Voting or weighing?

Benjamin Graham said that in the short term the market is a voting machine, but in the longer term it is a weighing machine. It seems to me that the markets are in a voting mood at the moment. The liquidity provided by central banks has driven up asset prices over the past couple of months, so that equity markets are at six months highs.

If you have read Gordon Pepper’s book, The Liquidity Theory of Asset Prices, this shouldn’t be a huge surprise. When the ECB joined the Fed and BoE at the liquidity party through its LTRO, it was the signal investors had been waiting for. The threat of a Dexia style funding crisis was largely removed, so the excess liquidity sloshing around in the system could seek out risk assets with a degree of confidence.

The ECB has taken off the Trichet hair shirt and Draghi has donned his party shirt. While solvency concerns remain and structural problems in the eurozone persist, in the short term, who cares? The crisis can has been given another boot down the road.

With European economies either in recession or close to recession, there is little or no demand for credit from the real economy, so the liquidity creation of central banks flows into asset markets. The initial beneficiary was fixed interest markets, but with near term tail risk removed, equity markets have taken up the baton.

Investors are voting with their money, regardless of the cyclical negatives. Fund managers cannot be left behind. Those with high cash positions are risking their careers, so capitulation is the name of the game. Without a shock event, this process has further to run, although the “easy” money has already been made.

Equity markets look cheap relative to bonds (except bonds might be expensive). However, that is predicated on top of the cycle earnings making PEs look cheaper than the underlying reality. We’ve already seen some flickers of disappointment and distress in the corporate world.  These are just the first pebbles but the avalanche of downgrades may not come for a while. The process of corporate profit margins peaking typically takes longer than the bears anticipate, lulling the bulls into a false sense of security.

The weighing machine will not be operational until the cycle turns. The excess liquidity will have to be destroyed somehow. This will either be through inflation, where the value of each monetary unit depreciates relative to physical assets. Alternatively, a portion of the money created gets incinerated by defaults and bad debts, which tends to be deflationary.

The eurozone appears to be set up for a deflationary outcome. The collapsing domestic demand outside the core is profoundly deflationary and the ECB’s liquidity operations are unlikely to turn the tide. In the US and UK, an inflationary denouement is possible, but the weakening eurozone economy and early signs of stuttering growth in China may see a period of disinflation or even mild deflation first.

If the Fed and BoE decide deflation is the dominant force they will push monetary policy to the limits to fend it off. Ultimately they could set off an inflationary surge, wrong footing investors. Markets extract the maximum pain from the maximum number of people. What would cause the maximum pain would be deflation, where investors sell real assets and load up on bonds, followed by an episode of inflation, destroying the real value of said bonds.

Ultimately the value of assets will need to be weighed. The cash flows attaching to both bonds and equities will have to be measured by a proper yard stick. There is no doubt that discount rates are too low and that low discount rates have boosted asset prices.

Sovereign bond yields in “safe” countries (i.e. US, Germany, UK), where there is little default risk, have been pushed to levels unthinkable just a few years ago. Risk free rates are exceptionally low. These will rise at some stage either because growth returns or inflations rears its ugly head. When this happens, asset markets will get caned.

However, I feel this is still some way off. I can’t see the deleveraging phase of the global economy lasting much less than another five years, so it may not be until near the end of this decade that the scales are recalibrated.

In the mean time, some wealth will be destroyed through recession, deflation and default. We could even see falling equity markets again when recession cuts into corporate profit margins. Fiscal consolidation and government spending cuts are also negative for corporate profit margins.

Central banks are scared witless that a further collapse in asset prices will set in motion another debt liquidation spiral. They are right to fear this, but the aggregate level of corporate profits and tax revenues are inadequate to support the current level of all asset prices (equities, corporate and government bonds) at a sensible discount rate. Something will have to give. Either defaults will reduce the principal and interest costs or inflation will have to erode the real value of the principal and interest payable.

One way or another the scales will show that the current level of asset prices is too high in real terms. They have to fall either in nominal terms or the real value has to be eroded by inflation. As for the day of judgement, who knows, but sooner or later it will come.