How has the Financial Markets Changed Over Time part 1

To say that the markets will always stay the same is naive.  In wall street the bankers and traders continue to evolve to try to take advantage of loopholes in regulation and improvements in technology to give themselves an edge to either make money through out right trades or create products and services to collect commissions.  This article shall give a general overview of how the game has changed and characteristics that is unlikely to come back and new anomalies that might be on the road ahead.  In addition the demographics on the world are also changing, this will also have an effect on the markets.

Firstly, the Possibly more prevalent in the western countries than the asian ones .  According to USA Today, next year there will be the US will have 79 million people hitting the retirement age of 65, whilst in Europe a similarly large number will also hit this number.  It was noted from PsyFiTec that:

The recent Barclays UK Equity-Gilt Study (which unfortunately isn’t available on-line although you can buy it at £100 a pop, if you’re especially interested) makes some interesting observations about the effect of demographics on markets. You might expect that when the surge of post-war Baby Boomers starts to retire and begins looking for income then you’d see a decline in the funds invested in stocks and a surge in those invested in bonds. As the study points out this, in fact, is exactly what was seen in Japan in the 1990’s and now appears to be what we’re seeing in the US: the fit of the curve of people approaching retirement, saving hugely for it and then slumping into a blissful Third-Age is very close to that of the changes in US market valuations.

He adds that:

So, maybe the US is set for a twenty year period of slow growth, but maybe enhanced immigration will change the population profile. Maybe the aging population will want to party their lives away on cruise ships, but maybe the falling value of their retirement income will force them to opt for a pedalo on the local duck pond instead. Maybe drug companies can look forward to a boom in sales to geriatrics but maybe cash-strapped governments will legislate to make them look more like utilities than Klondike gold-rushers. Maybe government bonds will be a bust, but maybe inflation will remain subdued due to overcapacity in the face of a declining market for consumption.

Meanwhile Asian societies continue their quest towards self-sustaining economies and as their wealth increases their appetite for Western assets continues to grow. Maybe this growth will be checked by internal problems or environmental constraints but maybe it won’t. Overall there are a lot of maybes which mean that the straightforward expectation that demographics will lead to a reduction in market returns isn’t quite so obvious as we might expect.

Prediction is never straightforward, but we can be fairly assured that the hoards of grey-pated elders streaming towards retirement are going to be looking for safe income streams. That’s probably where we should start to look for a demographic dividend.

In essence we should realize that with a greater demographic needing fixed returns, the bond markets and fixed income structured products are likely to balloon.  In addition with the recent market turmoil, its hard to believe that such fixed income products can promise good and steady returns.   It was noted that there are instances of underfunded pensions.

The reasons are:

  • The most obvious reason is investment performance, which has taken a hit.
  • The pension protection act of 2006 requires funds to be fully funded starting next year.
  • Misleading actuarial assumptions that assumed, on average, 8 percent returns.
  • The cost of benefits.
  • The aging workforce.
  • And the ratio of retired to active employees.

All of this means they will need to adjust various assumptions to make them more realistic.

Next, different asset classes are behaving unlike they were before for 2 reasons. First there has been dropping barriers to entry for different assets due to the introduction of ETFs, which replicate the exposure almost every asset class out there.  This means an invest-able benchmark  which creates an environment where fund managers and traders are judged by this instrument as most of the time they are not judged about their overall performance but rather how they outperform the market the particular ETF or index  as stated here. Abnormal Returns has done well in highlighting the effects of as they noted from Minyanville:

This point is illustrated nicely in a post today by Howard Simons at Minyanville.com.  In it he examines how the behavior of standard corporate indices changed after the introduction of an investment grade corporate bond ETFs:  the iShares iBoxx $ Invest Grade Corp Bond (LQD) .  Simons writes:

Indexation of any kind changes the behavior of investment managers who inevitably get their performance measured against an index. What’s worse is how even the most arbitrarily assembled index, one which might be important only to its creator and to anyone who has a vested interest in volume therefor, suddenly is elevated to exalted status by participants at all levels. Even the broadest and most senior indices change behavior; you’ll find individual investors fretting they’re underperforming the S&P 500 and not have an inkling as to why they should care.

An example of an asset class that has greatly changed is the commodities

Commo Finance

As can be seen from the chart between 1990-2003, the movement of commodities was inversely related the S&P 500. However after that, the movement of commodities mimicked the movements of the S&P closely. Such a phenomenon was also noted by the high correlation of 0.65 amongst the different asset classes recently this is seen below in a study done by barclays noted by zero hedge

correlation

However systematic relative strength did note that dispersion between different returns from different countries remains high and that this bodes well for momentum strategies which switch between various countries.

correlation

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