Why are the markets rising despite the crises?

Leo Leiderman  credit: Inbal Marmari
Leo Leiderman credit: Inbal Marmari

Prof. Leo Leiderman, Bank Hapoalim chief economic advisor and Tel Aviv University senior lecturer explains the contradictory trends in  US, European and Israeli markets.

Just 18 months ago, things seemed different. Global inflation had reared its ugly head following the global pandemic, and the world's central banks - Israel's in particular - raised interest rates sharply. Another bubble burst, and stock markets reacted accordingly. The leading indices fell by 20% or more and pessimism reigned.

Looking at the US stock market today, it's as if there never was a crisis. The Nasdaq and S&P 500 are at all-time highs, and the AI trend is igniting the markets. European stock markets are also part of the celebration, and even Japan's numbers haven't been seen since the late 80s.

And here in Israel? Despite the war, a growing deficit, and the fact that Moody's downgraded Israel's credit rating for the first time in history, the stock market is on the up and up this year. The TA 90 index, which lists second-tier traded companies, since January has performed much like Nasdaq indices with a return of about 11% in under three months. Ironically, last year, long before the war, the Tel Aviv Stock exchange was underperforming.

About three weeks ago, "Globes" main headline was "Shekel at a 9-month high, stock market up 8% since the downgrade." Minister of Finance Bezalel Smotrich shared the image across social networks, adding, "Israel's economy is strong and with G-d's help, it will continue to get stronger."

To what extent does stock market performance reflect a country's strength? It's complicated question. Japan, for example, recently entered a recession, and growth figures for Germany and the UK are also not stellar. Prof. Leo Leiderman, Chief Economic Advisor to Bank Hapoalim, and a senior lecturer in economics at Tel Aviv University, has an answer.

Germany and Japan

"Two current examples are Germany and Japan," explains Prof. Leiderman. "According to most indicators, Germany is in a recession, due, among other things, to the war between Russia and Ukraine. Despite this, the main stock index, the DAX 40, recently reached an all-time high. Japan's economy has also treaded water over several years, and is currently in recession, and the Nikkei 225 index has risen steadily from June 2012 till today. In fact, this index recently returned to its November 1989 peak (about 40,000 points), a level that had prevailed before Japan entered into a deep and prolonged economic and financial crisis."

In terms of theory and practice, is there an internal contradiction in the gaps?

"There isn't necessarily a contradiction. First, the role of financial markets and stock markets in particular is to look ahead, and to set prices not for the present, but on the forecast capital value of revenue streams (dividends and capital gains) over the next five-ten years, and more.

"Secondly, studies indicate that although at the beginning of a recession, and even before it, stock indices tend to fall, from the point of view of investors, after a while these declines possibly create opportunities for future profit. Since a recession is usually a temporary situation, the stock market recovery begins long before the recession ends.

"The legendary investor Warren Buffett summed it up, saying that he typically buys stocks in a slowdown or recession, and sells them when the economy recovers."

You give a lot of credit to investors, are they that rational?

"There is extensive economic literature regarding your question and a number of Nobel Prizes have been awarded to economists who've studied the subject, the most prominent of which is Prof. Robert Shiller of Yale University, who received the Nobel Prize in 2013. Using his models, Shiller was able to predict the dot.com crisis of 2000, and the subprime mortgage crisis.

"In our context, I will cite two of Shiller's important conclusions. First, financial markets are usually much more volatile than real economic data as represented, for example, by GDP and employment figures. Today especially, with advanced, modern electronic and digital commerce technology, financial markets react very quickly to any information or data that seems relevant.

"On the other hand, production, employment and other real indicators react relatively slowly. For the most part, it takes time for companies to decide to increase staff and production, as does implementation of these decisions.

"Secondly, it is certainly possible to identify various important episodes where the stock indices were influenced mainly by psychological and emotional factors, herd mentality, fashion, and the like. Some of these episodes were characterized by share price bubbles, that is, situations in which the price of a stock doesn't exactly reflect a reasonable current value on the expected future profit."

The interest rate effect

Are we just talking about expected future profits, or are other factors responsible for these record-breaking market highs?

"There's no doubt that changes in interest rates greatly affect the pricing of assets in the markets. Some of the bubbles in recent decades were due largely to sharp reductions in interest rates by central banks, reductions that made investing in stocks more worthwhile. The reverse is also true: many episodes of a collapse in share prices reflected the market's reaction to a sharp increase in interest rates".

Meaning, in your opinion, market volatility, in part, reflects central bank volatility?

"Definitely. It's clear that during a period like the coronavirus crisis, interest rate reductions are needed to support the economy, and in periods of economic overheating, it's advisable for central banks to implement a restraining policy.

"Nevertheless, I believe that the (US) Federal Reserve, as well as the European [Central Bank], acted with excessive volatility. When they lowered the interest rate, it could have been done in more moderate stages than what actually took place, and likewise when they raised the interest rate. Bottom line: the interest rate policy was partly stabilizing, but also partly destabilizing for the financial markets."

Wall Street keeps on going, and the Fed chair has announced that the plan to cut interest rates three times later this year is still in place. In your opinion, are we in a bubble that will end with a downward correction?

" Some of the indices, like the Nasdaq and S&P 500, are close to breaking or have already broken historic highs, and history has shown that in such situations, indices will make corrections for technical reasons, including profit-taking. Even the current situation runs the risk of this type of correction. However, there is uncertainty and volatility, and it's impossible to schedule the timing and force of price corrections, if there will be any at all.

"What's different this time is that the central banks interest rates are expected not to increase, but to decrease. Therefore, the situation in which a sharp increase in interest rates would trigger a correction, or a stock market crisis, does not apply this time. At the macro level, it's important to note that the interest rate has finally returned to a level considered normal. In this situation, we can plan on nominal interest rates of about 4%-4.5% per year, inflation of about 2.5% per year, and a real interest rate of about 2%."

Leiderman notes that although the Fed has indicated a plan to lower interest rates three times this year, the market's original forecast was far more optimistic, with about six interest rate cuts. Meanwhile, the markets have aligned themselves to the Fed's forecast, and were not affected by the change.

"The indices were hardly damaged by the drop from six Fed interest rate reductions expected this year to a maximum of three expected reductions. At the same time, it's important to note the AI revolution that is sweeping the entire world, its effect on technology stocks and others, and the increase in expected profitability and production productivity in the US.

"It's very difficult to determine the 'correct' pricing of a company that's expected to greatly benefit the citizens of the world through the application of innovative technologies. Nonetheless, we cannot rule out the possibility that even if there is no overall market bubble, some such companies may be priced in a bubble-like manner."

Do you have any tips?

"Negative surprises, so-called 'black swans', can always happen, so the recommended approach is to diversify the asset portfolio and control for risks. Prominent among the global risk factors are the possibility of extreme policies on the part of Trump, if he is elected, and an escalation in geopolitical tensions."

Published by Globes, Israel business news - en.globes.co.il - on March 26, 2024.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2024.

Leo Leiderman  credit: Inbal Marmari
Leo Leiderman credit: Inbal Marmari
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