By David Scott | Monday 15 May 2017
There have been no functioning markets since at least 2008, and probably much longer. That’s when central banks started purchasing financial assets, for real, which means that is also the point when price discovery died. And without price discovery no market can function efficiently, if at all. If we continue to use terms like ‘investor’ and ‘markets’ for what we see today, we would need to invent new terms for what these words once meant. Because they surely are not the same thing even though alot of people would like you to believe they are, because it serves their purpose.
Central banks have become bubble maintaining machines, and that is their main function now. You could perhaps get away with saying that the dot-com bubble, or maybe even the US housing bubble, were not created by central banks, but you can’t do that for the everything bubble of now. The central banks blew their bubbles in order to firstly allow banks and other financial institutions not to fail and second of all to make good profits to refill their reserves and then to replenish them ready for the next set back.
They have two tools in order to blow their bubbles which they are both using currently at the same time. The first one is asset purchases (with printed money), which props up the prices of assets, through artificial demand. The second is (ultra-) low interest rates, which allows for more participants to buy more assets, in another form of artificial demand. The most important central bank-created bubble is in housing, because it makes owners of it feel wealthier (so Politicians love it too) and it facilitates bubbles in stocks and bonds. Home prices in many places in the world have grown much higher than either economic growth or homebuyers’ wages can justify or even maintain longer term. But the bubbles created by artificial demand cannot be allowed to burst all at once as that would shatter the economy and the public spirit. So it has to be done gradually and predictably.
The problem is, Central Banks have no control over their own bubbles once created and they may or may not devise ways to reduce their balance sheets, but the bubbles that balance sheet expansion created cannot be deflated in the same way. If they did have ‘bubble control’, they would have chosen to keep both the stock markets and housing prices at a much lower level, with only a gradual increase. That would have given the impression that things were still doing well and under control.
Getting out in time is bubble territory by its very definition. It’s not investing. Investing is buying an interest in something that you expect to do well because of underlying growth creating value and attraction, not because too much money has pushed it beyond a sustainable level. Over the long term price reversion to mean is one the guiding economic principle that governs economic forces. The longer prices stay out of kilter the nastier the longer term adjustment is when reversion inevitably takes place. This bubble is over thirty years old now and has morphed into the bubble of everything as Central Banks have blown ever greater ones, fearful like the political class that addressing the core issues would not go down well with an electorate who has been promised things that are not really deliverable.
One can only be a real investor in functioning markets, otherwise it’s just speculation in the belief you can get out before price discovery reimpose itself.
The virtue of the time honoured practice of cost-benefit value investing does not reveal itself every day but it avoids the pitfalls that speculators succumb to, even if it means foregoing additional speculative gains in the short term. This steady approach has a long and proven track-record of compounding wealth over time.
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