Things Are No Different After All

Source : The Business Times, January 23, 2008

FOR months, the warning signs were apparent, but euphoric investors, boosted by a liquidity-driven bull market that had lasted more than three years, chose to ignore them. Furthermore, they were lulled into complacency by repeated bouncebacks from various shocks ranging from Chinese monetary tightening to the yen 'carry trade'.

Now, in the space of months, markets are making up for lost time, rapidly repricing risks even as abject fear replaces complacency and bewildered investors find themselves firmly in the grip of the bear.

The first whiff of the beast came when global markets were jolted by a Wall Street plunge on Friday, Aug 3 last year, following release of a weaker-than-expected US jobs report and news of massive layoffs at American Home Mortgage Investments because of a collapsing property market.

On Monday, Aug 6, the Straits Times Index (STI) plunged 127 points or 3.7 per cent to 3,308 in response to worries over the exposure of local banks to US collaterised debt obligations (CDOs), but thanks to a slew of immediate 'buy' reports from local analysts, it rebounded 111 points the next day. Two months later, it hit an all-time high.

In recommending a 'buy' on local banks, one foreign house at the time said '(the selling) is clearly an over-reaction and we would urge investors to buy the Singapore banks . . . at current prices. The risk from CDOs has been priced in'.

A foreign research house at the same time wrote that its analysis showed that there were no signs of a bear market and urged clients to stay invested. '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 enormous supply-side expansion,' it said.

To be fair, analysts were not entirely to blame for being so wide of the mark. Banks themselves were unaware of the extent of the problem and even normally conservative public sector officials were quick to step forth with reassurances - Mervyn King, the Bank of England governor, on Aug 8, said sub-prime woes were largely confined to the US and there would be no international crisis as a result.

Moreover, until only very recently, US Federal Reserve and Bush administration officials maintained that US growth was robust, the economy was resilient and despite a crashing dollar, there was nothing to worry about.

A further factor at play in fostering complacency in the face of rising risk was market conditioning - for example, a mini-crash in China early in 2007 raised contagion fears that sent stocks diving, but the resulting correction was short-lived because China quickly recovered. Similarly, the unwinding of the yen 'carry trade' adversely affected stocks for only a few days before the rally resumed.

Because the bull repeatedly reasserted itself in the face of such adversity, the majority of observers expected the US sub-prime crisis to blow over just as quickly. The mantra from the bullish camp was 'this time is different'.

Not all analysts and brokers were bullish - Morgan Stanley was among a small minority to warn of impending danger, writing last August that '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'. It is very likely that just as markets are liable to overshoot on the upside because of irrational exuberance, they can equally overshoot on the downside because of irrational fear. In fact, until the full extent of the US slowdown and its impact on all corporate profits - not just the banks' - is known, markets could still come under intense pressure. As we noted last August, things are really no different from historical trends.