Circle of Life

— Ongoing turmoil in the Middle East is a convenient excuse for why global markets are under pressure. But it’s not the real reason. In fact, it’s much simpler than that. Markets are correcting because they went up too much. How’s that for an insight?

— It all comes down to price and value. When a market is overpriced, and sentiment turns (a euphemism for ‘reality dawning’), it will decline on good or bad news. The news, whether it’s trouble in the Middle East or bankrupt sovereigns in Europe, is merely the excuse for the sell-off…not the reason.

— The reason for last night’s sell-off in the US? Our guess is that investors are now starting to wonder what the world will look like after QEII ends in June. And they don’t like what they see. So they’re selling equities and buying bonds…and finally, the US dollar is catching a bid!

— Moody’s Ratings service has been doing its bit to help the dollar. Earlier this week, it downgraded Greece’s debt and last night it downgraded Spain’s sovereign debt rating. We didn’t think the dire state of the Eurozone was actually news but there must still be some lazy asset managers out there who need Moody’s to confirm the obvious.

— So, Moody’s rubbishes Europe, and the greenback strengthens. Too easy.

— But it also helped intensify the negative sentiment towards equities. If the sell-off continues to gather pace, it will undo Bernanke’s grand and retarded experiment of trying to create wealth by increasing stock prices. Unfortunately, it will also probably inspire him to try harder. QEII might not end…it might just morph into QEIII.

— In years to come, we’ll look back on this period as a form of financial insanity, and wonder why no one did anything to get the bernank’s finger off the electronic printing key.

— But self-interest has become so short term people can hardly see past their noses anymore. We rely on central bankers, politicians – anyone but ourselves – to make things ‘better.’ We think by simply printing money we can erase the problems caused by the biggest financial meltdown in history.

— The long term is for someone else to deal with.

— But humans haven’t really changed. This is just another chapter playing out in the long story of human folly.

— In our younger days we collected sayings by American Indians (if three constitutes a collection). Our favourite is by White Cloud. It’s called the Circle of Life and the first few sentences resonate very strongly:

Man has a poor understanding of life. He mistakes knowledge for wisdom. He tries to unveil the holy secrets of our Father, the Great Spirit.

He attempts to impose his laws and ways on Mother Earth.

Even though he, himself, is a part of nature, he chooses to disregard, and ignore it, for the sake of his own immediate gain.

But the laws of nature are far stronger than those of mankind…

— After a credit inflation, you get a deflation. We’ve had the ying, but Bernanke is trying to stop to yang. And he’s succeeded so far. But the game he is playing is completely unsustainable. The laws of nature will prevail.

— The just released Fed Flow of Funds Report (for the fourth quarter of 2010) contained some interesting info. The number you’ll probably see widely reported is that of household net worth…it increased by $2.1 trillion to $56.8 trillion.

— However this was entirely due to the stock market advance, which pushed up the value of pension funds, mutual funds and stocks held by the public.  Housing values actually fell and are lower now than in the first quarter of 2009. It’s just as well banks don’t need to mark their asset values to market.

— The bigger story in the Flow of Funds Report is the US economy is entirely dependent on government support to maintain its growth. Overall credit, or debt market growth was 5.1 per cent. The Household sector is still deleveraging, business sector debt grew by a decent 3.6 per cent…but Federal Government borrowing is keeping the whole ship afloat. It increased by 14.6 per cent in the fourth quarter, or $1.3 trillion annualised.

— The Feds have been propping up the whole credit market structure since late 2008. Bernanke has been helping too, expanding his balance sheet to $2.6 trillion and increasing his holdings of Treasury securities by $476 billion (to $1.25 trillion) over the past 12 months.

— This might be fiscal and monetary insanity, but in the short term they’re getting away with it. The bond market is holding up. And with a renewed bout of asset price deflation on our hands, US Treasury’s will probably look good again for a while.

— The worst of both worlds will hit when confidence in Bernanke and the Feds dries up. Then, you’ll probably see deflating bond AND equity markets, an ugly combination. How that could possibly come about is a story for another day.

— In Australia, the market has been under more pressure than other developed markets. We put that down to foreign investors dumping stocks because of the confusion and uncertainty surrounding the carbon tax.

— And local investors probably aren’t too enamoured with the market either. Cash is still a handy competitor when you actually consider risk. Yesterday’s employment numbers were not flash and China is slowing down. Oh, and our housing market has stalled. Not a good combo.

— But don’t despair. If you’ve been too bullish and find yourself holding too much in the way of risky stocks, there’ll be a bounce soon enough. Then all the experts will proclaim an end to the sell-off and a resumption of the bull market.

— That will be a good time to sell.

Greg Canavan
For Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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…o pity life there, for the grand sweep of neptune’s arm across the fair isle of japan has wrought destruction…

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