Wednesday, August 26, 2009

Insight: Beware the bubble’s distorted allure

By Tim Price
Published: August 25 2009 (Financial Times)

What kind of a financial crisis are you having? If you are a graduating student, good luck with the job hunt. If you are a banker or an economist still in employment, you are probably keeping your head down while you count the bonus that your fellow taxpayers have so generously if involuntarily gifted you. If an otherwise blameless investor, you are probably wondering why you are being penalised with such derisory deposit rates and whether you should be jumping on to the equity market rally instead.

That might be dangerous. Headline equity index returns, year to date, are desperately misleading. There is, in fact, a two-tier market in operation: speculative (or, more politely, “growth”) stocks, which have done fantastically, and everything else. Industrial metals and mining stocks are one of the best-performing sectors internationally – not a little surprising, given that the global recovery has yet to be sustainably confirmed; energy and utilities sector stocks, along with plenty of other classic defensives, have largely been a washout. (They may yet have their day.)

And an analysis of the Altman Z Score, which assesses the likelihood of corporate insolvency by comparing various balance sheet measures, shows that the frankly flakiest companies have seen their shares hugely outperform the rest of the market even as their capital strength deteriorates. In short, this has been a rally driven by junk.

But then what should we expect, when governments and their nominally independent central bank associates have conspired to manipulate prices throughout the capital asset structure, primarily to bail out banks that are conspicuously unfit for purpose? We are now trapped within a global parody of free markets.

Within this parody, governments redirect a waterfall of capital towards the banks. The banks then “invest” this in effect free money in what looks suspiciously like securities speculation and property lending. Meet the new bank: same as the old bank. And while the sums “borrowed” from future taxpayers as economic stimulus have been extraordinary in the west, they are not even the largest. Relative to gross domestic product, as fund managers Eric Sprott and David Franklin point out, China has been busily stimulating its economy more than anyone – injecting the equivalent of fully 64 per cent of its first half 2008 GDP during the first half of 2009. That is the equivalent of buying 122 Ford Class aircraft carriers costing $8.1bn each.

Some questions now deserve to be answered. With credit provision in full-scale withdrawal, does it really make sense to be contemplating bank stocks as investments, not least given the messy governmental scrutiny at work in the sector? And if private sector credit availability is set for broad retreat throughout the Anglo-Saxon economies, how on earth can our nascent economic recovery be described as anything other than pale, sickly and fragile? Equity markets have rallied nicely from their lows, but a degree of realism is surely in order.

The banking sector profits of recent years were never sustainable, inasmuch as they were built on the sandy foundations of leverage. Corporations and households around the world are now urgently paying down debt and rebuilding their balance sheets. They are, in short, battening down the hatches in preparation for a nuclear winter. There is little credit to spare for that diminished crowd with the appetite to take it on. Those are not conditions conducive to a robust recovery, far less to a new boom.

So for those chasing the rally: what, precisely, is your endgame? Perhaps you see extraordinary levels of government indebtedness miraculously evaporating amid new economic expansion, even as taxes rise. Perhaps you see ailing, cash-hoarding banks mysteriously opening the lending taps for the next wave of entrepreneurs. Or perhaps you are looking at the future through the hugely distorting prism of the recent credit bubble. Years of massive misallocation of capital cannot be followed by effortless recovery.

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