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An uneasy calm has settled over financial markets.
Economist Staff, The Economist
February 21, 2007
It is a scene familiar to all Western lovers. The cavalry is riding through a mountain pass. One officer turns to a comrade. "I don't like it," he says nervously. "It's too quiet." The next second, an arrow hits him in the chest.
The financial markets are in a similar state of nervous anticipation. Things have been going extremely well. According to David Rosenberg of Merrill Lynch, the American stockmarket has sustained its longest run since 1954 without a day's decline of 2 percent. The interest-rate spread offered by high-yield, or junk, bonds over Treasury bonds is thinner than ever. Volatility is low. A market "correction", aimed straight at the chest, seems overdue.
The terminology of financial markets can be imprecise. A crash is a sudden, precipitate decline like "Black Monday" in October 1987, when the Dow Jones Industrial Average fell by 22.6 percent in one day. A bear market is a longer-lasting event such as the period from March 2000 to March 2003 when British share prices fell by half. A correction is somewhere between the two, neither as violent as a crash nor as prolonged as a bear market, with prices falling by around 10-20 percent.
Bull markets are generally interrupted by a few corrections. Apart from the 1987 crash, the great bull market of 1982-2000 saw setbacks in 1990, 1994 and 1998. There was a wobble in May-June last year (emerging markets took the biggest hit), but this bull market has trotted on pretty serenely for four years.
Corrections can be caused by economic downturns or by some kind of unexpected event, such as the Russian debt crisis of 1998. But they could also be seen as part of the natural rhythm of markets, as traders and investors pocket profits before climbing to new peaks.
What might prompt a correction now? One possible trigger might be the trend in corporate profits. For more than three years, American profits have been growing at an annual rate of over 10 percent. This has lent strong support to the stockmarket.
But capital is taking a bigger slice of America's national income now than in any of the past 40 years. Even if profits could hold that share, they would merely rise in line with the economy, perhaps by 5-6 percent a year (including inflation). Already, the pace appears to be slowing. In the fourth quarter of 2006, according to Capital Economics, a consultancy, the proportion of S&P 500 companies reporting disappointing earnings rose to its highest level in more than two years. If that trend continues, investors could lose heart.
Then there is debt. Last week HSBC admitted that its riskier American mortgage-holders were defaulting in unexpected numbers. American banks have also become noticeably more restrictive in their lending standards to companies, according to Albert Edwards, the famously bearish strategist at Dresdner Kleinwort.
Historically, tougher bank attitudes have been associated with changes in the default rate for corporate bonds. That default rate has been very low over the past three years, a big reason why corporate-bond spreads have been so narrow.
But a sudden upturn in consumer- or corporate-debt defaults could prompt a sell-off in the bond markets. That could easily trigger stockmarket weakness and would also prove an interesting test of the robustness of the credit-derivatives markets, where investors insure themselves against default. The derivatives market was a lot smaller when defaults last peaked, in 2002.
Or perhaps the selling will be set off by geopolitics. The war of words between America and Iran continues unabated, and with America intensifying its efforts to pacify Iraq, there is a danger that the two sides may blunder into military conflict. Now that investors (and consumers) have become used to oil at $50-60 a barrel, a sudden leap to $80 or even $100 might prove very damaging to confidence.
Sometimes, the cue to get out of shares comes from within the market itself, as in 1989 when the collapse of a buy-out offer for United Airlines prompted a sharp decline in prices. Investors are now fixated on hopes of multibillion-dollar takeover offers from private-equity groups. Were a big deal to fail, investors' disappointment might turn to broader disaffection.
Of course, markets are used to clambering over a "wall of worry" and they may already have discounted any or all of these possible triggers and traumas. But as Merrill Lynch said recently, there is "a whiff of complacency in the air". And that can be dangerous. Remember the American civil war's General John Sedgwick, whose last recorded words were: "They couldn't hit an elephant at this distance."