Different This Time? Be Very Afraid...

Source : The Business Times, August 7, 2007

Real culprit is complacency fed by a 4-year liquidity-driven bull market

ACCORDING to conventional wisdom, the source of the problem in stock markets all over the world is the rapid deterioration in the US credit market caused by the sub-prime mortgage crisis.

If one were to trace this back even further to divine the 'real' cause, fingers could be pointed at a crashing US property market and high interest rates which have triggered massive defaults on those mortgages which in turn then caused the present crisis.

These are undoubtedly symptomatic factors that have contributed to the current turmoil in financial markets. The real culprit, however, is something far more insidious.

It is complacency, born from a four-year liquidity-driven bull market which had investors believing that 'this time is different'; complacency bred on an uncommon conditioning to believe that all corrections would be short-lived because, well, because 'this time is different'.

Thus far, it appears that most observers are holding on to this view, the consensus outlook being that although the market may undergo more short-term pain in the next few weeks, its strong fundamentals should eventually prevail.

In its Aug 3 Global Investment Strategy for example, Canadian research house BCA Research summarised this view when it said that although the damage from the sub-prime fallout will persist for a while because problems are more pervasive than first believed, it does not believe the recent selloff signals the beginning of a bear market.

'There is plenty of growth outside of the US economy: economic news from China and the rest of Asia has been very strong . . . suffice to say that the world economy is still in a low-inflation boom, driven by an enormous supply-side expansion', it said.

It all sounds very appealing - in cliched broker jargon, the present mini-crash qualifies as a 'much-needed correction' for an 'overbought' market that might even present 'bargain-hunting' opportunities.

Once 'overbought' becomes 'oversold' and once the market has 'digested' the bad news, it should easily be able to resume its uptrend.

To be honest, such a happy scenario is entirely possible. The problem, however, is that 'this time is different' can cut both ways. Over the past 15 months global markets have been rocked as violently as they are now on three occasions - in May last year when US Federal Reserve chief Ben Bernanke unwittingly stoked inflation/interest rate fears, in February this year when China crashed 9 per cent in one day and in April when China again crashed on fears of the unwinding of the yen 'carry trade'.

In each instance prices recovered quickly, thus enhancing the complacency and conditioning referred to earlier. So it's no surprise that the prognosis for the present crisis is the same as before - a brief period of pain before the bull run resumes.

But surely the spreading rot from the sub-prime crisis suggests the rather inconvenient truth that this time really is different because it is the crucial financial sector which is under threat, and that it would be too simplistic to expect a swift return to the heady days of May and June when stocks regularly rose to all-time highs?

US broker Morgan Stanley is possibly the only big name so far to share this view. In its Aug 5 assessment of the exposure Singapore banks have to the US mortgage fiasco, it hit the nail on the head when it wrote 'the market has for some time exhibited excessive optimism, driven by liquidity rather than fundamentals and hence has been willing to extrapolate the positive and ignore the negative'.

The truth is that no one knows yet the full extent financial stocks everywhere are exposed to the US sub-prime market's problems and it may take several weeks or maybe months before all the rot is uncovered. And if the financial sector is undermined, so is the entire market.

Until then investors will remain nervous while hoping for salvation from the US Fed in the shape of interest rate cuts (the futures market is now pricing in at least two rate cuts over the next 12 months).

However, buying heavily into 'this time is different' too soon would be a dangerously risky proposition because ironically, this time round, it is not the reasons to buy which are different but the reason to sell.