The Hindu Business Line : Investors, frogs and Yellowstone effect

The current firmness in equity prices is akin to the warm glow of pleasure that a frog may feel when water begins to boil. Resistance to the fundamental deterioration through manipulation of technical indicators and through the provision of liquidity would be to set the stock market up for a Yellowstone effect, which is the consequence of an extreme event, says V. Anantha Nageswaran, cautioning investors.

IN HIS weekly `Global Performance Monitor' (September 7), Credit Suisse First Boston's Jonathan Wilmot discusses extreme events and the `Yellowstone effect'. "Extreme events are occurrences which overwhelm normal coping strategies in plants, animals, organisations etc., but also lead to persistent changes in system or agent behaviour.

"Efforts to suppress or avert unpleasant or destructive outcomes in a dynamic system are often doomed to failure, or in some cases can make the probability of a catastrophic episode much greater. This is sometimes called the Yellowstone effect.

"A century of zero tolerance for fires, natural or man-made, in Yellowstone National Park actually pushed the forest into a super-critical state. Trees aged, grew closer together and combustible material of all sorts built up on the forest floor. Then in 1988 an uncontrollable conflagration took hold, burning 1.5 million acres before it was done, a scale of destruction never seen before and unimaginable until it happened. Left to itself, a continuous series of smaller fires would have cleaned up the forest in a way that would have prevented such catastrophic propagation of the initial spark."

That is, the `Yellowstone effect' is the consequence of an extreme event. It is important to bear in mind that the probability of extreme events is dictated by how normal events are suppressed or allowed their free play. If suppressed, the probability of extreme events increases, as does the severity of their consequences.

Financial assets set up for `Yellowstone effect'

Action in financial markets which, I presume, prompted Mr Wilmot and his team to write this piece seems to fit with the description of how the `Yellowstone effect' is precipitated. Friday's action in financial markets is a case in point. The spot price of light sweet New York crude was successfully repelled from breaking through resistance levels and it closed the day a lot lower. This has nothing to do with fundamentals. Fundamentally, American fuel inventories are far lower than they were in March.

Further, recently, Mr Fareed Zakaria, editor of Newsweek International, had mentioned in an article that Sports Utility Vehicles that are notoriously fuel-inefficient comprise nearly 55 per cent of all vehicles on the road in America compared to just 5 per cent a decade ago. It means that, regardless of an economic slowdown, fuel demand would continue to remain high in the US, preventing energy demand from shrinking with any cyclical or structural economic slowdown. Yet, technical targets on oil prices were closely watched and repelled on Friday.

This, in turn, caused the US Dow-Jones Industrial Average (DJIA) that spent the bulk of the day in negative territory to finish the day higher. Interestingly, the Dow-Jones transportation average recorded a similar outcome. Technical analysts view this index as a leading indicator of how the DJIA would behave. Recently, the index had tested the 200-day moving average twice and bounced higher. That is a positive sign for chartists. Yet, yesterday's close was important. Had it closed below 3203 — the previous high reached in end-June — it would have been a disappointment. It would have amounted to a double top. In technical analysis, it is a negative signal. For the bulk of the day, the index hovered below that level but managed to spike above that at close. Coupled with the lower close of the crude oil price - well below the highs of the day and below the previous Friday's close - the market's technical fundamentals have been preserved.

Preserving tech health to offset lack of fundamental support

It might be somewhat unusual for this writer to deal at length with a subject that he is only remotely familiar with. Yet, it seems more than a coincidence that a day after the worst inventory report in the US, crude oil price should drop suddenly and the Dow Jones indices should finish in positive territory — both overcoming important technical obstacles in opposite directions.

Vested interests are setting up the stock market for the Yellowstone effect. The stock market rally lacks fundamental traction. I shall elaborate. Two arguments have been put forward for the recent rise in equity prices: The US President, Mr George Bush, has surged ahead in polls and two, the price of crude oil has retreated.

Republican Presidencies are bad for the stock market

Is a Republican Presidency good for the stock market? This question has been answered unambiguously by research. A paper published in Journal of Finance in October 2003 has proved conclusively that Democratic presidencies are good for stock markets than Republican presidencies. Mr Bush' first term did not disturb the research finding. Interested readers could read the concise summary that Prof Hal Varian presented in his New York Times article in November 2003 (http://www.sims.berkeley.

edu/hal/people/hal /NYTimes/2003-11-20.html).

Professors Santa-Clara and Valkanov look at the excess market return — the difference between a broad index of stock prices (basically the Standard & Poor's 500-stock index) and the three-month Treasury bill rate — between 1927 and 1998. The excess return measures how attractive stock investments are compared with completely safe investments like short-term T-bills. Using this measure, they find that during those 72 years the stock market returned about 11 per cent more a year under Democratic presidents and 2 percent more under Republicans — a striking difference.

Some Republican sympathisers suggest that the possibility of Mr Elliott Spitzer, Attorney-General of New York, becoming the Attorney-General in Mr Kerry's cabinet, is causing investors to cheer the improving poll rating of Mr Bush. This flies in the face of Mr Spitzer's crusades in favour of actual underlying investors and against Wall Street intermediaries. This logic means that Wall Street is favouring Mr Bush so that it can continue to defraud investors. If so, investors have an easy decision to make.

Case for higher oil prices remains intact

That the price of oil has retreated from its peak near $50 is a fact but it is no one's case that it has become an economic stimulant. As have been argued many times in the past, fundamental drivers of higher oil price in 2005 are very much in place. Whether or not it would cause a reduction in global growth is a matter of debate. But, all recessions in the past have been preceded by a spike in the price of oil and denial by economists that such a spike would not affect global economies. Enough said.

Therefore, fundamentally, there is no justification, in the face of an oil price shock, waning economic growth and peak in corporate profits (which has, incidentally, not yet caused a downward revision to profit outlook in the fourth quarter for Corporate America by analysts), for stocks to rally. Yet, they are rallying.

Can liquidity ride to the rescue, as in 2003?

The one plausible defence is that an economic slowdown would cause the Federal Reserve to pause in its rate hikes, allow long rates to come down and create a liquidity-induced rally like the one the world witnessed from April 2003. Stocks are rallying thus, because bonds are rallying.

The yield on the 10-year US Treasury has never come down so much as it has between July and September even as the Federal Reserve embarked on a tightening spree. The bond market has thus challenged the Federal Reserve assumptions. The bond market has been, in effect, saying that the rate hikes were unlikely to be sustained since they were coinciding with the beginning of the economic downturn. Economic data have vindicated the bond market. Growth has slowed and inflation fears have receded.

This has resulted in a 50 per cent jump in mortgage refinancing activity since early July. The Federal Reserve Chairman, Mr Alan Greenspan, has concluded that low interest rate induced economic activity was the only game in town and his testimony to the House Budget Committee on Wednesday gave a glimpse of this line of reasoning. He was relatively tentative on growth outlook and less so on the benign inflation outlook. Indeed, despite a decline in productivity trends, he was sure that inflation would abate as corporate margins began to come off their peaks.

If the Chairman expands on this theme in the coming months, then the December Federal funds futures contacts would begin to retreat from the 2.0 per cent Federal funds rate that it has priced in. Three days do not make a trend but since the Chairman spoke, the contract has begun to move in that direction.

As though on cue, Federal Reserve Board economists have produced a discussion paper that tentatively claims that large asset purchases by a central bank would affect the price and yield of that asset (http://www.federalreserve.gov/pubs/feds/2004/index.html).

In other words, if the US Federal Reserve so desires, it can buy long-term government bonds, keep their prices up and yields down and thus stimulate the economy even if the Federal funds rate cannot be lowered much further. Releasing the paper in September has neatly coincided with the weakness in economic data and Mr Greenspan laying the groundwork for backing away from a vigorous economic expansion.

It would prove to be unsustainable, even fatal

Thus, on the rate scenario, if we are back to post-Iraq war 2003, what is wrong with equities rallying? Many things would go wrong. For starters, with the Federal Reserve acting as the central banker for both America and China (it maintains a fixed exchange rate with the US dollar), it would be essentially providing stimulus to the latter too and nullify their stated desire to slow the pace of economic growth. This would make sure that oil prices reach $50 and beyond. That spells recession.

Second, it would push many marginal borrowers in America to buy homes or refinance their houses at low floating rates from relatively high fixed rates. The housing bubble would become larger and American households would be leveraged even further, perhaps beyond any possible repair.

Third, the share of financial corporations in the corporate profit would rise even higher, continuing the hollowing out of industrial activity in the US.

Fourthly, when the plunge comes, America would be far more leveraged than it is even now and thus go into a Japanese-style economic slump of the 1990s except that it would be potentially even more painful than what Japan endured and is enduring.

Therefore, if investors were smart, they would equate the current firmness in equity prices to the warm glow of pleasure that a frog feels when the water begins to boil. Resistance to the fundamental deterioration through manipulation of technical indicators and through the provision of liquidity would be to set the stock market up for a Yellowstone effect. You have been warned.

(The author is an economist based in Singapore. Please address feedback to nageswar@singnet.com.sg)

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