Synchronized markets warp perception and force politicians and investors alike into historic errors – but eventually collapse under their own contradictions. ~ John Authers
John Authers, investment columnist for the Financial Times, explains why so many market orthodoxies were smashed during the financial crisis in The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How to Prevent Them in the Future. Published by FT Press, the book offers a comprehensive treatment of the factors that led to the global synchronization of markets as well as some cautions for those who still cling to these orthodoxies. More than that, Mr. Authers has some concrete suggestions for how to prevent these synchronized bubbles in the future.
5 Trends from the Fearful Rise of Markets
Mr. Authers weaves five main themes throughout the book. Over and over we see these trends borne out in the economic events of the past few decades:
- Principal/Agent Splits: When you as a principal hire an agent like a financial advisor to manage your money, you expect that they will act in your best interest. But the agent may in fact have numerous conflicts which prevent him/her from doing so. What’s best for you may not be what’s best for the agent’s firm or for him/her personally.
- Herding: There are strong incentives for today’s investment professionals to follow the crowd or risk losing their job. When everyone is in the same investments at the same time, bubbles inflate.
- Safety in Numbers: Mathematical models have contributed to the illusion of certainty in markets. These models promoted the idea that there was safety in diversification, but missed the fact that investors using this strategy all at once created mispriced asset values. When those asset prices inevitably revert to the mean, markets correct swiftly and violently.
- Moral Hazard: As the memories of the 1930s faded, banks found ways to circumvent and eventually dismantle the rules put in place to prevent another Great Depression. Eventually bankers and investors came to believe that there would be no penalty for taking increased risks as a result of government bailouts and easy money.
- The Rise of Markets and the Fall of Banks: Many of the roles banks have traditionally played have been usurped by the capital markets. Assets that were once available only to professionals are now accessible to almost anyone with the click of a mouse. Companies that wanted to raise capital had to go to the bank. Now they have the option of doing so via markets.
Many of these trends are still in place in spite of (as evidenced by?) the record rebound in the stock market.
Part I: The Rise
The book is divided into three parts. Part I looks at the rise of the investment banking industry, Modern Portfolio Theory and indexing and how all three have helped in the formation of asset bubbles and busts. Long Term Capital Management (LTCM) was run by at least a couple of Nobel Laureates in the 90s and it was based on mathematical models. When it failed spectacularly, the Federal Reserve intervened to rescue the markets from collateral damage. And so the Greenspan put was born. You might call it the prequel to the quantitative easing saga to which we are currently being subjected.
Once LTCM was rescued, moral hazard gave investors the confidence to put more money to work in the markets. They promptly migrated en masse into dot com companies. That bubble topped out on March 10, 2000 and the Nasdaq proceeded to fall 79% over the next 2 years. As we all know, it has yet to even come close to fully recovering 10 years later.
Part II: The Fall
The most recent bust began on February 27, 2007 with the “Shanghai Surprise” and was followed by 2 years of extreme volatility, bank runs, financial failures, and selective rescues for financial institutions and auto companies. Many companies that were deemed too big to fail received billions in taxpayer backstops. Those outside the Too Big to Fail bubble actually did fail.
Mr. Authers aptly points out a number of financial orthodoxies that were destroyed in the crash. Chief among them may have been what he calls the “paradox of diversification” and of course modern portfolio theory, from which this orthodoxy emanated. The paradox of diversification means that “the more investors bought in to assets on the assumption that they were not correlated, the more they tended to become correlated.”
Part III: The Fearful Rise
Part III details the stock market revival that was sparked by a recovery in emerging markets, especially China’s stimulus efforts. Next came one bailout and stimulus program after another as governments and central bankers worldwide pulled out all the stops to bring global markets back from the abyss. These efforts did spark a market rally, but they also increased moral hazard, and herding behaviour to ever higher levels.
According to Mr. Authers, the 2009 rally was the most impressive in a century, but there are still signs that the “perverse synchronization” of markets remains. He ends the book with some suggestions on how to combat each of the five main trends mentioned above. For one, he suggests that if we want to keep the idea of indexing around, we should be using fundamental parameters rather than capitalization weighting. He also thinks that investment managers need to be compensated differently and that investors should simply refuse to pay the types of fees charged by hedge funds.
There is so much more to this book than I have room to comment on here. If you have any interest in learning about some of the other suggestions Mr. Authers has for re-introducing fear into the markets, or if you just want to try to understand how markets have become so highly correlated, this book is well worth your time.