A year on from the onset of the credit crunch seems a good moment to reflect on the way that markets have behaved since that point.

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A year on from the onset of the credit crunch seems a good moment to reflect on the way that markets have behaved since that point. One lesson learnt over many years is that in times of crisis an understanding of market dynamics is far a more useful guide to short term action than detailed or sophisticated analysis of valuation metrics. You can’t fight a market trend with reason alone when sentiment is running so strongly the other way.

After a bad month in June, and one of the worst first six months of the year since the 1930s, many markets now look oversold. But at the same time many leading market indices, including the S&P 500 and the FTSE 100, are either bumping up against, or already pushing through, the lows set in March at the time of the Bear Stearns rescue. If those lows are decisively broken, then even after the inevitable rally you can be sure of a further downward leg to this bear market.

An oversold market is in any case a minor comfort. As Marc Faber correctly observes, markets that are oversold can stay that way for longer than anyone expects. What complicates the issue this time round is that we are witnessing a dramatic two tier market, in which financials, anything to do with housing and now the consumer are taking a severe beating, while resource stocks have again hit new recent highs on the back of still strengthening commodity prices.

Were it not for the increasing number of resource stocks now climbing into the main market indices, the damage to index performance would have been even greater. As it is, the falls in some markets have been brutal (Stockholm down 35% over 12 months, the CAC 40 by 28%, for example). Many indices have fallen by between 10% and 18% over the last month alone. Such acceleration is unsustainable and normally the prelude to a correction the other way.

Those who doubt that we are witnessing a genuine bear market however are running out of ammunition to defend their case. With the media now moving onto full doom and gloom alert, sentiment is not going to get better any time soon. A lot clearly still rides on the outlook for the two sectors, financials and commodities, that have been pulling the market in different directions.

There have been at least three failed attempts to call the turn in banks so far, but the big money has mostly stayed on the short side. Without a rally in financials stock markets as a whole will not go higher. Experience suggests that when the banks do eventually come back into favour after their current woes, the bounce back may well be dramatic  - even more so than usual given the amount of short selling that has been concentrated in the sector. Those who are not aboard already will be in danger of being left behind. 

As for commodities, the oil price has replaced the credit crunch as the main spectre at the market feast.  Few now recall that it is 25 years ago this year that Saudi Arabia first formally agreed to adopt the role of swing producer within Opec – a far-sighted decision that in the short term paved the way for oil to fall to $10 a barrel, but later helped to underpin the “great moderation” (and bull markets) of the subsequent 20 years.

What is different about the current crisis is that the oil price is being driven higher not by supply constraints but by surging demand, mainly from the developing world, including Opec members themselves. Peter Davies, a former chief economist at BP, pointed out at a recent seminar organised by Lombard Street Research that Opec is right to say that there is no current shortage of crude oil. The price has continued to rise despite the fact that in terms of supply and demand the market is back in equilibrium.

The self-interest that finally convinced Opec in 1983 to opt for moderate over exorbitant price increases has been undermined more recently however by the continued (and some would say recklessly induced) weakness of the dollar. There is also a limit to the extra supply that Opec can bring on stream quickly. The concentration of power in the oil markets is shifting to new producers, such as Russia, with different agendas to the old. 

What is driving prices higher now is expectation of further gains – something you can blame on speculators if you are looking for an easy scapegoat (though they are only one of the many group of players in the oil market). Given the strength of new demand, a future shortage in supply is clearly looming and higher prices today are needed to rectify it. A new equilibrium in the $50-$80 a barrel range looks the most logical place to settle – but in the short term there is nothing to stop the current price going higher. In fact fear of higher oil prices is in danger of becoming a self-fulfilling vicious circle. The more that prices rise, the bigger the damage they will do – and the greater they will fall subsequently.

 


Jonathan Davis
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