Stock markets around the world keep going up. Australia’s stock market keeps going sideways. You’d think we missed nothing on our three week trip to Europe.
But there are signs that the duct tape holding markets together is fraying at the edges. Slowly but surely, even the mainstream commentary on financial markets is turning pessimistic.
Our favourite new symptom of a coming crash is excessively high prices. At some point, even central bankers have to admit that investment prices are waaay out of whack.
In the US, the Fed is warning about a new tech bubble. The Reserve Bank of Australia is warning about a bubble in Australian housing. Neither asked who might’ve inflated those bubbles with inflationary monetary policy.
Then there are the usual signs that a bear market crash is in the works. More and more celebrity investors around the world are worrying about a bubble in shares. In the weekend Australian Financial Review, Nobel Laureate economist Robert Schiller went through a who’s who of bubble believers. In Europe, deflation is looming once again and a bank crisis in Portugal is in the mix. In the US, inflation is creeping into bond yields and more of it could cause interest rates to surge unexpectedly.
Financial markets are supposed to be forward looking. That means their prices tell you what to expect.
So what do the dizzying heights in US stock prices, European bonds and Australian real estate tell us about the future? To be honest, we’re too dizzy to know. But if central bankers and mainstream commentators are starting to acknowledge the market is artificially high, we’ve got a new kind of problem.
Comments about bubbles and overvaluation are usually only in the mainstream news after the bubble has already burst. Central bankers are last to realise there was a bubble in the first place. If everyone knows houses and shares are overvalued, but they don’t go down, where does that leave us? Has the market officially disconnected from reality?
Or maybe the market is just mistaken. Of course, markets don’t always know what to expect. Sometimes they get a surprise. But at the moment, even surprises don’t seem to bother prices. Outside financial markets, all hell was breaking loose over the last few weeks.
Someone shot down a plane over Ukraine. Israel launched a ground offensive in Gaza. In Iraq militants have been rampaging at will. They even found and took over Saddam Hussein’s former chemical weapons factory. And in Syria the fighting continues too.
There are two conclusions you could draw from all this:
The market expected political instability
The market no longer cares. It just trundles along regardless.
We asked Mr Market which it is and didn’t get an answer. He’s dizzy too. High on drugs provided by central bankers around the world. And maybe that explains it. After all, Australia doesn’t have the same wacky monetary policies as the US and Europe, and our stock market is going sideways.
Before you envy the US and Europe, remember that no economic policy is a free lunch. Our low interest rates make houses expensive for new buyers in the same stroke as inflating the wealth of homeowners.
When governments and central banks manipulate market prices they lose their honesty. They no longer predict or price in reality. We’re left with a world that can go mad without seeing financial markets react.
Where does that leave investors?
Well, the stability you see in stock prices and government bonds is fake. When it breaks down, it will break down very dramatically. So keep paying attention to those fraying edges. At some point, reality will make a comeback, even into the deluded and disconnected world of financial markets.
We couldn’t leave off a little bit of political commentary for you. While financial markets are artificially stable, the political world is in turmoil. Should you be worried about Ukraine or the Middle East? We don’t think so.
Without a bit of warfare every now and then, why would anyone need the likes of Tony Abbott, Barack Obama, Benjamin Netanyahu and Vladimir Putin? What do you think would happen to politicians if peace actually broke out?
The political system is rigged with very bad incentives. And none are worse than the incentive for conflict. But there are very few incentives for conflict to get out of hand. So politicians like wars to stay cold.
The good news is that politics doesn’t always get in the way. What happens when politicians don’t get involved with people’s lives?
In the Gaza strip, many of the homes in illegal Israeli settlements are built by Palestinian builders and labourers. We can’t think of a better example of how capitalism, prosperity and peace go hand in hand. Until politicians get involved.
As the musician Tim Minchin elegantly put it when singing about the Arab Israeli conflict, ‘Why not, not eat pigs together?’
Unfortunately, everybody loves pork, of the political variety. Politics is just too popular a passtime to be abolished. If you can get your man in power, he has the power. The power to tax others, to restrict your competitors with licensing and regulations, and the power to hand out cash. In the Middle East and Ukraine, that power includes war. And so conflict consolidates power.
Hopefully our politicians don’t face the same incentives when it comes to war. Then again, Australia has a history of getting involved…
for The Daily Reckoning Australia