10 April 2009

New York Times Debate on the Bear Market Rally

The Gray Lady features a debate on the bear market rally this morning, featuring Barry Ritholtz, whose blog the Pig visits several times each trading day.

M.I.T. professor Simon Johnson leads off the debate with this worrying thesis:

Some stock market rallies are reassuring. Others provide at least temporary respite. And a third kind, more commonly seen in emerging markets, actually expose deeper underlying problems and contribute to a further downturn.

We seem to be experiencing this third kind of rally in the U.S. right now. Equity prices are up sharply, but the debt market continues to indicate a high probability of default. In particular, the level and recent trajectory of credit default swap spreads suggest that, as the financial system as a whole stabilizes, market participants expect increasing odds of failure (and failed bailout attempts) for the very largest banks.

Stanford professor Nicholas Bloom follows up, arguing that while the global economy is still uncertain about future growth, it is far less uncertain than it was in the Autumn:

Fortunately, the G-20 leaders have agreed to maintain free markets as well as sensible increases in financial regulation — which is radical, unprecedented stuff. As a result stock market uncertainty – measured by implied volatility, commonly known as the “financial fear factor” - has fallen. A measure of uncertainty (tracking implied volatility of the S & P 500) shows a more than three fold jump after the collapse of Lehman in September 2008. But that measure has fallen back by 50 percent as political uncertainty has receded.

Of course, there is still tremendous uncertainty about the extent of the damage to economy. We still don’t know the value of the toxic assets central to the banking crisis. Fear remains a factor, leading firms to postpone investment and hiring decisions. But we are moving past the big spike in uncertainty of last fall. And if uncertainty continues to decline, growth should start to rebound.

Barry Ritholtz looks at the bigger investing picture, and warns against both buy-and-hold, and more importantly, hunting for bottoms:

[I]f you managed to catch the exact low in December 1974, well, then, you would have had to accept an enormous level of volatility. That low was followed by a 75 percent rally, a 27 percent sell off, a 38 percent rally and a 24 percent sell off. But those are nominal numbers. Adjust the returns for inflation, and you actually lost about 75 percent of your money in real terms.

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