Global markets became extremely volatile last year. Stock, commodity and foreign exchange prices started to fluctuate wildly. The S&P500 index ranged from 800 up to over 1500 and then down below 700. The VIX volatility index, also known as the fear index, reached a sharp peak, shown below. How will markets behave in the future? When will financial stability return? Is market stability a thing of the past? And what will be the consequences of economic rescue plans? This article presents a brief overview of how market instability might unfold.
[Source: OptionVue Systems]
Volatility of Prices
The prices of many shares, commodities and currencies are now very unstable. They are moving wildly out of balance. They shoot up too high. The fall too low, and very quickly. Consider the oil price shown below, for example. Surely the oil price history can not reflect the real value of oil. The real value of oil probably lies somewhere in the middle of the chart, between the recent extremes of $40 and $150.
[Source: OptionVue Systems]
Many businesses find it very difficult to operate in this volatile environment. They can’t predict prices or exchange rates, and they can’t make reliable forecasts or budgets. Many are shedding employees, reducing the scale of operations, or closing.
Trust
But businesses face an even bigger problem than volatility: many can’t borrow money. And their customers can no longer borrow money. Much international trade can no longer be financed.
The core of the financial crisis is that trust has been destroyed. The financial system relies upon trust. Banks and other lenders can no longer trust the creditworthiness of borrowers as confidently as they once did. Balance sheets, budget forecasts and credit ratings can no longer be relied upon. That’s why less money is flowing around the economy. This affects nearly everyone in the economically developed world.
Financial Over-reaction
Financial authorities seek a quick fix to the global financial crisis. In their haste they are possibly over-reacting. Rescue plans have been very large, and hasty. They seek to get money flowing around the economy again, and quickly, before too many businesses and people go bankrupt. Much economic policy is now reactive, driven by the immediate fear of deflation, recession, and short term political consequences. Longer term goals, such as the control of inflation, debt and budgets, are being sacrificed to fix financial problems in the short term. Some stimulus packages and rescue plans have been a little heavy handed because they create large debts which will have to be repaid over many years, and they are injecting unprecedented levels of liquidity into the system.
Rocking the Boat
The situation is a little like a “landlubber” family in a little boat. The children all rush to see a fish over one side. The boat tilts. The family pet labrador rushes over to join the children’s excitement. The boat tilts over dangerously more. The adults quickly shift what weight they have to the opposite side of the boat to restore balance. The fish then swims underneath the boat to the other side. First the children follow to see the fish. This is called instability. Market volatility is price instability.
The market value of many of the world’s largest corporations have risen and fallen across a very great range during the last two years. The S&P500 index, shown below, measures the combined market value of many of the world’s largest corporations. The valuations are driven more by collective mass perception than by actual underlying value. Prices are driven by psychology and sentiment about the future. What would be a natural level of the S&P500 if prices were stable? After all, the underlying values of all those companies which make up the index can’t be changing so wildly. Will prices stabilize around a realistic valuation?
[Source: OptionVue Systems]
In the little boat described earlier, when the children and the dog join the big people on one side of the boat, the boat risks tilting too far the other way. The adults would then need to quickly shift their weight back across to the other side to restore equilibrium. This alternation between extremes could go on forever.
Interest Rate Instability
We have already seen instability in short term US interest rates. To stimulate the economy rates were cut from near 6% in 2001 to 1% in 2004. Some say too low. To slow an overheated economy rates were then raised to 5.25% in 2006. Some say too high. Now they’ve been cut down to near zero to try to get the economy going again. The chart below looks a little like a boat rocking too far to either side. But that’s not low enough to create the desired stimulus. They need to go lower, but rates can’t go below zero. That’s why instead the authorities are now “printing” large quantities of new money, under a “quantitative easing” policy. They are “easing” monetary policy by increasing the quantity of money in the system. But that money hasn’t started to flow around the system yet. Many businesses still can not borrow the money they need to continue normally. The extra money and low interest rates have not restored the trust which is needed. Money doesn’t buy trust.
[Source: www.tradingeconomics.com]
When the money starts to flow around the economy again, conditions will improve. When conditions improve, more money will start to flow, and more rapidly. Improvement causes more money to flow, and the flow of more money causes more improvement. Each amplifies the other. But when all of the money flows around again as quickly as it did before, during the good times, there will be undesirable consequences. Too much money in a system causes inflation. The authorities will have to remove liquidity from the system again to prevent inflation. They will have to make a major move back in the other direction, somehow to remove from the system all the extra money which they are now injecting in unprecedented quantities at an unprecedented rate. They will need to make a weighty shift back to the other side of the boat. If they react too quickly and too heavily, they might shift too far again.
Ongoing Financial Instability
We might see significant instability in many prices for years to come. Share prices, commodity prices and foreign exchange rates might repeatedly fly too high and plunge too low, in short cycles. Each extreme causes a reversion too far to the other extreme. I would not be surprised to see a sequence of large price bubbles and busts over the coming years, until all of the disequilibria have been allowed to work their way out of the global system. The investment world may indeed be a very different place. Old investment strategies will no longer apply.
People in little boats want to be able to remain seated calmly, without getting wet, and without having to move too far too quickly. And they don’t like moving reactively or in a panic. People in little boats prefer ideally to move pro-actively and in a calm stable fashion. It seems that some of the financial moves to solve the crisis might be too much, too quickly.
Markets in the Future
Large stimulus packages might be sowing the seeds of ongoing instability. Because of the huge scale of the financial authorities’ reaction to the crisis, we might see a series of large booms and busts over the coming years. Prices may well continue to fly to wild extremes: too high, too low, and then back up too high again, as all the extra money in the system flows around the globe, essentially out of control. Some markets might swing between having too much money and then too little. Volatility may be here to stay for the foreseeable future. Stock market stability may well be a thing of the past, at least for a few years.