Five reasons why this is a crash, not a correction

 

 

 

This is a market crash, make no mistake. There are those who talk about a technical correction, an intermezzo. Don't believe a word. If this was merely yet another period of exuberance in equity markets, as happens from time to time, I would not be greatly worried. But this time is different. There are several factors coming together.

 

First, we are living in a world with unrealistic expectation about future economic growth. The potential real per capita growth rate of most industrial nations is in the order of 2/2.5% per cent, a bit higher for some, a bit lower for others. The difference between the euro area and the US, if measured on a per capita basis, is not as big as some people think, especially since many forecasters may have underestimated euro area productivity growth, and overestimated US productivity growth. With global inflation expectations – and targets – at about 2%, this suggests a nominal economic expansion in mature economies at a rate of 4/4.5%. Over long periods, and with stable wage/profit ratios, this is what we should expect in terms of market performance. Of course, the profit share has been rising at the expense of wages. But this trend is not going to continue indefinitely. I don’t predict a reversal in this trend either. But the current valuations are predicated on the assumption that the profit share is forever rising.

 

Second, the price of risk has been dangerously undervalued, to the effect that a bubble of previously unknown dimension has built up in the credit market. The corporate credit market has been operating on the basis that none of the risks ever turn sour. Junk bond spreads were never that low.

 

Forget the argument, espoused by those perennial optimists, that risk is nowadays spread more widely, and this is why the world is better insured against a global downturn. This argument is about as absurd as the argument in the late 1990s that there was such a thing as a new economy with its own distinct rules. A wider spread of risk is a great shock absorber for an asymmetric risk (for example, the risk caused by a natural catastrophe or a terrorist attack). But if we are faced with a symmetric shock that affects all categories of risk, all this means that we go down together – no matter how clever the products become.

 

Third, we see the emergence of some financial stress in parts of the market, notably the US subprime mortgage markets – the kind of industry that should have been regulated out of existence because its business model is a pure Ponzi game. There has been some contagion from the subprime to the prime mortgage industry, and there will be some contagion to other parts of the system. If you add in the stress that has already built up in the credit markets, this is another bubble that could burst simultaneously with the equity bubble.

 

Fourth, global exchange rates are out of kilter. The yen-euro rate is still hideously mispriced, despite the correction in the last few days.  While the euro will undoubtedly weaken against the yen, it will strengthen against dollar. As the US economy slows down, the US will look increasing less attractive to overseas investors, which have suffered a fall in real returns from their US investments. When the US fairy-tale economic story ends, global investors, and central banks, will shift their portfolios out of dollars and into euros.

 

Fifth – related to point forth – the global carry trade will unwind, and may causing point three. So this is not an entirely independent point. The carry trade is by definition an unsustainable form of trade, designed to arbitrage price differences between markets. The risk involved in these transactions is presently undervalued, which has prompted a vicious spiral (the carry traders would say a virtuous cycle) of falling spreads, and ever more carry trade. This will be stop at one point. And that point may not be far off.

 

So here are five reasons why this is a crash, not a correction. This does not mean that the price may not go up at some point this week. I am making no prediction about the timing, except to say that last week was the begin of a long bear market.

---