are not surprised by this. In their view, Greenspan’s Fed has recklessly nurtured a housing bubble and credit-induced consumer boom in order to sustain demand after shares tanked. Doug Noland, writer of the "Credit Bubble Bulletin," argues that the US economy requires $2.4 trillion of new credit this year to avoid collapse: almost a quarter of US GDP. The situation is no better in Britain, where rising house prices over the last few years have led to record extractions of housing equity. According to Crispin Odey, a hedge fund manager, there was little growth in workers’ incomes last year. Instead, rising consumption was financed by mortgage equity withdrawal. This credit-led binge has flattered corporate performance, since companies have been able to increase their sales without paying employees any more. But when the housing bubble bursts, consumption will collapse as it did in the early 1990s. In the past, bear markets have driven economies and stock markets back to equilibrium. Savings rise, consumption falls along with business investment, and other imbalances in the economy, such as trade deficits, are rectified. When the bear market’s work has been done, the economy and the stock market are primed to make solid gains again. However, this has not been the case for the recent bear market. Instead, the authorities on both sides of the Atlantic have bet that we can enjoy the giddy high of the boom while avoiding the gloomy low of the bust.