ptg ptg The Fearful Rise of Markets ptg This page intentionally left blank Download from <www.wowebook.com> ptg The Fearful Rise of Markets GLOBAL BUBBLES, SYNCHRONIZED MELTDOWNS, AND HOW TO PREVENT THEM IN THE FUTURE JOHN AUTHERS Download from <www.wowebook.com> ptg Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Pamela Boland Operations Manager: Gina Kanouse Senior Marketing Manager: Julie Phifer Publicity Manager: Laura Czaja Assistant Marketing Manager: Megan Colvin Cover Designer: Alan Clements Managing Editor: Kristy Hart Project Editors: Jovana San Nicolas-Shirley, Lori Lyons Copy Editor: Julie Anderson Proofreader: Apostrophe Editing Services Indexer: Erika Millen Compositor: Jake McFarland Manufacturing Buyer: Dan Uhrig © 2010 by John Authers Publishing as FT Press Upper Saddle River, New Jersey 07458 This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or finan- cial advice or other expert assistance is required in a specific situation, the serv- ices of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or applica- tion of any of the contents of this book. FT Press offers excellent discounts on this book when ordered in quantity for bulk pur- chases or special sales. For more information, please contact U.S. Corporate and Government Sales, 1-800-382-3419, corpsales@pearsontechgroup.com. For sales outside the U.S., please contact International Sales at international@pearson.com. Company and product names mentioned herein are the trademarks or registered trade- marks of their respective owners. All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher. Printed in the United States of America First Printing April 2010 ISBN-10: 0-13-707299-6 ISBN-13: 978-0-13-707299-6 Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson Education Singapore, Pte. Ltd. Pearson Education North Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educatión de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data Authers, John, 1966- The fearful rise of markets: global bubbles, synchronized meltdowns, and how to prevent them in the future / John Authers. p. cm. ISBN-13: 978-0-13-707299-6 (hardback : alk. paper) ISBN-10: 0-13-707299-6 (hardback : alk. paper) 1. International economic integration. 2. Globalization—Economic aspects. 3. Financial crises. 4. Economic stabilization. I. Title. HF1418.5.A98 2010 338.5’42—dc22 2010001943 ptg For Andie, Josie, and Jamie Download from <www.wowebook.com> ptg This page intentionally left blank Download from <www.wowebook.com> ptg Contents Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . ix About the Author . . . . . . . . . . . . . . . . . . . . . . . . xii Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii Timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvi Chapter 1: The Fearful Rise of Markets. . . . . . . . . . . . . . . . . 1 Part I: The Rise Chapter 2: Investment Becomes an Industry. . . . . . . . . . . . . 9 Chapter 3: Indexes and Efficient Markets . . . . . . . . . . . . . . 16 Chapter 4: Money Markets Supplant Banks. . . . . . . . . . . . . 25 Chapter 5: From Gold Standard to Oil Standard. . . . . . . . . 32 Chapter 6: Emerging Markets. . . . . . . . . . . . . . . . . . . . . . . . 40 Chapter 7 Junk Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Chapter 8: The Carry Trade . . . . . . . . . . . . . . . . . . . . . . . . . 55 Chapter 9: Foreign Exchange . . . . . . . . . . . . . . . . . . . . . . . . 62 Chapter 10: Irrational Exuberance . . . . . . . . . . . . . . . . . . . . . 69 Chapter 11: Banks Too Big to Fail . . . . . . . . . . . . . . . . . . . . . 76 Chapter 12: Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Chapter 13: Dot Coms and Cheap Money . . . . . . . . . . . . . . . 90 Chapter 14: BRICs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 ptg Chapter 15: Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Chapter 16: Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Part II: The Fall Chapter 17: Ending the Great Moderation . . . . . . . . . . . . 120 Chapter 18: Quant Funds . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Chapter 19: Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Chapter 20: Bank Runs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Chapter 21: Bastille Day: Reflexive Markets . . . . . . . . . . . 145 Chapter 22: Lessons from Lehman. . . . . . . . . . . . . . . . . . . 152 Chapter 23: Politics and Institutions. . . . . . . . . . . . . . . . . . 158 Chapter 24: The Paradox of Diversification . . . . . . . . . . . . 163 Part III: The Fearful Rise Chapter 25: Decoupling . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 Chapter 26: Banks Bounce . . . . . . . . . . . . . . . . . . . . . . . . . 179 Chapter 27: A New Bubble? . . . . . . . . . . . . . . . . . . . . . . . . 186 Conclusion: 2010 and After . . . . . . . . . . . . . . . . . . . . . . . . . 194 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 Select Bibliography . . . . . . . . . . . . . . . . . . . . . 215 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 Download from <www.wowebook.com> ptg Acknowledgments I submitted the manuscript for this book on the twentieth anniversary of my first day at the Financial Times, so I must first acknowledge my debt to the news organization where I have spent all my working life. I learned substantially all that I know about the world of investment during my career at the Financial Times, which has involved living in three countries, traveling to many more, and reporting on many of the events in this book. I learned much from all the many colleagues with whom I have worked, and I am grateful to all of them. I thank Lionel Barber, Martin Dickson, and Daniel Bogler for allowing me the time off needed to finish this book. Keith Fray, the Financial Times deputy head of statistics who suffers daily demands from me for graphics and information at the best of times, checked all the graphics. In particu- lar, I want to thank Philip Coggan, my mentor and predecessor, who probably helped me more than anyone else at the paper, and my cur- rent colleague in New York, Michael Mackenzie, who might know more about markets than anyone else I know. My studies at Columbia Business School, where I received an MBA in 2000, were also formative. I want to thank all my professors there, but in particular David Beim, Joel Brockner, Franklin Edwards, Paul Glasserman, and Bruce Greenwald for the many lessons I learned that proved invaluable for writing this book. It is also appro- priate to thank the Knight-Bagehot Fellowship and George A. Wiegers, for providing me with the funding for the MBA. This book is the result of my own conclusions, but these were formed by talking to a lot of people. In particular, I want to thank the following for interviews that helped in preparing the book: Antoine van Agtmael, Robert Arnott, Robert Barbera, David Beim, Mohamed [...]... fast-moving book is written in the style of John’s daily columns—concise, relevant, and containing perceptive examples Think of the book as your vehicle for a journey of discovery Each stop will precisely inform you of the forces that have come together to determine market valuations and correlations—or, in the words of John, the drivers of the rise in markets, their collapse, and their ongoing re-emergence... a minute-by-minute chart of 1 Download from THE FEARFUL RISE OF MARKETS the exchange rate of the Japanese yen against the U.S dollar At first I thought I had mistyped The chart was identical to the S&P If it were not so sinister, it might have been funny As the day wore on and turned into the next, we in the newsroom watched the two charts snaking identical courses across the screen... is The Day the World Changed” according to Northern Rock—money markets panic intensifies on both sides of the Atlantic xx Download from THE FEARFUL RISE OF MARKETS: A TIMELINE August 17, 2007: Fed cuts rates after Countrywide funding crisis The biggest U.S mortgage lender teeters on the brink of bankruptcy; then the Fed cuts rates—prompting new waves of money into emerging markets. .. all this, John Authers book also gives us hope that markets could also be made to work better in enhancing global welfare Mohamed A El-Erian, CEO and co-CIO of PIMCO, and author of When Markets Collide xv Download from The Fearful Rise of Markets: A Timeline The Rise November 23, 1954: U.S stock market recovers from the Great Crash Strict post-Depression regulation of U.S finance... to say that in the last half century, fear has been stripped from investors’ decisions With greed no longer moderated by fear, investors are left with overconfidence 4 Download from THE FEARFUL RISE OF MARKETS This, I suggest, is thanks to what might be called the fearful rise of markets The institutionalization of investment and the spread of markets to cover more of the global economy... meltdown of 2000.2 Some said good news for the world economy had understandably created overenthusiasm From 1950 to 2000, the world saw the renaissance of Germany and Japan, the peaceful end of the Cold War, and the rise of the emerging markets all events that had seemed almost impossible in 1950—while young and growing populations poured money into stocks Maybe the bubbles at the end of the century... THE FEARFUL RISE OF MARKETS the end investors and the managers that work for them; how risk management techniques can morph from being mitigators of risk to amplifiers; and why regulators have so much trouble maintaining their finger on the pulse of the markets As you proceed with your journey, you will come across a lot of interesting tidbits, including how emerging markets acquired the name... might answer that they are paid to take their clients’ money and make the best return they can, or to beat the market But in fact, they are mostly paid to maximize the assets they have under management (rather than profits) Investment managers generate fees as a percentage of the amount of money they manage, so their greatest fear is that clients will pull money from the fund, not that the fund will perform... bulb Then came the South Sea Bubble in England and the related Mississippi Bubble in France, as investors fell over themselves to finance prospecting in the New World Later 3 Download from THE FEARFUL RISE OF MARKETS there were bubbles in canals The Victorian era saw a bubble in U.S railroad stocks; the 1920s saw a bubble in U.S stocks, led by the exciting new technology of the motor... many of these areas, saw their roles usurped by markets Rather than disappear, they sought new things to do—and were increasingly lured into speculative excesses 6 Download from THE FEARFUL RISE OF MARKETS These toxic ingredients combined to create the conditions for the now notorious mess in the U.S subprime mortgage market, as financiers extended loans to people with no chance of . Ltd. Library of Congress Cataloging-in-Publication Data Authers, John, 196 6- The fearful rise of markets: global bubbles, synchronized meltdowns, and how to prevent them in the future / John Authers. p you of the forces that have come together to determine market valuations and correlations—or, in the words of John, the drivers of the rise in markets, their collapse, and their ongoing re-emergence. welfare. Mohamed A. El-Erian, CEO and co-CIO of PIMCO, and author of When Markets Collide FOREWORD xv Download from <www.wowebook.com> ptg The Fearful Rise of Markets: A Timeline The Rise November