Tony Jackson：He was too busy partying to inquire

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Common-sense confusion surrounds the bears’ bullets
By Tony Jackson

Published: August 29 2010 17:39 | Last updated: August 29 2010 17:39

It was inevitable, I suppose, that one or other bearish commentator would seize on the tale of the Polish man with a bullet in his head.

For those who missed it, this was last week’s true story about a man who received what he thought was a blow to the head at a New Year celebration some five years ago. He was too busy partying to inquire, and took the next day’s headache as a simple hangover. Doctors have now extracted a .22 round from under his scalp.

For Albert Edwards of Société Générale, the symbolism is too good to miss. For Wall Street, the party was the insane valuation peak of 10 years ago. As to the bullet, the patient has yet to realise it is even there.

Mr Edwards is what is known as a perma-bear. Those of his gloomy disposition – which I confess I partly share – are often characterised as stopped clocks. This raises an interesting question.

On the one hand, stopped clocks are very rarely right. But on the other, they are not invariably wrong.

There is certainly no shortage of Wall Street bears today. Mr Edwards sees the S&P 500 at 450, or nearly 60 per cent below today’s value. Smithers & Co thinks it is 50 per cent overvalued, which – assuming a reversion merely to fair value – means a fall of a third. First Global, which expects a 20 per cent fall, is positively sunny by comparison.

This might of course seem prima facie evidence that the market is touching bottom. As Professor Robert Shiller of Yale has shown, investors – amateur and professional – expect the market to rise by a greater proportion the more it has risen already, and vice versa. Welcome once more to irrational markets.

But neither Mr Edwards nor Mr Smithers is open to that charge, since they were bearish all along. Mr Edwards is an ardent deflationist. It comes as no surprise to him that bonds keep outperforming equities, so that US long Treasuries this year have returned 18 per cent in total, while the S&P has returned minus 4 per cent.

Mr Smithers, on the other hand, has claimed for years that the US market is seriously overvalued on the basis of its average 10-year multiple of earnings and in relation to corporate assets. He also argues that US corporate leverage is at a record high, that today’s high margins are unsustainable and that the squeeze on government deficits must inevitably also squeeze corporate cash flows.

But on top of such long-held and essentially rationalist positions, there is a general malaise of sentiment. Again, this is centred on the US.

On the one hand, we are told that the US economic model is broken. More generally, there is a vaguer sense that the eclipse of the US as the dominant world power, so often foretold in the past, is finally coming to pass.

Neither of those propositions is exactly new. But it does not help that the US refusal to embrace budget cuts, unlike the UK or Europe, is generally seen by hawkish commentators as just one more proof of the American disease.

This brings us, I think, to the centre of the problem. Among the foremost casualties of the financial collapse has been belief in the economic and financial models we use to make sense of the world.

Thus, exhaustive debate in this newspaper has shown that distinguished economists are hopelessly divided on whether the US or European approach to deficits is the right one – if indeed either is. At the financial level, consider the debate about the relationship between bond and equity yields.

Common sense suggests a simple answer. Suppose the two are in equilibrium, and then bond yields halve. This would make the yield on equities attractive, so investors would buy them and drive the yield down in proportion. That is, bond and equity yields should move more or less together.

Unfortunately, common sense also suggests the opposite. Suppose growth and inflation are accelerating. That should raise equity prices, and thus depress equity yields.

But it should also drive bond yields higher, both to adjust for inflation and to allow for the fact that growth creates more demand for credit, thus making it more expensive for the borrower. Thus, bond and equity yields should logically move in opposite directions.

So when the Fed chairman Ben Bernanke spoke of unusual uncertainty, he was speaking for investors as a class. But the longer uncertainty persists, I suggest, the more we should distrust the more apocalyptic scenarios it gives rise to.

For what it is worth, I share the feeling that US equities are overvalued. But as for the slump into deflation, the collapse of US supremacy and so forth, let us handle one thing at a time.


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