When Financial Markets Decouple From Reality

Before you continue with today’s Reckoning, do yourself a favour and watch Murray’s stock market updateon YouTube from yesterday. The Slipstream Trader points out that the ASX/200 staged a ‘false break out’ on Friday around the 4416 level. If you’re unfamiliar with his theory of price action, that means the new high isn’t a bullish signal but a ‘false’ signal.

Murray reckons the first stop on the correction to the point of control at 4200 is the 50-day moving average at 4300. That’s been taken out with this morning’s opening. Next stop, 4200. And if things get really bearish, look out for the bottom of the distribution at 4050. For the full story watch the 14 minute analysis here.

That’s the price action. What happened overnight to confirm the trend? Well, the Greeks are at it again. The €197 billion Greek bailout negotiated between the ‘troika’ of the IMF, the EU, the ECB and the major Greek parties should be ‘null and void,’ according to 37-year old Alexi Tsipras, the leader of the Coalition for the Radical Left that did so well in the weekend parliamentary elections.

Cue more political uncertainty for financial markets. But to be honest, it’s getting harder to tell the difference between politics and finances these days. The cosy relationship between central banks and governments is responsible for this. The financial has become political. And currently, the political is a complete mess in Europe.

Central banks used to just be responsible for the stability of the currency, but now they’re responsible for the entire financial system. And because the financial crisis has torpedoed government finances and the economy, the entire system of free enterprise in the Western world has finally been supplanted by central planning. All the resources of the nation get directed to the State where they are to be taxed, allocated, or otherwise redistributed by the very smart people we elect.

What a great racket this whole deal turns out to be for financial institutions. You can borrow from virtually any global central bank at near-zero rates and then buy government bonds yielding, say, 2%. It’s free money!

It’s also the trade you make if you’re a big firm terrified of the euro. The chart below shows what we mean. Yields on 10-year US Treasury notes are trading just above their record lows from September of last year. In other words, investors are so nervous about what’s going on in Europe that they’re willing to loan money to the US government for 10 years at 1.88% interest! What kind of rational person or firm would do this?!

The consolidation of global liquidity in the coming bond market Stalingrad

The consolidation of global liquidity in the coming bond market Stalingrad

Well, obviously the concentration of cash in Treasuries makes sense if you don’t want to be in cash and don’t want to be in Europe. But let’s call it what it is: a massive concentration of assets in a dwindling number of asset classes. To us, it’s akin to capital being conscripted in the US government instead of being free to go do other work, like start a business.

If anything, this is a reminder of one of the biggest drawbacks to being a debtor country. When you borrow short term (the maturity schedule of your debt shifts to the short end of the yield curve) it becomes very interest rate sensitive. For now, this is great news for the United States government. It can run $1.5 trillion annual deficits…and investors can’t get enough of the stuff being issued by the Treasury Department!

But at higher rates, the interest on the debt becomes an albatross on the economy. Interest rates do move up, from time to time. But that is another story for another day.

For today, we want to make the point that financial markets have all but decoupled from reality. The manipulation of interest rates has completely distorted prices. If prices don’t communicate useful information anymore, markets aren’t markets. They’re just…vehicles for transferring money from one party to another…from the suckers to the Madoffs.

Getting back to yesterday’s topic of barbaric gold vs. Charlie Munger’s productive businesses, how is it possible to invest in productive businesses when the financial system has been completely compromised and overtaken by a dynamic which doesn’t allocate capital but only funds deficits and profitable trades for investment banks? This isn’t just a dysfunctional market. It’s a complete farce.

It all goes back to what Benjamin Graham, the godfather of value investing, wrote about buying stocks with a ‘margin of safety’. Graham wrote that when a stock’s price is below the intrinsic (book) value of the shares, the difference is your ‘margin of safety’. You’re getting the liquidation value of the business at a discount. It doesn’t guarantee you won’t lose money on the shares (price and value being different things being a good start).

Warren Buffet and Charlie Munger took this one step further and said you can look beyond book value to a return on equity. They looked for book value. But the real goal was a business that could sustain high returns on equity over time.

When it comes to that, some businesses are better than others. Some managers are better than others. And some investors are better at spotting good businesses run by good managers than others – at least that is the proposition behind Berkshire Hathaway, as far we understand it.

The trouble today, as we see it, is that share prices have been hijacked by this evolution in the relationship between the financial sector, central banks, and governments. You might think you’re buying a good business at a good price, but if we don’t live in very enterprising times with real markets, what good is it to do the hard work of valuation?

This is a question we’ll leave with our colleague Greg Canavan to take up tomorrow. He’s the value investing expert in the bunch, and we’ve been discussing it with him over the last few days anyway. Stay tuned.


Dan Denning
for Markets and Money

From the Archives…

Markets and the Aurelius Vision
2012-05-04 – Greg Canavan

How the RBA’s Interest Rate Cuts Cause a Housing Bubble
2012-05-03 – Nick Hubble

How a Cashless Society Promotes Tyranny
2012-05-02 – Dan Denning

2012-05-01 – Dan Denning

Risky Investments in a Market Full of Conmen
2012-04-30 – Bill Bonner

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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It seems like Governments are trying to create risk free investments whether it be in the share market or real estate to suck more money into asset prices. Too good to be true in the real world.

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