Markets Today

Some quick thoughts on the current market panic. This has perhaps not been the best time to be away from the office. I am finishing my book about the methods of Sir John Templeton, whose calm reflections on previous crises is a salutary reminder of how best to react to market panics like the current one. Because service will be intermittent for the next couple of weeks, until I return to full-time duty, I propose to rebate all subscriptions for this month.

The current shakeout is following the script of earlier August crises, in gathering momentum at a pace which appears to have taken everyone by surprise. When markets fall this fast this quickly, you can be sure that it is not just about the story which is said to have prompted it (real though the Eurozone crisis and slowing economic growth are). There will also be deleveraging and other technical factors as investors caught the wrong side of the move are squeezed by margin calls and the need to salvage their positions by liquidating or covering short positions. The effect of this is to accentuate the market movement.  

There is nothing much to be gained by trying to call the bottom at times like this – trying to catch a falling knife, in market parlance, is a dangerous and dispiriting game. When the rally comes after a move such as this, it will be sharp and sudden but until the bottom of the current move has been located, there is nothing to stop it falling further until liquidation or capitulation selling has been completed. The first rally will typically regain a reasonable proportion of the losses which have been experienced in the current move. Action by the Federal Reserve is one potential trigger.

This is certainly a good time however, for those with cash to invest, to be on the lookout for the bargains which the current selloff will ensure do now appear. If there stocks on your watchlist before the panic, now is the time to keep them on the radar. Market history shows that all the great stock market investors, including John Templeton, achieved most of their superior performance during bear markets and market panics. Whenever there is indiscriminate selling, bargains will appear – but only those who are positioned to have cash at hand to invest are able to profit.

Is this the start of a new bear market? It is certainly now a good possibility. The technical signals from the market are poor. Paradoxically however they are almost too poor. Bear markets rarely start with a sudden sharp decline like this one, which now rivals in magnitude that seen during the first Greek crisis last summer. Bear markets typically follow a path of slower and more inexorable decline. If that holds true against his time, we could still get one more leg up in the second half of this year (as for example the American fund manager Ken Fisher believes we will see).

There are some other positive straws in the wind. The dividend yield on the equity market in the UK has once again risen above the bond yield – normally a good indicator of long term value in the market.  The crossover signalled the turning point in 2003. In 2008 and again last year, at times of market stress, it did not mark the end of the market panic, but it did mark the point at which longer term  value could be more safely identified, and the risk of getting involved in equities reduced significantly.  Even if the market does go down further from here, you can be reasonably confident that you will get the loss from this level (though not the whole market move) back before too long.

 

The same thing applies to readings of the VIX, a market-traded measure of volatility widely interpreted as being a proxy for risk aversion amongst investors. History records that when it goes above its current levels, which are at their highest at any point since the global financial crisis in 2008, it is a relatively safe time from a longer term perspective to take on more risk. The same caveat applies however. The situation could get a lot worse in the short term – but any further deterioration from here will be recovered in due course, unlikely though it may appear at this point.

 

All that said, it is not yet clear how the current crisis will be resolved, or what will trigger any recovery.  The Eurozone crisis, as I have noted before, is like watching a car crash in slow motion. One view is that the markets are in effect challenging the Eurozone either to break up or move straight to the closer fiscal union which will be needed at a minimum to resolve the sovereign debt issue. The choice is one that Europe will have to make in due course. The problem is of course that national governments have no mandate from their voters to take that big step; and even if they do it is not guaranteed to succeed (see for example the article by the respected German banker Otmar Issing in the Financial Times today).  For that reason it seems unlikely that the crisis can be resolved quickly.

Three years ago, after the credit crisis broke, it was commonly agreed that we were entering a period where, for better or worse, governments would perforce become more important players in the financial markets. The risk of policy errors would be high – and we are alas seeing the validity of that point of view in everything that is now taking place. It takes time for politicians to start dealing with tomorrow’s problem’s rather than yesterdays’.  

Although gold will inevitably suffer a correction when the equity market rallies, it does not look like a good time to reduce exposure for the medium term.  As you can see from the chart, as a store of value in uncertain times gold has been particularly strong ever since a combination of the credit crisis and policymakers” inadequate response sent real interest rates sharply negative.