Normalcy bias and the new Weimar? Macro blog

Dear All,

We are prone to "normalcy bias" as referred to in this excellent piece titled: 'There is nothing normal about today's market' written by FT contributor Merryn Somerset Webb (Full piece at the bottom).

The world is full of debt, artificially low interest rates and everyone is making money based on consumption being moved forward courtesy of the Governments - all of this tosecure: Just one more time-ticket to extend this rally.

The stock market rally being the only real success in this so called plan, the abillity to keep 10 Year low in the US has failed - despite being prime objective in POMO and the FED's expansive balance sheet.

Now they can not let the stock market fail can they? Well, it's medium- and long-term not up to them, and everyone I know now firmly believe we will see something closer to Goldman Sachs bullish call, than my more sanguine call, which is we are in final phase of this madness.

Friday and Monday were blow-off days - Wild moves like this tends to come at the END OF CYCLES, not to start new ones - the official excuse being the situation in Africa (When will we see the first Asian unrests?)

Valuations are now stretched - and euphoria or normalcy bias is as strong as I have seen since 2000 and 2007. The world has not changed - if anything we are have onto the brink of financial disaster with more and more countries finding their FUNDING YIELDS too high to carry.

Crude pressing up against 100 $ a barrel and with more supply issues likely to happen I find it hard not to go back to 1970s buzzwords like:  Energy crisis, Big government, unemployment and rising inflation.

Our local beer Carlsberg, which now for the umpteenth time failed to meet expectations, are increasing beer prices due to commodity inflation a situation many producers around the world is contemplating just now.

Furthermore everything is now priced in as per this chart from Albert Edwards of Soc. Gen:


Source: Albert Edwards, Soc. Gen

I think there are two major trends/paradigm' which is up for discussion right now:

Can rising debt levels be sustained forever with no impact?

When does debt become an issue? There is also new word to be learned: Chartalism  (http://goo.gl/NFe8P)  - Link to headline of this blog:  Global Weimar.

The smart money is beginning to doubt if this can continue much longer - the normalcy bias being one of: This will happen but not now later........based on historic performance of risky assets it may look tempting to continue this line of thinking, but then do not you ignore facts like:

• marginal cost of capital is RISING not stable?
• Social Unrest in Africa - Asia next?
• Massive inflation issue in EMG countries.
• The biggest money lender: China is tightening monetary policy
• Housing prices remain deflated
• Banks remains under-capitalized

The sustainability of non-democratic governing over time.
More illusive yet more importantly - the social order and International play-book for keeping trade- and diplomatic ties are being rewritten is it not?

It is becoming very clear that the normalcy bias of keeping what you know as 'stability' in place (read: dictators to maintain flow of commodities) is not going to work over time. Any recession is followed by a WAR - this is 'War light' and it goes towards one of out top calls for 2011 being: The year of Social Unrest. Even China can no longer feel safe as inflation is getting out of control (China raised petrol prices overnight Reuters on Petrol Price hike)

As the EU, the US starts to feel the ramification of keeping dictators in place and to accept non-democratic leaders as there equals they open up for the dynamic which works in The Law of Conservation of energy: "A consequence of this law is that energy can neither be created or destroyed: it can only be transformed from one state to another" - The unleash of energy from the conservation period becomes one which generates MORE VOLATILITY not less as was the only excuse for keeping the relationship in the first place. Again Western practical thinking will have failed.

This blog is not a call for buying a farm in the middle of nowhere and preparing for famine, recession or war. It's merely a state of facts: The Normalcy Bias is prevalent in the policy makers mind and unfortunately also in the main-stream investors, this is ALWAYS a time for being EXTREMELY cautious.

Personally I am and have been short S&P since 1116-00 - long Bunds (@122.83) and Bonds(@118 '19), long some puts in S&P and long the US Dollar(@1.3630) as the European banking crisis is about to restart again, but as it has often been the case, I may to too early, but the two dynamics mentioned above here is something one has to accept - change is here, its happening and the impact on the markets will not follow the prefered path of this world: Keep it quiet and it will go away.

Not being able to work, not being able to feed your family and not being able to speak freely is something no one will accept over time.

Steen Jakobsen, Copenhagen, Feb. 22, 2010

Attached the FT article mentioned above:

http://www.ft.com/cms/s/2/685eb896-3b8b-11e0-a96d-00144feabdc0.html#axzz1Efgv7J8S

There is nothing normal about today's markets

By Merryn Somerset Webb

Published: February 18 2011 18:18 | Last updated: February 18 2011 18:18

Af riend's grandmother telephoned her  earlier this week to say she was frightened. She had a feeling she hadn't had since just before the second world war. The feeling? That another big war isn't terribly far away.

She has watched the rise of China; she has watched the explosions in the Middle East; and she has noticed how inflation is eating away at living standards worldwide. She isn't quite sure what will happen next, but experience tells her things can change very fast.

You can discount her wobbles as those of a nervy 96-year-old and I dare say you will. But you could also look at her list of worries another way – and ask if the rest of us aren't a tad too complacent about everything.

The vast majority of people suffer from what behavioural scientists call "normalcy bias" – the assumption, even in the face of evidence to the contrary, that things will continue as they always have. If something hasn't happened before, why would it now?

This explains why people don't leave nightclubs as soon as they smell burning and why a bafflingly large number of people refuse to evacuate their homes even as floods begin to engulf them.

It might even be why Mervyn King refuses to accept that high inflation in the UK is more than just a blip: it has been so low for so long, the change is hard to accept – in spite of the evidence that it is getting pretty dug in.

For more on this, it is worth reading Barton Biggs' 2008 book, Wealth War and Wisdom, in which he looks at how, when bad things happen, "events move much faster than anyone expects... and the barbarians are on top of you before you can escape". Biggs doesn't appear to suffer from normalcy bias: he advocates preparing for the future by buying up a small farm and stocking it with "seed, fertiliser, canned food, wine, medicine, clothes, etc".

However, the reason I'm thinking about this now is because investors are particularly prone to normalcy bias.

Consider the housing bubbles. One of my striking memories of the pre-crisis period was being told by a TV presenter that the fact that house prices hadn't fallen made it clear they never would. The more they rose, the more she assumed they would rise – even in the face of chart after chart showing the house price to income ratio hitting impossible heights. She still thinks that the falls of recent years are a "blip".

Then look at what's going on today. I've written here about China before, but the bias is happily at work here: there's plenty of evidence to suggest a massive credit bubble is ready to blow. But still the consensus is that the Chinese government will somehow manage to make it OK – "they always have so far", one fund manager told me this week. Sound familiar?

Then there are the emerging markets. Their stocks used to be cheap relative to developed markets. So they went up. That led investors to assume that they would outperform developed markets indefinitely. It hasn't quite worked out like that.

Emerging markets aren't cheap any more and, from Brazil to India, they are being slammed by the kind of rampant price inflation that doesn't do much for any asset class. The result? Not outperformance but underperformance: the FTSE Developed All Cap Index is up 5.4 per cent so far this year, while the All Emerging All Cap is down 4.2 per cent.

One final example: commodity markets. The general view now is that we are back on track

with a commodity supercycle – one in which the price of copper will hit a new high every day for ever. But what if, as Ruffer's Henry Maxey suggests, the huge rises in commodity prices at the moment actually only reflect a shift in money flows?

The average investor can't see the point of taking the political risk of being directly invested in emerging markets so he is moving his money to make a bet on growth and inflation via commodities instead. As a strategy, this makes some sense but it also makes the bubbling market more fragile than the supercycle argument – which relies on real not speculative demand – suggests.

So what might choke it off? The obvious answer is tighter monetary policy in the US and China. That could be coming sooner than the market thinks: with the US consumer price index up 1 per cent in January, the days of free-wheeling quantitative easing – which has provided much of the liquidity to markets over the last few years – might be numbered. Note too that China has raised interest rates twice in the past six weeks and only yesterday tightened things a little more by increasing the reserve requirements of its big banks.

Much more of this and perhaps it will suddenly look more normal for commodity prices to fall rather than rise.

Merryn Somerset Webb is editor-in-chief of Money Week and previously worked as a stockbroker. The views expressed in her column are personal.

merryn@ft.com