Thursday, November 16, 2006

To the point: Have we lost our fear of those all too-familiar bogeymen?

By Edmond Warner Last Updated: 1:07am GMT 10/11/2006

When climbing a ladder, the further you are from the ground, the better it is not to look down. The mere thought of a fall can be the mother of its own invention. The same can be true of economies and markets. This is why so many investors currently have their heads tilted back and their fingers mentally crossed.

It is an old adage that financial markets climb walls of worry. If there were no doubts or uncertainties then assets would always be fully priced. Instead, the awareness of risk creates a discount factor in asset pricing. This, in turn, is the opportunity for an investor to profit from a willingness to assimilate risk, to live with its grumbling in the pit of his stomach.

While the very best investors are adept at listening to their intestinal turmoil, most practice the art of imagined pain referral. They pick on a small imagined twinge in their little finger – a minor concern about a generally successful investment, perhaps – to draw attention away from the more substantive worries they really ought to be concerning themselves with.

advertisementOf course, as investment is a great spectator sport, there are many individuals and organisations that exist to bruit loudly the risks inherent in the markets. Investment strategists and media commentators, in their different ways, publicise the precariousness of the ladder and the extent of the drop. In the UK, the Bank of England and the FSA do the same, albeit in a more stylised and measured manner.

Now, with the Dow Jones Industrial Average at a record high, and the UK's FTSE 100 index at levels last seen in February 2001, it is remarkable how little noise the professional doom-mongers are making. Call me old fashioned, but right now I want to be hearing about collapsing confidence, profit crunches, stagflation and fire and brimstone raining down from the great investment god in the sky upon investors drunk on their own imagined immortality.

Either that or I want to see equity valuations at very modest levels to reflect a general acceptance that the big gains are behind us and that the balance of risk has shifted in favour of a slowdown (or even just a hiccough) in the near future.

Instead, bond markets are priced as though the monetary authorities have got everything under control (a little bit more tightening in one or two places, including the UK, and nasty old inflation will slink away). And equity markets are positively celebrating corporates' current successes with valuations that assume they can be replicated out into the middle distance.

Most frustrating of all for someone bred to wave a red warning flag is the difficulty in finding dangers to highlight. Or, more exactly, dangers with novelty value that may attract attention, for most risks to the current happy conjuncture in the markets have been around for some time. Familiarity, it would appear, has indeed bred contempt.

If you are ever in need of smelling salts to shock you out of a bullish reverie, turn to a copy of the Bank of England's most recent semi-annual Financial Stability Report. There, clinically presented, you will find the most dangerous bogeymen stalking the markets. None of them are a surprise (indebted households, imbalances between economies, dangerously low risk premia etc), but there is something about their presentation in this way that should bring you to your senses.

Only this time it doesn't. A rereading of July's report didn't leave me sweaty with fear, merely smothered in familiarity. And this, it may be, is the greatest risk to markets currently. Our bogeymen have been with us for too long. They appear more Shrek than Freddy Krueger.

One of the six major risks cited in the report is that of the rapid releveraging of corporates around the world, in large part the work and influence of the private equity industry. This week the FSA launched a discussion paper on the workings of private equity and warned of the inevitability of default by a large corporate or a cluster of smaller ones.

Significantly, though, the FSA stopped short of claiming that such a default would likely lead to systemic problems. US experience shows that such defaults are dealt with as localised incidents – in just the same way that recent hedge fund collapses have not cratered the entire hedge industry or the financial markets.

Although the trends identified by the authorities are worthy of monitoring and lively discussion, their development is still some way short of dangerous, systemic excess. Where, then, might the end of the bull market originate?

World economies are at a dangerous stage in their cycles, the point at which the direction of change in monetary policy is in question. Moreover, there is an apparent desynchronisation of the US and European economies that adds an extra dollop of risk to the markets.

There is understandable talk of American interest rates falling, just as British rates, for example, are pushed further upwards. One country frets about the fragility of its housing market; the other about the seeming indestructibility of its. Both have reason to wonder about inflation trends. If the interest rate differential between the two widens, then a drop in the dollar could slow the UK to an uncompetitive standstill.

The UK monetary authorities may yet come under pressure to take risks with short-term inflation for the sake of economic activity. The US authorities may find themselves scrambling to get ahead of collapsing consumer confidence. Markets are unlikely to find either an edifying sight.

These are just my worries, along with the worry that I can't find enough to worry about. Have your own, whatever they might be, because when markets are priced for perfection, you can be sure that they are missing something.

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