2021-10-13

The Bear Market Slowly Emerges from the Mist

NBER: Is Stock Index Membership for Sale?
While major stock market indices are followed by large monetary investments, we document that membership decisions for the S&P 500 index have a nontrivial amount of discretion. We show that firms’ purchases of S&P ratings appear to improve their chance of entering the index (but purchases of Moody’s ratings do not). Furthermore, firms tend to purchase more S&P ratings when there are openings in the index membership. Such a pattern is also confirmed by an event study that explores a rule change on index membership in 2002. Finally, discretionary additions exhibit subsequent deterioration in financial performance relative to rule-based additions.
I sort of file away lots of news items like stars in the nightsky. When they start forming a pattern I sit up and take notice. Something I've believed for a long time and no doubt mentioned in prior posts is that the Federal Reserve will fail, literally or perceptually, in the next "real" bear market. The 2008 financial crisis was a bear market in price, but not really in time or i policy response. There was no reform like Sarbanes-Oxley in the prior bear. The crooks were never punished, instead they received most of the bailout money! The recession barely qualified, it was one of the most shallow in history (though manufacturing was hit hard).

In the next real bear market, institutions will come down. The past month saw two Fed official resign over insider trading charges. Fed Chairman Powell may be done with rising inflation becoming an issue for Republicans, Democrat Sentor Warren already blasted him and also the Biden admin may want an MMTer in the job. What seemed liked a slam dunk reappiointment with the Fed riding a wave of popularity now looks like an institution coming under serious scrutiny. If this continues, the Fed will either be restrained and pullback from intervention or it will submit to political demands from POTUS or Congress, which will mean excessive inflation with the current slate.

The story above broadens the scope of institutional failure to passive investing and major stock market indexes. It also parallels the housing bubble fraud of paying for ratings on CDOs and other securities. I assume the next bear market will see some type of major reform, possibly limiting participation in the stock market or similarly strong restrictions on activity. This is the first story that puts some meat on that idea. The market is going to tank in a bear market, people look to blame someone, and the politicians will say, "Here's one of the largest index providers selling access to their indexes. They destroyed your retirement." If there is any truth to what that paper claims, even if it doesn't rise to anything criminal, it will be a PR disaster in a bear market and will be justifiation for all manner of regulations. If there is no bear market coming soon, S&P can get out front and settle it before it turns into something they cannot control.

Maybe this S&P story will fade, but this is the type of story that will emerge when a major bear market gets underway. Core institutions will go bust or be targeted by regulators and politicians. However, when the negative stories are already hitting major financial market institutions and companies, it makes me wonder. Recall an analyst called for Citigroup to cut its dividend in Nov 2007 and they did in Janaury 2008. This story is nowhere near that level yet and that was financially driven, but the corroborating piece of evidence I'm working with is that I suspect the markets may have already topped or have only one last blow-off move left in them.

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