Now that the sunshine of Easter has passed, it’s time for some doom and gloom. We live in a society that rushes towards the end game, whatever the end may be. People as individuals can employ critical thinking. People as a group tend to migrate as a herd. The behavioral side of economics has just begun to gain traction. We are going to look at a small slice of it through the examination of market cycles and why the recent sell off in the stock market may be a clue of bigger things to follow.
There are two storm clouds on the horizon the Euro crisis and the U.S. equity markets. These two episodes could combine to force global equity markets lower, sharply hike interest rates on sovereign debt and create a super rally in the U.S. Dollar.
The European debt crisis started with Ireland. They had been the model child for development within the European Union. Prior to the debt bubble collapsing, their unemployment rate was at an all time low of 4%. Home ownership had sky rocketed and they were quickly emerging as a force in the financial services sector. However, their banks and the Irish people had assumed the continuation of their upward trajectory was a given and based tomorrow’s payments on today’s earnings. When the crisis hit in November of 2010, they transferred privately owned bank debt to the people through government issuance of new debt at a higher interest rate to attract buyers. However, it was quickly realized their paper was simply junk and they were bailed out by the European Union and the International Monetary Fund as well as other independent sovereign nations.
Greece was in a similar situation and is now receiving bailout terms better than those that were offered to Ireland. This has led the Irish people to decide whether they intend to repay the ECB at all. Furthermore, the issue of Spain’s debt is now on the front burner. The interest rates Spain is paying on the open market to finance their debts are unsustainable. The Spanish debt is distributed among its citizens through over extended mortgages, much like our own. However, Spanish law does not allow easy outs to greedy individuals the way we do. Therefore, Spain will need a bailout and due to the size of its debt ($2.4 Trillion) will want better terms than Greece ($550 Billion). Finally, now that the bailout procedure is established, they’ll be able to push for similar treatment.
Ireland, November 2010. Greece, February 2012 (2nd bailout). Spain, ? 2012.
The cycle is shortening and speeding up as the players of the game learn the bailout rules. The simple rule is that it’s first come, first served. The race to the rescue funds has begun.
Abruptly changing gears to look at the U.S. equity market and starting with the tech bubble of the late 90’s we can see that investors were willing to pay for tomorrow’s earnings today. The herd then paid for next week’s earnings, next month’s, next quarter’s and so on until all valuations were skewed.
The 2007 rally saw a test of the 2000 highs. However, company earnings were far less than they were through the tech rally. Much of 07’s rally was based on easy monetary policy and cash out refinancing. Finally, out of the financial crisis of 2009 we have gotten most of our money back on WEAKER earnings still. A market flooded with Dollars fueled the ‘09 rally. The price to earnings ratio of the S&P 500 has been in a steady downward trend for the last 10 years. A fall in share price from these levels would be expected. A solid rally will see the P/E ratio increase with share price but the time is not yet. This is simply the third wave of weaker highs.
Finally, there is a real possibility that a declining stock market may coincide with the needs for further bailouts. Further sovereign bailouts will deeply erode investor confidence. This will force higher sovereign yields across the board as investors demand higher payment for holding risky paper assets (could sovereign yields outpace corporate yields?). The rise in yields will crack the 30-year bull market in bonds, further reducing investors’ willingness to buy. This leaves the U.S. Dollar as the only currency liquid enough to absorb a tidal wave of safe haven money looking for a home. Ending on a brighter note, this will make it far cheaper to vacation overseas with your family in 2013.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer