Monday, 13 October 2008

A bloody week for stocks

Last week was a tumultuous one for global stock markets, with many markets seeing record-breaking losses.

The MSCI World Index of 23 developed markets lost 20.1 percent, the most since records began in 1970. In Europe, the Dow Jones Stoxx 600 Index fell 21.5 percent, its worst weekly loss on record. The MSCI Asia Pacific Index fell 17.8 percent, also its worst weekly loss on record.

National stock indices also saw record-breaking declines. The Standard & Poor's 500 Index lost 18.2 percent, its worst loss since it was reconstituted as a 500-stock index in 1957. Japan's Nikkei 225 Stock Average lost an even-greater 24.3 percent, the worst weekly decline since its creation in 1950.

Most of the other major world stock markets fell around the same order of magnitude last week. In fact, last week's losses constituted a very substantial proportion of the declines in stock markets this year so far.

It is, of course, all the consequence of the credit crisis.

The development of this credit crisis last week can be seen in the movement in the London Interbank Offered Rate (LIBOR). LIBOR for three-month US-dollar loans rose to 4.82 percent on Friday, up from 4.33 percent the previous week. With three-month US Treasury yields falling to 0.18 percent on Friday from 0.47 percent the previous week, the difference between the two rates, or the TED spread, is now at 464 basis points, the highest since Bloomberg began tracking the data in 1984.

The rise in the LIBOR occurred despite coordinated rate cuts by some of the most important central banks in the world. The Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada and Sweden's Riksbank each reduced their benchmark rates by half a percentage point on 8 October while the Swiss National Bank lowered its target range for the Swiss franc three-month LIBOR. The People's Bank of China also made a contribution by cutting its official rate by 0.27 percentage point while a day earlier, the Reserve Bank of Australia had cut its benchmark rate by a full percentage point.

Apart from the rate cuts, steps taken by governments so far include guarantees of bank loans and deposits and capital injections into banks. There is also of course the United States' controversial Troubled Asset Relief Program, which aims to relieve banks of troubled mortgage assets.

While the steps taken thus far have largely been unilateral, uncoordinated and ad hoc, there is a clear movement towards changing this. At the Group of Seven meeting at the end of last week, government finance ministers agreed to, in their own words, "take all necessary steps to unfreeze credit and money markets". Then on Sunday, leaders from the 15 countries that share the euro currency announced a plan to address the financial crisis that included state guarantees for bank debt and injections of state capital into banks.

At some point, all the government actions being taken will eventually stem the financial crisis. Markets will then bottom and, eventually, recover as well.

However, the recovery may take some time. While some market commentators have asked whether the past week represents a capitulation by investors, thus marking a bottom in the market, I think this question is premature. While a short-term bottom is possible, even probable, a longer-term bottom is more likely some way off.

The government actions being taken are designed primarily to slow the financial deleveraging process, not stop it. With continued deleveraging, financial institutions and investors will remain under pressure to sell assets, which will in turn put continued downward pressure on prices.

Continued deleveraging also means that we will still have an economic recession to go through. With a recession, corporate earnings are going to be depressed. This will hurt stock valuations that currently may look attractive after the recent fall in prices.

In any case, even if a recovery is imminent, investors may have relatively limited upside potential from stocks at current price levels. The financial crisis surely means the end of the credit bubble. This in turn means that earnings growth once the economic recovery is underway is unlikely to match that of the past decade or so. It also means less money will be available to fuel another bull market in stocks, especially with governments likely to be competing for money to deal with the effects of the recession.

Still, even if the bloodbath in stock markets last week turns out not to be the capitulation that market-timers have been looking for, there is little doubt that there has been a large shift in the psychology of stock investors. The sense of crisis that has pervaded credit markets for some time has finally hit stock markets with full force.

So even if stock markets did not hit bottom last week, they probably took a large step towards it.

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