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What’s Really Going On In Equity Markets

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FT blog

In October 1998, when the Fed under Alan Greenspan was forced to cut the Fed funds rate to bring back liquidity to the markets after the near-meltdown of the LTCM hedge fund, the result was also to stimulate markets that had not needed the help, Authers reminds us.

Large technology stocks, and the growing wave of dotcoms, were the greatest beneficiaries. The Nasdaq Composite index gained 40 per cent in three months, and tripled in less than 18 months as it roared through 1999. This, he says, helps explain the current reference to stocks as “partying like it’s 1999″.

There is another example, he notes: In 1987, after Greenspan’s Fed cut rates to avert a crisis in the wake of the Black Monday stock market crash, the response was again a bubble.

Traders know that both these incidents created bubbles that eventually burst. But they also know that in both 1998 and 1987, the euphoria created by the rate cuts lasted more than a year — plenty of time to make strong short-term profits, notes Authers.

Teun Draaisma, European equity strategist at Morgan Stanley, advocated selling in June, and then aggressively re-entering the market in August, for exactly these reasons. He says another bout of ‘equity mania’ is possible, with retail investors piling in and companies indulging in strategic mergers and deals.

He also predicts that the episode will “end in tears” — but that still leaves time for investors to make fat profits in the interim.

As everyone is working on the same assumptions, gains could be limited this time, Authers warns. Tobias Levkovich, US equity strategist at Citigroup and a bull on the market for most of this year, sounds a note of caution. “As most investors are now searching for performance data on past beneficiaries of Fed actions, we suspect some ‘institutional herding’ may arbitrage away much of the opportunity fairly quickly”, notes Levkovich.

Profit margins tend to be cyclical, and appear to be peaking. Earnings multiples, in turn, tend to be lowest when profit margins are high. Thus, some analysts would say current low earnings multiples simply show that the market wisely does not expect corporate profits to continue at their current heady levels.
Equity investors are also betting that growth will come more and more from the emerging markets, which successfully “decouple” from the US, while the US economy will continue to weaken. And they are ready to pull their money out as soon as the bubble seems ready to burst.

apologies if this has already been posted but it is interesting stuff and very much worth reading.

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