" Plunging markets are far from irrational | Oliver Kamm - Times Online

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From The Times
October 28, 2008

Plunging markets are far from irrational

There is a simple explanation for falls in share prices - investors fear a depression is coming

Oliver Kamm

In the month to date, stock markets in the US and Europe have declined by more than a quarter. In Asia they have fallen by slightly more. And with these declines has come a surge in stock market volatility.

Why is it happening? Does it matter to anyone except the traders shown slumped or shouting on television? And is this any rational way to run an economy?

Perhaps surprisingly, the answers are fairly straightforward. And the main lesson to be drawn is not that capital markets are inherently dangerous and destabilising. It is rather that they can help to protect people from future risks that were disastrously overlooked in the long build-up to today's financial crisis.

Stock markets have been collapsing for three main reasons. First, in more stable economic times, investors often employed a practice known as the “carry trade”. This meant borrowing in a currency with a very low interest rate - typically the yen - and investing the money in higher-yielding markets (Australia and New Zealand are good examples). As interest rates have been slashed throughout the developed world, this trade has become much less attractive.

Secondly, the crisis has exacted a heavy toll on hedge funds. These are like upmarket mutual funds for very wealthy private investors. They differ from, say, pension funds or unit trusts in two main ways. They can borrow to invest (known as leverage); and they can sell stocks that they do not own, in the hope that the price will fall and they can buy the stock back at a profit (known as short-selling). This means that hedge funds are often better placed to take an opposite position to conventional investment fashion than funds with a more conventional mandate.

Yet with neither justice nor logic, hedge funds have suddenly assumed the role of villain, according to tabloid mythology of the credit crisis. More seriously, regulators have curtailed their capacity to sell short. This is misguided. It is contributing to a flood of redemptions from hedge funds - which requires the funds to sell their assets.

Thirdly, and most important, investors are considering the economic outlook and concluding that there are immense risks to their future wealth. The value of any financial asset depends on how much cash it will generate for an investor in the future. In the case of a bond, the cash flows are the stream of future interest payments. In the case of a stock, they are the stream of future dividends paid out of corporate earnings. To work out what those cash flows are worth now, you have to apply a discount rate to your expectations for the future payments. A dividend payable in 2010 is less valuable to an investor now than a dividend paid in 2008, because it is less certain - so you have to apply a higher discount rate it to work out its value today.

Quite suddenly, the risk to the world economic outlook has ratcheted up. Investors see bad data and the collapse of leading banks, and worry that a cyclical economic downturn might become a depression. The risk of a seriously nasty outcome means that companies' future earnings are less certain. So sharp falls in stock prices, and the volatility of stock markets, are far from irrational. They are a signal - not a cause - of the underlying stresses in the world economy.

How far does this matter to the ordinary consumer and saver? It matters because most of us have money tied up in pension funds, which are invested, to a greater or lesser extent, in the stock market. The only sensible course to take is to regard investing as a long-term discipline. Investment returns become less volatile on average - and hence less risky - over longer time horizons.

And yes, financial markets are a valuable feature of a modern economy. They put companies who need money, and can use it productively, in touch with people who have money, and hope to boost their financial returns by investing it.

Is this not a trite conclusion, given all that has happened? No, it is not. The ructions that have engulfed the Western financial system come down to many things - but they started in the US housing bubble. The housing market in the UK has also frozen up. Houses are a huge investment for most of us - yet are terribly difficult to trade.

Robert Shiller, a Yale economist, has recently proposed a remedy in an outstanding short primer, The Subprime Meltdown. He argues that creating derivatives markets in house prices would help to tame the cycle of boom and bust. Sceptical investors could express that view in more immediate ways than selling their own homes. Housebuilders would note the expected price declines signalled by the market, and scale back their building activities.

Shiller's idea is plausible. It illustrates how financial markets need not be the casino or bearpit of popular criticism. Investment is above all about efficiently managing risk. Investors can spread their risk by diversifying their portfolios across stocks and asset classes. Financial markets also enable businesses to hedge against risks. These are valuable disciplines, and they can help us in future. As Shiller envisages, they might even correct the most damaging distortion in our economy: the fascination with bricks and mortar, to the detriment of making things and providing services.

Oliver Kamm is a Times leader writer and former investment banker

As if investors were taking cash from the exchanges and piling coins under the bed. When in fact value was wiped from the exchanges because this was money that didn't exist. And instead you propose another means of leveraging! Never join that East End poker game unless you can cover your bets ...

Richard, Seattle, USA

So, is this what former investment bankers do now?Better than begging I guess.Shiller's idea isn't plausible as the derivatives would follow/amplify a bubble like any other.Try encouraging people to save more,and companies to concentrate on delivering dividends-or is that too old school?

mark, brussels (uk xpat), belgium

Mr.Schiller's idea is brilliant. The house, due to tax advanages, has gained in value far beyond its real value but worse it has sucked in captal that could have been used to finance new industries and services. If those disappear then the houses could be worthless.Detroit has $2000+houses for sale.

Roger Corfield, Arusha, Tanzania

why tax on first homes? there should be restrictions on borrowing - both on loan-to-value and on salary multiples. but better to leave the markets - equity holders take risk. bail them out and there's no incentive for a company to shape up. tax less, spend less but better, interfere less. brown out.

jem, london, uk

My government just destroyed 3/4 of a trillion dollars with FASB Rule 157. B/c of fractional reserve banking, that destroyed $7 trillion and counting in lending capacity. In other words, $7T in capital to fund future growth has been destroyed. So yes, in that sense, markets are reacting rationally.

Wendy, Federal Way, WA, USA

"Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works"

John Stuart Mill

Andy, London,

For too long various 'service' & 'financial' companies were growing at an unbelievable speed & rate, causing stock markets to keep going up.
We had a financial companies with staff of 16 worth £4bn?
Now is the correction time.
All this false and 'created' growth is being adjusted to its real value.

savo, london, uk

I'm just an average joe (I'm not a plumber) who pulled everything out of the market at 11,500. Irrational? maybe. But I don't understand derivatives, credit default swaps, the role of hedge funds, etc. Make the markets more understandable and people will re-invest. Until then, I'm out.

Ed, Sebring, FL, USA

The markets may not be the problem, rather the analysts and fund managers who fail to explain the risks to the public, and have a vested interest in talking up the market. In 1998 the FTSE was higher than it is today, so how long-term does investment have to be with so-called fund 'managers'.

S. Smith, London, UK

The plain fact is that the stock markets are just not the way to run the world economy!! The wild swings in the market values are clearly somewhat irrational!! Whatever movement does happen is often a gross over-reaction.
We need to find a better way to run our economies since it is our future!!

Dr V B Petersen, Cape Town , South Africa

The simple way to 'correct the most damaging distortion in our economy: the fascination with bricks and mortar, to the detriment of making things and providing services' is to tax gains on first houses as they do in other countries. The present situation is ridiculous.

Colin, shrewsbury,

You are too optimistic about builders reacting to feedback. Here we are in the umpteenth month of the financial crisis, and the little town where I live is still committed to building a brand-new Mall. There is little finance and no signed-up tenants, but the construction continues.

jon livesey, Sunnyvale, CA/USA

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