Of irrational apathy and exuberance!

In 1996 Alan Greenspan, then the chairman of the Federal Reserve Bank, when addressing the American Enterprise Institute enquired, “… But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Just over a month ago, fixed-income investors saw a bleak future on the horizon. Some bond traders lamented the fact that government was not issuing enough paper and that the appetite for corporate paper has fallen, impacting on the liquidity of the market. However, the main concern also was the negative outlook for inflation, which has negatively impacted on the spreads between medium- and long-term bonds.

Suddenly Investec Asset Management releases a report that suggests that fears of inflation are exaggerated since the CPIX number needed rebasing. Every Tom, Dick and Jabulane sitting behind the trading desk reacted with such remarkable exuberance to this news as if such information had not existed in the market before. The bond market immediately moved into a bull phase and financial stock leaped to its highest in two months.

This sudden “correction” defies all logic since market participants should have acted on such information long before Investec Asset Management confirmed what was already common knowledge in the market.

Earnings forecasts of banks globally have suffered downward pressure as a result of the sub-prime debacle and unfavourable US economic conditions. Incidentally, in 2000 Governor Edward M. Gramlich of the Federal Reserve Bank of Philadelphia lauded the ingenuity of banks in expanding the home mortgage market to all socioeconomic classes. It was of no consequence or concern that banks were granting loans at record levels to borrowers with suspect credit history. Eight years later, the chickens came home to roost!

The release of better-than-expected results by some US banks, namely Citigroup, JP Morgan, Wells Fargo and PNC Financial Services Group, helped financial stocks to rally sharply in a short period of time. It is not that these banks have made significant profits, which excited market participants, but that they have posted less than expected losses.

It is important to note that the consequence of financial woes of US banks had no specific relevance to local banks. None of the local banks, besides Investec, suffered losses as a result of the sub-prime debacle and in fact they had reported healthy profits at their respective year-ends. Although earnings forecasts of local banks have been moderated, none of them is expected to be issuing profit-warnings.

What is perplexing is how local market participants appear to base their trade decisions on the reaction of US and EU market participants to earnings outlook of US banks. The circumstances under which US banks embarrassed themselves and posted massive losses are irrelevant to the local conditions.

The extent to which financial stocks in SA have declined in the last few months and the depressed bond market, and how they revived, is confirmation that we markets are not irrational; it is those driving the markets that are irrational. One would have thought that stocks presenting investors with an attractive dividend, especially those of local banks, would have traded at more than disappointing levels. If local banks were listed on the US stock exchanges, then the reaction of the market would have made more sense.

Although the US economy is on a go-slow, the global economy remains in a longer-term growth phase. Developing economies still account for a larger share of the global net production growth, which does not explain the negative sentiment by markets on these economies, and particularly in respect of financial stocks in these economies.

The markets are somersaulting between extraordinary levels of irrational apathy and exuberance. It is troubling that those who drive markets appear not to be employing their full capabilities to analyse data and forecast future trends; than to base their optimism and pessimism on extraneous information and destroy value for investors. The great random leveler in the market place – luck – arguably appears to be playing an ever-increasing role as a determinant of success and failure of market participants.

Joseph Stiglitz in his book, “Globalisation and its Discontents”, contends that markets, when left to their own devices, distort their own functioning. Perhaps market participants should not be left to their own devices.