After some hair-raising swings in August, stocks appear to have found their feet again. The Dow Jones index finished August marginally ahead, while the FTSE 100 has risen around 8% over the past fortnight to a three-week high. But the jitters of the past few weeks are unlikely to subside anytime soon – and not just because September is traditionally the weakest month of the year for both US and UK stocks.
Financial markets are peering into a fog, says Patrick Hosking in The Times. Opaque derivatives, such as those at the heart of the credit crunch – collateralised debt obligations (CDOs), including securities based on subprime mortgages – are notoriously hard to value because they are so thinly traded, while banks are not obliged to report losses immediately. So there can be “long delays before losses are reported or crystallised”; the drip of bad news could go on for months.
People also forget how much leverage is attached to the $20trn credit derivatives market, says Anthony Hilton in the Evening Standard. Take a hedge fund that assumes it is two-times geared because half its portfolio is financed by borrowed money. If its portfolio consists of funds of funds (these are typically three times geared) that in turn own riskier classes of CDOs, which are normally nine times geared, then the combined gearing is 54 times (2 x 3 x 9).
Given this, Lombard Street Research calculates that this implies that a market move of just 2% could wipe out the entire portfolio and bankrupt the fund. But it gets worse: in a portfolio where the CDOs are themselves based on other CDOs – CDOs squared, or even cubed – then the gearing would also be squared or cubed. Nobody knows “what they have committed to or what it will cost them as it unwinds”. And markets cannot “gain composure” until we know where the “collateral damage [among banks and hedge funds] is”, says Justin Urquhart-Stewart of Seven Investment Management.
There has been plenty of talk about picking up cheap stocks amid the recent market falls; analysts note that the FTSE 100 is on a p/e of just 11, while the S&P 500 p/e of 17 is at a 12-year low. But for one thing, “how many will be prepared to take the plunge” given the uncertain extent of problems in the credit market, asks Neil Hume in the FT. And for another, stocks are only cheap if earnings hold up and there’s “not a lot of confidence” on that front, as a US fund manager told the International Herald Tribune.
As Harvard University’s Martin Feldstein points out, the US is in danger of a recession as the credit freeze crimps borrowing and indebted American consumers rein in their spending as home prices – which have underpinned consumption – slide. Financial sector earnings, which comprise a third of the total, look especially vulnerable; all told, a recession could wipe 35% off profits, says Albert Edwards of Dresner Kleinwort.
Moreover, profit growth is slowing anyway after the torrid pace of the last few years. Factoring in the economic cycle, the US market is still 1.8 times overvalued, calculates Smithers & Co. In the UK, too, profits have reached a high point and are set to pull back, says John Kennedy of the Scottish Investment Trust, and the consumer is facing a “crunch”.
Nor can stocks henceforth count on the buzz from mergers and acquisitions (M&A). The Wall Street Journal points out that the value of European M&A deals fell by 69% in August, a record summer fall, as private-equity deals caught by the credit squeeze petered out. It’s doubtful that lower US interest rates could resuscitate the housing bubble as loose mortgage lending has become a thing of the past. As Hume puts it, this is a “much-changed world” and making money “just became far harder”.