Sunday, April 20, 2008

Four questions we must ask ourselves this Passover

(John Authers in the FT) At Passover the world's Jews gather to commemorate the Hebrews' flight from Egypt and eat a stylised dinner known as the Seder .

Central to the undertaking are four questions, which must be asked by the youngest participant, on the meaning behind different Passover traditions.

In the Passover spirit, here are four questions that demand to be asked about the confusing state of the markets, and some attempts to answer them. The answers to the Passover questions are straightforward; the problems with the markets, less so. *

Why has the S&P 500 barely fallen 10 per cent from its all-time high, when other markets are behaving as though the world were in deep crisis ?

Stocks' resilience is often cited by bulls. There was a (questionable) perception as the crisis started that stocks were cheap. If brokers' estimates for this year's earnings are accurate, they are much cheaper now, as earnings are supposed to grow at double digits starting in the next quarter.

Then there is a widespread belief that the fire sale of Bear Stearns last month was a moment of catharsis. Folk wisdom is that such moments are the ideal moment to buy.

The argument is self-contradictory: so many people believe this that it is obvious the market has not reached catharsis.

Also, stocks are not as resilient as they look. International indices tend to be quoted in dollars and are inflated by the dollar's weakness. In local currency terms, world industrial stocks are down 17 per cent from their top, and consumer discretionary stocks are down 26 per cent, according to MSCI.

Mining and energy stocks, buoyed by commodity prices - which have their own issues - help mask this.

* Why are money markets sinking into severe trouble again, when central banks have done so much to force them them to return to normal?

When they are working, nobody notices the money markets, which banks use to lend to each other. One of the painful lessons of the past months is that any sign of their malfunctioning must be taken very seriously.

The clearest indicator of trouble is when the Libor rate - the benchmark at which banks lend to each other - rises significantly above the official government interest rate. This indicates banks are hoarding cash or are unprepared to lend to each other.

Co-ordinated action by central banks in December was meant to address this, and the spread of Libor over official rates came down.

But since the Bear Stearns debacle, which should have been an emphatic signal that the Federal Reserve was there to stand behind dodgy-looking collateral from other banks, money markets have seized up again.

Libor's spread over official rates has widened by about 0.25 percentage points.

It is hard to explain this unless the bankers are afraid of something that has not yet reached the light of day. It strikes a bizarre contrast with the returning confidence in other sectors.

* Why are commodity prices rising when, with people so worried about the economy, we should expect them to be falling?

This is also critical, on many levels. In the aftermath of the Bear Stearns debacle, commodity prices tumbled, with the main indices for the sector falling more than 10 per cent in less than a week. But that turned out not to be a turn but merely an interruption.

Oil has regained its losses to set all-time highs. Other commodities have regained about half of their lost ground. The S&P GSCI commodity index is back at an all-time high, and up more than 11 per cent since its post-Bear low.

No explanation is encouraging. The sector may be in a bubble as investors look for an inflation hedge. Or they are reacting to scary signs that global supply of commodities from oil to rice is knocking up against capacity constraints. That would depress economic activity.

* Why do so many believe that the US economy will make a swift recovery, when the credit problems are only just starting to affect the real world?

In the US, no indicators yet show anything more than a light recession. If employment falls more, that will change. But the bulls' argument is that the US is getting such a jolt - from tax rebates, base rate cuts and the weak dollar - that it can scarcely help recovering.

Further, the precipitous decline in housing activity, with starts down almost 60 per cent in two years, cannot go on much longer. It has taken a huge bite out of economic growth. If it merely stabilises at a low level, that will be enough for growth to start improving.

The arguments against are clear: the credit squeeze has yet to hit Main Street, while the wealth effects from lower house prices and higher food and fuel prices could kill off the consumer.

Traders hope the economy can make a V-shaped recovery. If there is clear evidence of this, shares will go far higher. If it is only a U, or even the dreaded L, watch out.

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