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Merchants of doom are rarely right

Wednesday 24 October 2007 02:59PM

Out of the woodwork at such junctures come a familiar cast of soothsayers to predict that everything is bound to end in catastrophe, just as (so it often turns out) said soothsayers have been predicting for many years. The history of the modern financial era is that such fears are normally misplaced, a fact which seems to infuriate those of bearish disposition and sometimes drives them to new heights of extravagant language.

Because markets are cyclical, their fears often seem to be justified for a short period, but the Armageddon solution they have been warning about rarely comes to pass. A good example would be the cluster of books that predicted a global depression in the 1990s. During the nasty recession of 1990-91 such gloom fell on ready ears, but proved only to be the prelude to one of the most remarkable bull markets of all time, in which bonds, equities and property all shared handsomely. Stirred but apparently not shaken in their beliefs, advocates of the Krondatieff wave and others of a doomster disposition retired to lick their wounds.  

Nothing is more certain about the current credit crisis that we must all prepare for a new wave of gloomy tidings.  Marc Faber, one well-followed market watcher, warns in his latest report for example: “We have reached a major turning point in the credit super-cycle with dire future consequences for asset prices….The coming asset bear market will spread from one region to another and from one asset class to another and will eventually bring about a global recession”.

Another strategy newsletter that caught my eye this week talks about “the crisis developing into one of global, and maybe epic proportions. We expect a deep recession beginning in 2008 and very possibly even a depression”. The fallout, on this view, will be worse than in the Asian Crisis of the 1990s. It is time, says this writer, for investors to start hoarding gold and stashing it somewhere safe and out of sight (because in savage economic downturns, lawlessness invariably increases).   

There are other ways to view the current market situation. Mr Faber insists that the US stock market will not exceed its highs in July for the foreseeable future. Richard Russell, the Grand Old Man of technical analysis, who has been analyzing market movements for longer than 99% of people working in the markets have been employed, disagrees. He says that most of the technical indicators he has been looking at for 50 odd years point in the direction of bullishness.
 
According to the American money manager Ken Fisher, the irony is that most big bear markets in stocks don't start with a dramatic downward movement in prices. Once they get under way they are normally characterised by broad but steady monthly declines, punctuated by a succession of falling highs. Dramatic market plunges played out in an avalanche of gruesome headlines are not what tend to happen when bear markets are about to start.

According to Mr Fisher the biggest differences between a bear market and a market correction, are magnitude and duration. “A correction is a short-term 10%-20% scary global downturn. It's short, sharp and comes from nowhere with a spike top and a fantastic story leading you to believe more downside is ahead. It's over just as fast and rockets higher returning to a new high about as fast as it fell. One to four months down and then back up. Four months later the whacky story that pervaded the downturn sounds silly, but at the time it first appears you can't really disprove it".

Does that sound something like what we have been seeing recently? It certainly has echoes. That is not to say that the drama that has been playing out in the past few weeks is going to be without its adverse consequences. It would be remarkable if recent events in the credit market did not have tangible and enduring impact on the real economy as well as on hedge funds, private equity and banks.

It seems certain that a number of hedge funds will be culled (which may be no bad thing, given that the aggregate value added of the hedge fund industry is arguably even less than that of the mutual fund business), the buyout bubble will finally start to deflate and banks will have to work their way through a painful overhang of actual or potentially unprofitable deals. Investors may once again start to price risk more rationally.

But these effects need not be as disastrous as some are predicting. The mistake that doomsters often make is (a) to confuse the possibility of a severe outcome with the probability that it will happen and (b) to argue that any market fall has to be the prelude to a crisis, rather than simply a normal market correction. A full-blown credit crunch, in which banks remain unwilling to lend to each other, and the withdrawal of credit leads to a recession, is clearly a worrying possibility.

But is it the most likely one however? I would say not, not least because it is too early to say. Knowing that fortune favours the prepared mind, prudent investors will always be mindful of the worst case outcome and prepared to change tack if they must. The opportunity cost of betting that one will occur however can be painfully high, as it proved to be after the LTCM crisis in 1998. In moments of crisis, telling the market how to behave, rather than waiting to see what it tells you it is going to do, the besetting sin of doomsters, is rarely a recipe for money management success.

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