2009 June 20 Saturday
Fear Fatigue Drives Stock Market Rebound?

Andy Xie, who some of you may recognize as formerly an economist for Morgan Stanley, writes that the stock market rally of recent months comes from investors getting tired of fear. Given the poor fundamentals this argument is at least plausible.

Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves.

Fear drove the market too far down after greed drove it too far up. Now fear fatigue has set in and investors have gotten tired of sitting on the sidelines.

Xie also believes that foreign buying of US Treasury bonds will decline and therefore Treasury interest rates will return to historic patterns of being about 2.5% above inflation.

The 10-year Treasury yield historically averages about 6 percent, with about 3.5 percent inflation and a real yield of 2.5 percent. This reflects the preferences of marginal buyers in the United States. Foreign central banks have pushed down the yield requirement substantially over the past seven years. If marginal buyers become American again, as I believe, Treasury yields will surge even higher from current levels.

So shy away from longer term bonds right now. You'll be able to earn much better yields if you wait.

If Xie is correct then there are some bigger consequences in store. First off, government debt servicing costs will soar and therefore the US government (as well as state and local governments) will have less money to spend on services and will be looking much harder at ways to raise taxes.

Higher interest rates will raise the cost of capital for the private sector too. But I'm not so sure about the impacts on private sector growth. If the national savings rate continues to rise then households might have more money available to invest.

On the plus side, net additions to household debt began to slow in 2007, and since the third quarter of last year liabilities have shrunk by $421 billion. For the first time ever, households have paid off more debt than they took on for two quarters in a row.

On the other hand, the Chinese might feel compelled to continue to buy Treasuries. The high savings rate in China might be driven by selective abortion of female fetuses and the resulting greater competition to attract wives.

In 2007, Chinese household savings as a share of disposable income was 30%, up from 16% in 1990. One possible reason for the jump in savings: The dearth of women is making China’s marriage market extremely competitive, and families with boys are accumulating wealth to make their sons more attractive matches.

Selective abortion increased savings in China, drove Chinese to buy more American bonds, and then this helped cause the real estate and debt bubble in the United States.

Chinese savings look set to rise even further as the sex ratio becomes even more unbalanced.

While the high savings rate in China has global impact, existing explanations are incomplete. This paper proposes a competitive saving motive as a new explanation: as the country experiences a rising sex ratio imbalance, the increased competition in the marriage market has induced the Chinese, especially parents with a son, to postpone consumption in favor of wealth accumulation. The pressure on savings spills over to other households through higher costs of house purchases. Both cross-regional and household-level evidence supports this hypothesis. This factor can potentially account for about half of the actual increase in the household savings rate during 1990-2007.

This has implications that go beyond China since selective abortion for sex selection is practiced in Vietnam, India, and other countries.

Share |      By Randall Parker at 2009 June 20 11:51 AM  Economics Motivation

Aki_Izayoi said at June 20, 2009 1:41 PM:

If you had a brokerage account Randall, do you think having large short positions would be a good idea? Or maybe you are an inflationist who thinks the Fed will print enough money to prop up asset prices.

Randall Parker said at June 20, 2009 1:48 PM:

Short positions make sense if you can figure out that some class of assets is going to tank. I tend to prefer to figure out what is going to go up rather than what is going to go down. I suspect there's some evolutionary reason for my preference. I think I like owning real things.

You can protect yourself from inflation in lots of ways. Buy foreign stocks. Buy stocks that hold reserves such as oil in the ground whose value will keep up with inflation. Even Buffett's franchise stocks will preserve value. Though during the inflation I expect P/E ratios to fall as people basically act like they want higher dividends to make up for inflation.

Inflation is a problem if you trade in and out of positions a lot since inflation will create false gains. So capital gains tax costs go up during an inflationary period.

When the economy recovers I think inflation becomes a real risk.

Matt@Occidentalism.org said at June 20, 2009 10:56 PM:

I wonder, what will be the tipping point for reversing the preference from sons to daughters in China?

kurt9 said at June 22, 2009 5:31 PM:

I hear the recent rally is due to the Chinese buying up as much commodities as they can at the fire-sale prices they are available at.

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