THE NOUGHTIES AND 1930S LOOK VERY ALIKE
By John Authers in London 2009-12-30

Just how dreadful for stock markets has this decade been? For the US, still by far the world's biggest stock market, the noughties saw worse performance than the depression-hit 1930s, making this the worst decade since equity markets have existed in their recognisable current form.

In real terms, the S&P 500, the most widely used benchmark of US stocks, fell 30.4 per cent in the 1930s. On the eve of the Christmas break this year, it had fallen by 37.5 per cent since the beginning of 2000. There are caveats: the bear market of the 1930s started in October 1929, while the current bear market started just after the beginning of the decade, in March 2000, when the technology bubble burst. Also, the serious deflation of the 1930s boosted stocks' performance in real terms, as they could fall in value and still maintain their buying power. But the bottom line remains that, from the perspective of stock markets, the two decades look very similar, even if the 1930s saw much greater pain in the real economy.

The key difference may lie in policy decisions. Both began with a collapse in asset prices following a speculative frenzy. In the 1930s, politicians let the market take its knocks, and a banking crisis ensued, followed by the Depression. Mindful of this precedent, the Federal Reserve cut interest rates aggressively in 2001, while politicians offered tax cuts. The result was that stock markets were able to rebound in early 2003, even though long-run metrics suggested stocks were still far more expensive than their historical average. Arguably, this merely postponed the inevitable and made the reckoning worse when it came. Cheap rates to stave off the equity sell-off also nurtured the financial engineering that allowed lenders to offer credit at artificially cheap rates.

The dotcom bust also prompted a change in the drivers of markets. Hedge funds made money during the first three years of the decade while mainstream mutual funds, invested in the stock market, fell by more than 40 per cent. This prompted investors to pull money from mutual funds and entrust it to hedge funds which, with the ability to move more widely between markets, to bet on prices going down as well as up, and to leverage up their bets using borrowed money, soon became the most powerful force for exaggerating market trends. Cheap leverage made it all the easier for big hedge funds to dominate daily market movements.

 Financial innovations also widened the scope for the funds, with exchange-traded securities making it far easier to trade swiftly in and out of emerging markets, and in markets for commodities and foreign exchange. Institutions reacted to the dotcom bust by looking for new assets that had low historic correlations with stocks, and poured in. But while these markets had had little relationship to stocks and bonds while they remained separate markets for specialist investors, the influx of money from institutions began to change this.

As time went by, correlations between countries and asset classes steadily increased.

In consequence the 2008 bust, when it came, was the most correlated and global collapse in asset prices in history, and was followed by the sharpest and most severe fall in global economic activity yet seen.

As the dust settled, however, there were some winners. After much turbulence the decade saw the drastic weakening of the dollar against the euro, which only came into existence in 1999. As the euro grew into its role as the world's second most important currency, it gained 41 per cent against the dollar.

This was also the decade when emerging markets came into their own. Since 1999 the MSCI World index, covering the developed markets, is down 19.5 per cent in dollar terms (and a much uglier 43.4 per cent in euro terms).

Meanwhile, MSCI's emerging markets index has almost doubled, gaining 94 per cent, while its Bric index (covering Brazil, Russia, India and China) has risen 173.5 per cent. After traditionally trading at a discount to developed world stocks, the bigger emerging markets now trade at a premium, showing that investors believe the risks associated with investing in such markets are outweighed by the chance of superior growth.

The word “Bric” only came into the language in 2001, after Goldman Sachs's Jim O'Neill used it in a report suggesting reforms to the G7 economic summits. It helped prompt many institutions to increase their holdings in emerging markets.

In tandem with confidence in the Brics came a sustained bull market in commodities, led by oil and industrial metals. Academic research showed that historically commodities had a low correlation with stocks as well as lower volatility, but similar returns. This implied that big institutions could reduce their risk without compromising their returns by buying commodities and led to a stampede to enter the market.

 The Bric countries' stock markets are weighted towards natural resources companies, and so the booms in commodities and in Brics ran together – until both collapsed amid the crisis of 2008.

But hopes revived swiftly, and the decade ended with Brics and oil both more than double their lows. Much in the decade about to begin rests on whether the confidence in the Brics proves