This was the year the coyote looked down
Monday, 31 December 2007
John Authers FOR China, an ever more imposing presence in the world, 2007 was the Year of the Pig. For the markets, it was the Year of the Coyote.
Recall that Wile E. Coyote, in the old Roadrunner cartoons, can run off the edge of a cliff and keep going. It is only when he looks down that he stops defying gravity and falls to earth.
That is what happened to the credit markets this year. Market participants finally looked down, saw that many of the securities they had created with the aid of financial gimmickry were truly worthless, and fell back to earth. Nothing will ever return the credit market to the glories it had reached earlier this year.
But the coyote has another propensity. Dynamite could explode in his face, or a 10-ton rock could flatten him, but he would always live to brush himself off and walk away. The equity markets seem to have exhibited exactly that quality. In spite of the credit disaster, signs of economic slowdown and of a potential severe dip in corporate earnings across the developed world, this was still a perfectly respectable year for equities.
However, that did not mean that the trends of the past few years continued unabated. This year ended with a debate over whether equities, down from their peaks set earlier this year, were entering a bear market, or merely the final, most volatile stage of a "mature bull" market. There will be more on that debate, but note that nobody denies that, somehow or other, the equity cycle is turning. That can be seen by looking at the trends beneath the headline indices. Small caps finally underperformed the bigger stocks. Growth outperformed value, to a stunning extent. Financial stocks collapsed, as did the consumer discretionary sector. In all cases, this brought an end to trends that had lasted since the bursting of the internet bubble in 2000.
Another, less widely remarked, trend to end was the bull market in metals. After years of impressive gains, propelled by growing demand from China and other emerging markets, the Dow Jones AIG industrial metals index peaked early in the year, and then fell more than 20 per cent. Intriguingly, this appeared to have no effect at all on various emerging markets, such as Brazil, whose success had been predicated on booming raw materials prices.
There were some trends that did not turn. The dollar remained an international punch bag all year long.
Two commodities appeared entwined with the greenback, rising as it fell: crude oil, which hit a record price although it failed to reach $100 a barrel, and gold, which passed $800 an ounce. The gold price implies bearishness about the future, while the oil price, which rose for much of this decade on the same demand factors that pushed up metals, appears now to have reached the point where it may inflict a burden on developed economies.
Meanwhile, the emerging markets behaved more like the roadrunner: with a gleeful "Mbeep! Mbeep!," they disappeared in a cloud of dust, leaving the developed markets far behind.
But at the end of all this, the equity markets look remarkably unscathed. Some of the most important indices for the developed markets, notably the S&P 500, finally regained the all-time highs they set shortly before the tech bubble burst in 2000.
It is interesting, however, to see that equities have had difficulty making headway beyond their highs of 2000. The S&P has come to rest below its 2000 highs, while the main European indices such as the FTSE 100 and the Eurofirst 300 never quite got there before the credit market turbulence took over.
How can we explain all this? It may be overreaching to come up with an explanation for all these phenomena. The world is a complicated place. But it is tempting to couch the pattern of the past few years in terms of cheap money.
Over many market and business cycles, price/earnings ratios have shown a marked tendency to revert to a long-term mean. By 2000, the cyclically-adjusted p/e ratio (derived by comparing prices with a 10-year rolling average of earnings) had moved above 40, its highest ever, compared with an average since 1900 of about 16. In all previous cycles, peak valuations have been followed by an overshoot in the other direction. That did not happen this time, disconcerting the bears in the process. Instead, central banks, led by the Federal Reserve under Alan Greenspan, aggressively eased interest rates, making money very cheap. The cyclically-adjusted p/e dipped below 25, but then stabilised at a far higher level than would normally be expected.
That cheap money propped up stocks and also unleashed the boom in the credit market and in various housing markets across the world. But it was not enough to propel stock markets to new highs and the contradictions involved with such cheap liquidity are now being ruthlessly exposed. The implication is that either earnings or share prices have much further to fall.
Such a view may well be proved unnecessarily gloomy. Once 2008 is also in the history books, we will have a better idea. But for now, although blackened and flattened, the coyote marches on.
.............................................
— FT Syndication Service
Recall that Wile E. Coyote, in the old Roadrunner cartoons, can run off the edge of a cliff and keep going. It is only when he looks down that he stops defying gravity and falls to earth.
That is what happened to the credit markets this year. Market participants finally looked down, saw that many of the securities they had created with the aid of financial gimmickry were truly worthless, and fell back to earth. Nothing will ever return the credit market to the glories it had reached earlier this year.
But the coyote has another propensity. Dynamite could explode in his face, or a 10-ton rock could flatten him, but he would always live to brush himself off and walk away. The equity markets seem to have exhibited exactly that quality. In spite of the credit disaster, signs of economic slowdown and of a potential severe dip in corporate earnings across the developed world, this was still a perfectly respectable year for equities.
However, that did not mean that the trends of the past few years continued unabated. This year ended with a debate over whether equities, down from their peaks set earlier this year, were entering a bear market, or merely the final, most volatile stage of a "mature bull" market. There will be more on that debate, but note that nobody denies that, somehow or other, the equity cycle is turning. That can be seen by looking at the trends beneath the headline indices. Small caps finally underperformed the bigger stocks. Growth outperformed value, to a stunning extent. Financial stocks collapsed, as did the consumer discretionary sector. In all cases, this brought an end to trends that had lasted since the bursting of the internet bubble in 2000.
Another, less widely remarked, trend to end was the bull market in metals. After years of impressive gains, propelled by growing demand from China and other emerging markets, the Dow Jones AIG industrial metals index peaked early in the year, and then fell more than 20 per cent. Intriguingly, this appeared to have no effect at all on various emerging markets, such as Brazil, whose success had been predicated on booming raw materials prices.
There were some trends that did not turn. The dollar remained an international punch bag all year long.
Two commodities appeared entwined with the greenback, rising as it fell: crude oil, which hit a record price although it failed to reach $100 a barrel, and gold, which passed $800 an ounce. The gold price implies bearishness about the future, while the oil price, which rose for much of this decade on the same demand factors that pushed up metals, appears now to have reached the point where it may inflict a burden on developed economies.
Meanwhile, the emerging markets behaved more like the roadrunner: with a gleeful "Mbeep! Mbeep!," they disappeared in a cloud of dust, leaving the developed markets far behind.
But at the end of all this, the equity markets look remarkably unscathed. Some of the most important indices for the developed markets, notably the S&P 500, finally regained the all-time highs they set shortly before the tech bubble burst in 2000.
It is interesting, however, to see that equities have had difficulty making headway beyond their highs of 2000. The S&P has come to rest below its 2000 highs, while the main European indices such as the FTSE 100 and the Eurofirst 300 never quite got there before the credit market turbulence took over.
How can we explain all this? It may be overreaching to come up with an explanation for all these phenomena. The world is a complicated place. But it is tempting to couch the pattern of the past few years in terms of cheap money.
Over many market and business cycles, price/earnings ratios have shown a marked tendency to revert to a long-term mean. By 2000, the cyclically-adjusted p/e ratio (derived by comparing prices with a 10-year rolling average of earnings) had moved above 40, its highest ever, compared with an average since 1900 of about 16. In all previous cycles, peak valuations have been followed by an overshoot in the other direction. That did not happen this time, disconcerting the bears in the process. Instead, central banks, led by the Federal Reserve under Alan Greenspan, aggressively eased interest rates, making money very cheap. The cyclically-adjusted p/e dipped below 25, but then stabilised at a far higher level than would normally be expected.
That cheap money propped up stocks and also unleashed the boom in the credit market and in various housing markets across the world. But it was not enough to propel stock markets to new highs and the contradictions involved with such cheap liquidity are now being ruthlessly exposed. The implication is that either earnings or share prices have much further to fall.
Such a view may well be proved unnecessarily gloomy. Once 2008 is also in the history books, we will have a better idea. But for now, although blackened and flattened, the coyote marches on.
.............................................
— FT Syndication Service