From Peter Tchir of TF Market Advisors
The Placebo Effect
The “Placebo Effect” is fascinating. In a typical drug testing trial, one group of patients will receive the actual drug being tested, and a “control” group will be given an “inert” medicine (or “sugar pill”) that shouldn’t do anything for the patient, but the patient doesn’t know that.
So much of what I find wrong about “economics” is that it masquerades as far more of a science than it actually is. It doesn’t have theories that can be “tested” in a real world, where 2 similar situations are treated differently to see which “treatment” works better. Each economy and each situation is so different that it is IMPOSSIBLE to determine why policies failed or what should have been done differently. It is possible to come up with reasonable ideas and theories of what could have been done or should have been done, but they are only theories. The systems are so complex that finding situations with similar starting conditions with similarly motivated entities involved is simply impossible to find. The fact that so much of our policy seems to be based on research into what should have been done in the Great Depression and what has been seen in Japan is frankly scary. There is no way to “know” how the Great Depression would have turned out with a different set of policies. We can make conjectures, but that is all they are – conjectures.
Making it even more difficult to determine if a policy is working is the “placebo” effect. The market is being fed a lot of medicine (pun intended). LTRO and Greek “resolution” being the latest medicines. But are these treatments really working or are we rallying on a diet of pablum?
The LTRO was designed to support the market, the market is up, so the LTRO must be working. That at least is the logic many investors are applying. They see the improvement in sovereign debt yields, the avalanche of “positive” (if unfounded) headlines, and the relentless march higher of the stock market. So the plan is working? Not so fast. The treatment was designed to help the stock market. The stock market is encouraged by that and believes it is getting better. That price action in turn convinces more people that things are better or fixed, and creates further demand for stocks. But is it real or are we just in another “Placebo Effect” stock market rally? The problem with the patients who get better on the placebo, is that the effect tends to be short-lived since nothing is actually fixed.
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While the improvement in 5 year Italian yields has been impressive since the start of this year and is in almost 225 bps, we have seen prior “policy induced” rallies that ultimately faded. Maybe this time is different or maybe the “placebo effect” has just been stronger, or aided by other factors. The willingness of the market to forget that 3 times last year, it was convinced things were better only to get worse is amazing. The market wants to believe – a key criteria for making a “placebo” effective.
While Italian bonds have improved, the main reason is belief in LTRO and some signs of progress in the unelected Italian government. What is being ignored is evidence that banks are hoarding most of the LTRO cash for future debt repayment, growing concern that senior unsecured lenders to banks are becoming too subordinated by the ECB, changes in laws designed to hurt bondholders, growing concern over ECB’s SMP holdings – both as a form of subordination to other bondholders and a source of real risk to the countries backing up the ECB. Very little has been fixed and in fact progress has slowed down on some things. After the Unicredit rights offering spooked the market, the banks seem under far less pressure to improve their capital base. They seem to be able to convince the authorities that “they should wait for a better time to raise capital” and that with all the policies in place, risk has gone down and carry will help.
That reminds me a lot of what happened after Bear Stearns was rescued.
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Rather than making changes to derivatives after Bear Stearns was “rescued” (and there were special clauses in the JPM deal that addressed concerns on derivatives) nothing got changed. Rather than forcing the weakest banks to raise capital, the Fed wanted to let them wait until the markets were more receptive. The market saw the rescue and fed policy as an “all clear” sign and commenced another nice rally.
It is hard to remember, but the highs for the S&P 500 were reached in October 2007, after everyone was well aware of the lurking problems in the mortgage market. Subprime had already collapsed, banks were taking huge write-downs, but a few new policies from the Fed and an aggressive rate cut were enough to fuel an early fall rally. Nothing had been solved, yet the market hit a new high. It took time for the market to realize that nothing had really happened, and that liquidity didn’t solve the problems and we slid towards new lows, but the market has a long history of temporarily responding to the central bank “medicine” only to rollover and hit new lows once the “placebo effect” is over.
I do not expect another crash like the what we saw in the fall of 2008, but continue to view the market as 5% - 10% overvalued. The longer we don’t take the pain, the bigger the fall as it gives more time for the problems in the system to spread and it makes them less controllable. If we get another sell-off, the impact of LTRO3 would be lower since the sell-off would be occurring with the knowledge that LTRO3 is a real possibility – ie, it will already be priced in. The willingness, even desire to keep bad and weak institutions on life support is a mistake. The complexity of the system is growing, and once the effects of the latest “treatment” wear off, that added complexity makes the next wave of problems harder to arrest.
There is some possibility we in a 2009/2010 central bank fueled rally, but I see more similarities to the October 2007 rally, the post Bear Stearns rally, and the countless Europe is solved rallies of last year. Remain very cautious and don’t mistake a “placebo effect” for a “cure”.