I sometimes get attacks of gout. When I do, I often get a feeling of euphoria when the attack fades. My mood will often be better even though I’m still in discomfort than it is when I’m in normal good health.
I say this because it offers us reason for optimism in these dark days. Our mood is often best not when things are OK, but when they are improving and we expect them to improve further. As Adam Smith put it, “the progressive state is in reality the cheerful and the hearty state to all the different orders of the society. The stationary is dull; the declining, melancholy.” The social scientist Albert Hirschman called this the tunnel effect. If you are stuck in traffic in a road tunnel, but you see the lane next to you move, you’ll cheer up even if you are not moving in the expectation that you will move soon.
Stock markets behave like this. The biggest three-month rise in UK share prices in history since the South Sea bubble in 1720 came in the first quarter of 1975, when the index almost doubled in real terms. 1975 was a terrible time for investors: inflation was high, GDP was stagnating and profits were being squeezed badly. But things were less catastrophic than investors had feared, so the market soared in relief.
There’s another feature of stock markets – big rises are as likely as big falls. The market does not “rise like a feather and fall like a stone”. Thanks to the Bank of England, we have monthly data on share prices going back to 1709. During this time there have been 23 months when prices have fallen by 10 per cent or more. (This is precisely the number we’d expect to see if extreme returns – those of more than two standard deviations – followed a cubic power law, which tells us that such returns do follow a precise statistical distribution.)
But there have also been 25 months in this time when prices have risen by 10 per cent or more. Price jumps are as likely as crashes.
Positive feedback loops, therefore, work in both directions. One reason for the market’s sharp fall is that as volatility rose, risk parity traders (those who try to keep a constant level of volatility in their portfolios) sold even more. But when volatility falls back – and it is at a record high as I write – these traders will become buyers, which will amplify the price rise. And once prices stabilise, those value investors who have held back for fear of being swamped by momentum traders will also return to the market. And then momentum sellers will become momentum buyers.
And remember: the market is cheap by historic standards, with the dividend yield on the All-Share index near a 40-year low. Even if we assume that the yield should be permanently higher in future than it was in the past – to reflect higher risk and lower average growth – this still gives lots of room for a big rally.
Something else points to this. There has for years been a strong link between annual changes in US industrial production and in the All-Share index: the correlation has been 0.59 for annual changes since 1996, with each percentage point of higher output growth associated with 2.1 percentage points of higher returns. UK stocks are, therefore, global cyclicals. This tells us that when global output recovers, so too should shares. And even if there is some permanent loss of output, production should snap back sharply as economies return to something like normal.
Such a recovery should be accelerated by the worldwide loosening of fiscal and monetary policy. This can of course do nothing to raise demand while we are stuck indoors. But it can strengthen the subsequent recovery.
And just as recovering from gout improves my mood because the attack has made me value the health that I otherwise take for granted, so something like a return to normal economic conditions could greatly cheer up investors by making us appreciate prosperity and a normally-functioning society more.
In fact, this crisis might have a longer-term benefit. Governments around the world are discovering that they can do a lot to support ailing economies through direct lending to business or wage subsidies. Hitherto marginalised ideas such as helicopter money (whereby central banks simply top up our bank accounts) or a citizens’ basic income are now on the agenda. And artificial barriers to sensible policy such as concern for the public finances have been ditched, while the (long-awaited) possibility of coordinated fiscal expansion across the eurozone is now a reasonable prospect. In the longer term, all this should reduce investors’ fears of future recessions because they know that governments can do more to prevent them.
Yes, such measures represent a reversal of the “neoliberal” orthodoxy of recent decades. But remember – stock markets did very well under post-war social democracy; UK share prices more than quadrupled in real terms between 1945 and 1973. State intervention can be good for equities. (A proper free market would be a nightmare, but that’s another story.)
You might think all this is too optimistic. I say it, however, as a correction to a common error – the tendency to project our current mood into the future and thus to underestimate how it will change. I’m old enough to remember being told in October 1987 that the long bull market in equities was over, and in the early 90s that house prices would never rise again.
Such pessimism was of course wildly wrong. We’ve reasons to suspect that this time is no different. Of course, nobody knows when the market will recover or from what level. But we do know something: this too shall pass.
