Apr 01, 2014

    When might Wall Street sneeze next?

    IN JANUARY 1994, when the United States Federal Reserve unexpectedly raised its federal funds rate to tame what it saw as incipient inflation, it also effectively ended the local market's "super bull run" of 1993 that had lasted only about five months.

    It also spawned a saying that gained popular ground in the months and years that followed: "When Wall Street sneezes, the rest of the world catches a cold."

    True enough, traders spent an inordinately large amount of time in the 1990s poring over US economic data for clues as to whether there would be more rate hikes to follow that first and, if so, when these might occur.

    Fast forward 20 years and the local market appears to have come full circle - professional and amateur economists here now spend an inordinately large amount of time studying US economic releases to figure out when rates might start to rise.

    True, nobody looks at the 30-year Treasury yield this time. Neither, for that matter, does anyone pay attention to the 10-year or even two-year yield.

    But that's because: (a) investment horizons have become drastically shorter since then, and (b) inflation is not an issue - yet.

    More relevant, perhaps, is that since Wall Street's indices have set around 60 all-time highs in about 15 months and as the worry now is rising interest rates, the right question to ask is: When might Wall Street sneeze next? After 1994, the next jolt from the US came in 2000 when Nasdaq crashed, then 2008, when the sub-prime crisis erupted.

    Since then, it'd be fair to say that keeping interest rates artificially depressed for several years while flooding the economy with quantitative-easing money has probably introduced distortions into the market, some known and others unknown.

    A known distortion is that assets over the past five years have been allocated not according to their best economic uses, but on the basis of liquidity and yield considerations.

    An unknown distortion would be how much US stocks are now overvalued, if at all. In this regard, consider that the VIX index, which is derived from the options market's estimates of future volatility, is at 14.6, just off the 52-week low of 12 and way down from the high of 22.

    This suggests there's not much fear in the market which, in turn, is sometimes taken to mean that complacency is running high. Then again, this has been the case for five years now - not surprising, given that the Fed has basically guaranteed unlimited money printing if and when the market crashes.

    Interestingly, US newspaper Barron's last week reported that the Nobel-winning economist Robert Shiller has calculated the stock market's price-to-earnings ratio to be more than 25, which, according to Professor Shiller, is a level exceeded only three times before - prior to the 1929, 2000 and 2007 market crashes.

    If it is, the culprit would be the Fed because of its unprecedented stimulus and bailouts that have inflated its balance sheet by US$4 trillion (S$5 trillion). Most on Wall Street have embraced the Fed's actions, but there are prominent critics.

    In an interview with Fortune magazine, legendary fund manager Jeremy Grantham said there is no proof that the economy is any stronger from quantitative easing.

    "We invest our clients' money based on our seven-year prediction," he said. "Over the next seven years, we think the market will have negative returns.

    "The next bust will be unlike any other because the Fed and other central banks have taken on all this leverage that is out there and put it in their balance sheets. We have never had this before."