Equities still risky: Roubini

By Mark Noble | April 27, 2009 | Last updated on April 27, 2009
5 min read

(Orlando, FLA) — The current rebound in bank share prices has prompted optimism in the markets, but renowned forecaster Nouriel Roubini warns the fundamental factors just aren’t there to fuel a sustainable rally in stocks. But he doesn’t rule out a recovery altogether.

Roubini, professor of economics and international business at the Stern School of Business at New York University, has become arguably the most high profile commentator on the global financial crisis, in large part because he’s was one of the first voices to predict the credit crisis.

While he still forecasts a lot of gloom, Roubini, a keynote speaker at the CFA Institute’s Annual Conference in Orlando, Florida, says due to the efficacy of policy measures and stimulus programs being initiated by governments around the world, it looks like the markets will avoid doom. However, finding a bottom for the stock market is still some way off, meaning any surge in equity prices right now are symptomatic of a bear-market rally.

“The tail risk of near depression has been greatly reduced right now,” he says. Roubini believes this is a bear market rally, rather than the beginning of a systematic recovery for three reasons:

• The macro [economic] news is going to surprise on the downside. Economic growth is not going to be as quick as the consensus expects.”

• There will be pressure on earnings — not just financial firms but the corporate sector as well — given the weakness of the economy, deflationary pressures, reduced pricing power, constrained margins and corporate defaults.

• Finally, the financial shocks will reveal that some banks are in really big trouble. Even the stress tests are going to suggest that there are significant issues in some parts of the financial system. The process of deleveraging for highly leveraged institutions like hedge funds is going to continue.”

Roubini further notes that banks can’t have healthy earnings until the economy recovers, at least until next year; “The U.S. unemployment is already on its way to around 10.3%. This will only magnify the amount of defaults of loans being carried on bank balance sheets.”

He doesn’t expect the current stress testing on U.S. banks will shed any light on the risks being recovered, given the economic conditions experienced in the first quarter of 2009 are already worse than the worst-case assumptions being used to test the banks.

For this reason, Roubini predicts global losses from loans taken by financial institutions will be around $3.6 trillion.

Changes to the reserve requirements and accounting standards — put forth by the Financial Accounting Standards Board, which allows banks to “write-up” the value of some assets and avoid mark-to-market accounting — have allowed banks to appear more healthy. In addition, banks are allowed to borrow from governments at record low interest rates and then lend that money out at a higher spread.

Even among these favorable conditions, Roubini points out an apparently well-capitalized bank like Wells Fargo has only half the capital reserves than it was carrying in Q4.

Where earnings are being made by firms like Goldman Sachs, he says it’s from the same highly leveraged strategies in use before the crisis. Goldman Sachs has billions of dollars of net inflows from the aid money that institutions such as AIG have paid them to cover off their credit-default sway losses.

Goldman Sachs wants to return the money it received from the U.S. government’s troubled asset relief program (TARP). Roubini says this is because of the secured line of funding it’s getting from other firms being bailed out by the government.

“Now they want to return the TARP money and gamble it even more, and they’ve been gambling it like crazy. Most of their profits in the first quarter have come from trading activities that are highly risky,” he says. “Banks should all be prudent right now, and most of them are not.”

Roubini told Advisor.ca that eventually he expects banks to come to terms with a more stringent regulatory environment that clamps down on leverage. He won’t be surprised to see many of the world’s largest financial institutions break up, to avoid the massive capital charges they once carried, which in turn led to the belief they were “too big to fail.”

“The ‘too big to fail’ view has led to a massive wave of consolidation,” he says. “For instance Citigroup wanted to buy Wachovia, not because it was a good bank, but because it was a moral hazard and they wanted to achieve that ‘too big to fail’ status to obtain more government relief.”

He adds, “If you’re going keep having these large capital charges, many of these institutions may decide to break up rather than remain too big to fail.”

On a positive note, Roubini says a bottom in the stock market may be near — possibly as soon as the fall of 2009, if there are no major changes to the global economy that require him to revise his forecasts. He warns that the stock market in recent years has been a poor predictor of economic activity, having lagged the last recession in 2001 in predicting a recovery.

“If I’m right, an economic recovery is not coming in June, but rather in the first or second quarter of next year. The traditional view is that the stock market looks six months ahead, and a bottom should happen in the fall of 2009,” he says. “I wouldn’t rule out that the stock market might bottom, but then move sideways for a long period of time until there is a significant evidence of a robust recovery. People joke the stock market has predicted 15 of the nine recessions. The stock market has also predicted six of the last zero economic recoveries.”

He adds, “As time goes by, chances that the latest low becomes the true bottom increase. This happens for two reasons: As you reach a new bottom you may be closer to fundamental value consistent with [financial statements]. Secondly, as time goes by there are more aggressive policy options, the rate of economic contraction will slow down and you’re more likely to see the bottom of the economy. I do believe we’re closer to a bottom than we were a year ago, based on those factors.”


Mark Noble