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> The Fearful Rise of Markets
>
>
> By John Authers
> Published: May 21 2010 23:13 | Last updated: May 21 2010 23:13
> It was early in March 2007 that I realised that two of the world’s
> markets held each other in a tight and deadly embrace.
>
> A week earlier, global stock markets had suffered the “Shanghai
> Surprise”, when a 9 per cent fall on the Shanghai stock exchange led
> to a day of global turmoil. That afternoon on Wall Street, the Dow
> Jones Industrial Average dropped by 2 per cent in a matter of
> seconds. A long era of unnatural calm for markets was over.
>
> Watching from the FT’s New York newsroom, I tried to make sense of
> it. Stocks were rising again, but people were jittery. Currency
> markets were in upheaval. In what was becoming a nervous tic, I
> checked the Bloomberg terminal. One screen showed minute-by-minute
> action in the S&P 500, the main index of the US stock market. Then I
> called up a minute-by-minute chart of the exchange rate of the
> Japanese yen against the US dollar. At first I thought I had
> mistyped. The chart was identical to the S&P.
>
> Had it not been so sinister, it might have been funny. As the day
> wore on and turned into the next, we in the newsroom watched the two
> charts snaking across the screen. Every time the S&P rose, the
> dollar rose against the yen, and vice versa. What on earth was going
> on?
>
> Correlations like this are unnatural. In the years leading up to the
> Shanghai Surprise, the yen and the S&P had moved completely
> independently. They are two of the most liquid markets on earth,
> traded historically by completely different people, and there are
> many unconnected reasons why people would exchange in and out of the
> yen (for trade or tourism), or buy or sell a US stock (thanks to the
> latest news from corporate America). But since the Shanghai
> Surprise, statisticians have shown that any move in the S&P is
> sufficient to explain 40 per cent of moves in the yen, and vice
> versa. Does this matter? Perhaps more than you might think. These
> two measures should have nothing in common, which implies that
> neither market was being priced efficiently. Instead, these
> entangled markets were driven by the same investors, using the same
> flood of speculative money.
>
> The Shanghai Surprise, we now know, marked the start of the worst
> global financial crisis for at least 80 years, and plunged the
> global economy into freefall in 2009 – the most truly global
> economic crash on record. Inefficiently priced markets drove this
> dreadful process. If currencies are buoyed or depressed by
> speculation, they skew the terms of global trade. Governments’
> control over their own economies is compromised if exchange rates
> render their goods too cheap or too expensive. An excessive oil
> price can drive the world into recession. Extreme food prices mean
> starvation for millions. Money pouring into emerging markets stokes
> inflation and destabilises the economies on which the world now
> relies for its growth. If credit becomes too cheap and then too
> expensive for borrowers, then an unsustainable boom is followed by a
> bust.
>
> And for investors, risk management becomes impossible when all
> markets move in unison. With nowhere to hide, everyone’s pension
> plan takes a hit if markets crash together. In one week of October
> 2008, the value of global retirement assets took a hit of about 20
> per cent.
>
> . . .
>
> Such a cataclysm should have purged the speculation from the system
> for a generation. But by the end of 2009, when I began thinking
> about writing this book, risky assets were well into a strong
> resurgence and markets were even more tightly linked than they were
> in early 2007. Once again it was impossible to tell the difference
> between charts of the dollar and of the US stock market. Links with
> the prices of commodities and credit remained perversely tight.
> Since then some of that fearful symmetry has dwindled, but that is
> largely thanks to the Greek crisis – which points to other glaring
> weaknesses.
>
> The financial disaster of 2007 to 2009, then, has not cured any of
> the underlying factors that led markets to become intertwined and
> overinflated and to endanger the world economy. This does not mean
> that another synchronised bubble followed by a crash is inevitable,
> but it does mean that such an event remains a distinct possibility.
>
> Like many other financial commentators, I had the unnerving
> experience of trying to disentangle what had happened and explain it
> in real time, facing a camera each day to try to give a two-minute
> potted “short view” for FT.com’s video viewers. Having to venture an
> opinion so publicly and so regularly at least has the advantage that
> you soon learn when you have got something wrong (FT.com viewers are
> not backward at coming forward). In the feedback, as many others in
> the markets tried to nail what was wrong, a few recurring themes
> began to stand out from the noise. Not all were part of the
> political dialogue at the time. So I tentatively tried mapping out a
> book that would give a “short view” of the causes that led our
> markets to malfunction so badly.
>
> Investment bubbles are rooted in human psychology, so it is
> inevitable that they should occur from time to time. Markets are
> driven by the interplay of greed and fear. When greed swamps fear,
> as it tends to do at least once in every generation, an irrational
> bubble will result. When the pendulum snaps back to fear, the bubble
> bursts, causing a crash.
>
> History provides examples from at least as far back as the 17th
> century “Tulip Mania,” when Dutch merchants paid life savings for a
> single tulip bulb. Then came the South Sea Bubble in England and the
> related Mississippi Bubble in France, as investors fell over
> themselves to finance prospecting in the New World. Later there were
> bubbles in canals. The Victorian era saw a bubble in US railroad
> stocks; the 1920s saw a bubble in US stocks, led by the exciting new
> technology of the motor car.
>
> But the past few decades have seen more and more bubbles. Gold
> formed a bubble that burst in 1980; Mexican and other Latin American
> debt suffered the same fate in 1982 and again in 1994; Japanese
> stocks peaked and collapsed in 1990, followed soon after by
> Scandinavian banking stocks; stocks of the Asian “Tiger” economies
> came back to earth in 1997; and the internet bubble burst with the
> dotcom meltdown of 2000.
>
> Some said this was understandable. From 1950 to 2000, after all, the
> world saw the renaissance of Germany and Japan, the peaceful end of
> the cold war, and the rise of the emerging markets – all events that
> had seemed almost impossible in 1950 – while young and growing
> populations poured money into stocks. Maybe the bubbles at the end
> of the century were nothing more than froth after an unrepeatable
> Golden Age. But since then, the process has gone into overdrive.
> Bubbles in US house prices and in US mortgage-backed bonds, which
> started to burst in 2006, gave way to a bubble in Chinese stocks
> that burst in 2007. The year 2008 saw the bursting of bubbles in
> oil; industrial metals; foodstuffs; Latin American stocks; Russian
> stocks; Indian stocks; and even in currencies as varied as sterling,
> the Brazilian real and the Australian dollar.
>
> And then, 2009 brought one of the fastest rallies in history.
>
> News from the “real world” cannot possibly explain this. Why were
> markets so much more prone to bubbles? It is fashionable to blame
> greed. But this makes little sense; it implies that, worldwide,
> people have suddenly become greedier than they used to be. Greed,
> surely, is a constant of human nature. Rather, it is more accurate
> to say that in the past half century, fear has been stripped from
> investors’ decisions. With greed no longer moderated by fear,
> investors are left overconfident.
>
> . . .
>
> How did this happen? I suggest it is down to what might be called
> the fearful rise of markets. Over the decades, the
> institutionalisation of investment and the spread of markets to
> cover more of the global economy have inflated and synchronised
> bubbles. This rise of markets has brought several trends in its
> wake, all of which seemed to have contributed to the eventual
> disaster of 2008.
>
> Other people’s money. In the 1950s, investment was a game for
> amateurs, with less than 10 per cent of the stocks on the New York
> Stock Exchange held by institutions; now institutions drive each
> day’s trading. In the past, lending was for professionals, with
> banks controlling virtually all decisions. Now that role has been
> taken by the capital markets, which businesses can tap for funding.
> As economists put it, in both investing and lending, the
> “principals” have been split from the “agents”. When people make
> decisions about someone else’s money, they lose their fear and tend
> to take riskier decisions than they would with their own money.
>
> Herding. The pressures on investors from the investment industry,
> and from their own clients, are new to this generation, and they
> magnify the human propensity to crowd together in herds.
> Professional investors have strong incentives to crowd into
> investments that others have already made. When the weight of
> institutions’ money goes to the same place at the same time, bubbles
> inflate.
>
> Safety in numbers. Not long ago, market indices were compiled weekly
> by teams of actuaries using slide rules. Stocks, without guaranteed
> dividends, were regarded as riskier than bonds. Now computerised
> mathematical models measure risk with precision, and show how to
> trade it for return. When academics produced these theories, they
> were nuanced with many caveats. Their psychological impact on
> investors was cruder. They created the impression that markets could
> be controlled, and that led to overconfidence. They also promoted
> the idea that there was safety in diversification – investing in
> different assets. Diversification per se is almost impossible to
> argue against, but this notion ended up encouraging risk-taking and
> led investors into markets they did not understand. This in turn
> tightened the links between markets.
>
> Moral hazard. As memories of the bank failures of the 1930s grew
> fainter, governments eventually dismantled the limits imposed on
> banks in that era. Banks grew much bigger. Government bank rescues
> made money cheaper while fostering the impression among bankers that
> there would always be a rescue if they got into trouble. That
> created moral hazard – the belief that there would be no penalty for
> taking undue risks. Similarly, big bonuses for short-term
> performance, with no penalty for longer-term losses, encouraged
> hedge fund managers and investment bankers to take big short-term
> risks and further boosted overconfidence.
>
> The rise of markets and the fall of banks. Financial breakthroughs
> turned assets that were once available only to specialists into
> tradeable assets that investors anywhere in the world could buy or
> sell – at a second’s notice. Emerging market stocks, currencies,
> credit, and commodities once operated in their separate walled
> gardens and followed their own rules. Now they are all
> interchangeable financial assets, and when their markets expanded
> with the influx of money, many risky assets shot upward
> simultaneously, forming synchronised bubbles. Meanwhile, banks saw
> their roles usurped by markets. Rather than disappear, they sought
> new things to do – and were increasingly lured into speculative
> excesses.
>
> . . .
>
> There is one big problem when it comes to fixing these underlying
> factors – most of them are good ideas. Most of us need a
> professional institution to run our money for us; money market
> funds, or securitised mortgages, are popular because they help
> people raise money swiftly and cheaply. Further, the propensity to
> inflate bubbles is in the very fabric of world markets, so any
> reforms need to be systemic. While the absurdly complicated
> instruments that created the subprime bubble, such as the synthetic
> collateralised debt obligations that landed Goldman Sachs into
> trouble with the Securities and Exchange Commission, should go, the
> roots of the problem lie far deeper. Finding fixes will involve hard
> choices.
>
> Making this harder still, any solution must be filtered through
> human nature. Our tendency to suffer swings of emotion, to move in
> herds and to expect others to rescue us from the consequences of our
> actions, are never going to go away. So while I felt quite good
> about the diagnosis of the problem, I should be much more humble
> when proposing a solution. But in outline, I do have some ideas how
> markets can be made more fearful, and maybe more efficient.
>
> Moral hazard. Previous financial crises reined in moral hazard by
> inflicting grievous losses on key investors. The latest crisis was
> different – it showed that the US, the UK and other governments
> would spend trillions of dollars to sustain the biggest financial
> groups. Now, the belief that risk takers will be rescued is stronger
> than ever. So air must be taken out of markets that are currently
> betting that the government dare not let them fail. It is still too
> soon to do that. But at some point, either by raising interest rates
> or by allowing a big bank to go down, government must make clear it
> will not be there to bail out the reckless.
>
> A safe place to start would be the megabanks like Bank of America,
> which are even bigger as a result of shotgun mergers which were
> arranged during the crisis. They cannot be allowed to fail; instead,
> they must be regulated so tightly that they simply are not allowed
> to gamble, or they must be made smaller. Governments could raise
> reserve requirements, which in practice would force banks to sell
> off assets; this need not involve imposing a break-up.
>
> The decline of banks and the rise of markets. The rise of money
> markets created a new class of bank-like institutions that do not
> need to buy insurance to protect depositors. This shadow banking
> system, including money market funds (mutual funds that invest in
> the money markets), must now be regulated as if they were banks.
> Reforms to solidify the so-called repo market (in which banks borrow
> from each other over very short periods, putting up bonds as
> collateral) are vital. When this market seized up, banks were unable
> to get short-term funding.
>
> Regulators also need to overhaul the rules that inadvertently
> spurred banks to pile into mortgage-backed securities and outsource
> to rating agencies their central function as lenders – figuring out
> who can pay back a loan and who cannot.
>
> Like unemployed teenage boys, these banks have shown a terrible
> knack for getting into trouble when left to their own devices. Once
> money markets are subject to the same regulation as banks, their
> advantages may evaporate, enabling banks to regain their old
> businesses of lending. If not, the economy can possibly do without
> banks in their traditional form. Hedge funds drove many trends to
> destruction by 2007, but the much-feared disorderly collapse of a
> big hedge fund did not occur. Instead, it was the inherent
> instability of banks that brought the roof down. And so for banks,
> the status quo is not an option.
>
> Other people’s money. Banking system reforms must also address the
> conflicts between principals and agents that arise whenever those
> who take on a risk are able to sell that risk to other parties. In
> securitisation, where some principal-agent split is inevitable, loan
> originators must be required to hold a significant proportion of
> their loan portfolio – in other words to “eat their own cooking”.
> Investment banks that are now public might return to the partnership
> model. Then the money on the line would be that of the partners
> themselves, not shareholders. Again, this might not require
> government intervention. Existing investment banks could go private.
> Or hedge funds, which increasingly already carry out investment
> banking functions, could evolve further.
>
> . . .
>
> All of these areas have been amply discussed in the political
> dialogue, and rightly so. But they all broadly entail what people in
> the industry call the “sell-side” – the bankers involved in one way
> or another in selling securities. In fact, the trickiest principal-
> agent split affects the “buy-side”: investment managers. Asset
> bubbles on the scale we have recently seen do not happen unless
> something is going systematically wrong with the way in which our
> money is invested. It is hard to see how regulation can fix the
> problem.
>
> The fundamental problem is herding. The herd mentality of the
> current generation of investment managers is driven by the way they
> are paid and ranked. Rank them against their peers and an index, and
> pay them by how much money they manage, and experience shows that
> they will hug ever closer to each other and to key benchmarks such
> as the S&P 500. This inflates bubbles. “We see it time and time
> again, especially in tough times,” said Jim Melcher, a New York
> hedge fund manager. “Major investors act like a flock of sheep with
> wolves circling them. They band closer and closer together. You want
> to be somewhere in the middle of that flock.”
>
> What does he mean by this? Faced with widely published league tables
> comparing their recent performance to their peers, it does not pay a
> fund manager to attempt to do much better than everyone else. If
> they fail, investors will pull their money out. Crowd together with
> everyone else and there is safety in numbers. And if the market goes
> up, then so will the fund manager’s portfolio and their percentage
> management fee – even if they have done nothing more than passively
> benefit from the overall rise in the market. The way they are paid
> encourages them to behave like wildebeest on the Serengeti. Somehow,
> therefore, we must change the way we pay fund managers.
>
> For hedge funds, it is up to investors to refuse to pay fees on the
> skewed basis that at present encourages them to gear up to “go for
> broke” each year. Fixed annual fees, and basing any performance fees
> on periods much longer than one year, makes more sense. In mutual
> funds, it is far too easy for mediocrities to make money in an
> upward market. Their fees go up merely for taking in more funds. The
> practice of closet indexing – investing most of your assets in the
> companies on one index, but demanding the fees of a more active
> investor – must be actively discouraged, possibly by requiring
> “active” funds to publish their “active share” (the amount that
> their portfolio deviates from the index). Closet indexing might also
> be rendered less harmful if mainstream index funds moved toward
> fundamental indexing, weighting their portfolios according to
> fundamentals such as profits rather than their market price. This
> would force them to sell stocks as they become overvalued.
>
> Paying managers a fixed fee would no longer reward them merely for
> accumulating assets, and so funds would be less likely to grow too
> big. Rewards above a fixed fee should be reserved for genuinely
> excellent performance only.
>
> But this brings up the greatest problem: how to determine that
> performance? Benchmarking portfolio managers against their peers, or
> against a market index, just encourages herding. The solution may
> lie in the growing effort to understand and measure investing skill.
> It rests in mental discipline and the ability to resist the
> temptations of greed, panic and mental shortcuts. By looking at how
> fund managers perform day by day and trade by trade, psychologists
> are beginning to identify the truly talented. This effort should
> continue.
>
> The greatest power rests with those who make big asset allocation
> decisions – primarily brokers and pension fund consultants. They
> should follow what is known in the trade as a “barbell” – either
> their investments are passive, with minimal costs, or they are given
> to active managers on the basis of their skill, who are paid
> according to that skill. There is no room for anything in between.
>
> Another needed reform would change the design of investment products
> so as to deliver everyone from temptation. Rather than give savers a
> range of choices, give them a well-tailored default option, covering
> a sensible distribution across the main asset classes, with both
> passive and active management. To maintain investors’ confidence, it
> may make sense to declare guaranteed gains along the way, much as
> the old Victorian model of paternalistic pensions did. All of this
> would avoid the disaster of the 1990s as many investment managers
> had no choice but to keep pouring money into internet stocks, thanks
> to the “irrational exuberance” of their end clients.
>
> The default option would not be compulsory – you can choose
> something else if you wish. The key is that the default should be a
> good one and not overloaded by fees. The industry is already moving
> in this direction. This should restore investors’ confidence, avert
> the risk that “irrational exuberance” might again drive markets, and
> limit the worries for all managers about their success in
> accumulating assets. They would merely have to worry about
> performing skilfully enough to earn a bonus. But note that many of
> these changes are subtle, and it is hard for politicians to
> legislate to introduce them.
>
> . . .
>
> Will these reforms deliver us efficient markets? Theories must
> change, not just practice. The old theory of diversification
> prompted overconfidence and created the rush into “uncorrelated”
> assets that then became linked. Other core assumptions, such as
> stable correlations over time, random returns and emphasis on
> allocation by asset classes, have failed. We need a new theory.
>
> Academics are already on the case. Paul Woolley of the London School
> of Economics believes efficient markets might be salvaged if we can
> find a way to model the distorting effects of institutions on
> incentives. Andrew Lo, of the Massachusetts Institute of Technology,
> suggests markets are complex adaptive systems that can be modelled
> using Darwinian biology – which implies we are living in an era when
> a meteor has just hit the earth and we await the successors to the
> dinosaurs.
>
> But any new model, I now believe, must not aspire to the same
> precision as the old; finance and economics are contingent on human
> decision-making and not the laws of nature. Abandon the attempt to
> predict markets with precision, and we might avert a return to the
> overconfidence such models created in the past.
>
> As for diversification, it was the search for new “uncorrelated”
> asset classes that helped lead to disaster. Those who allocate
> assets must look at the risks those assets bear and leave a margin
> for error – meaning more in “conservative” assets, and less
> potential “upside,” than they would like.
>
> Again, thankfully, such ideas are already bubbling through the
> investment industry. All of these ideas involve putting limits on
> the wealth that markets can create. That would be akin to the trade-
> off the world made after the Depression. With the capitalist world
> ageing, the growth rate we can expect in the next few decades may
> well be significantly lower than in the second half of the 20th
> century. But even taking into account that consideration, many
> people would be happy to make that trade-off again. Such ideas might
> defer the next asset price bubble for a generation. And after three
> hectic years attempting each day on video to explain markets that
> had fundamentally deviated from common sense, it is a trade-off I
> too would make.
>
> John Authers became head of the FT’s Lex column in April. This is an
> edited extract from his book ‘The Fearful Rise of Markets’,
> published next week by the FT Press (price £20). To purchase a copy
> call the FT book ordering service on 0870 429 5884 or go to www.ft.com/bookshop
> . John Authers’ last piece for the magazine was a look at the
> landmark $1.25bn payment by Swiss banks to Holocaust survivors – 10
> years on. Read it at www.ft.com/restitution
>