Been too busy these days to post regularly and it makes me feel bad that I have not been disciplined enough to do so. The markets have been wonderfully kind to investors in January and we have seen some ridiculous moves on certain obscure stocks like Yoma, IEV etc. Very impressive moves especially considering Yoma rose uninterrupted from 8 cents to 58 cents in a span of a month and a half. Wish I was in it, but it was not to be. These kinds of moves only happens once in a long time so it was another missed opportunity for me. Well thats life.
February has started off in bullish fashion and markets have been on a tear. Small caps, mid caps, large caps, you name it, they have had a great run up. The US markets have reclaimed their 2011 highs after just 5 months. European markets have been a little more subtle but they have also done well over the past two months. Asian markets being the high beta play among all regions have outperformed. How did we end up here? Considering the talks of a doomsday event occurring in 2012 have been rife at the start of the year and here we have the best market performance for the month of January since 1987. That is why I love financial markets, the excitement and its unpredictable nature makes one look forward to every trading day.
So what is the reason for this strong bullish like rally? Like my good colleague was saying earlier this week. "It feels and looks like a bull market." Any betting man would not have placed bets on such a bullish move happening in the market at the beginning of the year. In my humble view, it boils down to just one word...liquidity. Liquidity, that is the key word for the investment world today. My ex boss used to say, liquidity is the most fickle element in financial markets as it can be here today and gone tomorrow. But before we get too worried about liquidity disappearing into thin air, bear in mind that the guys turning the liquidity taps in the world are not too interested to turn them off any time soon. So I really do not think liquidity is going to dry up any time soon.
Why do I say that? This is going to sound like its a conspiracy but I do think it is logical so lets see what you think. Central bankers are given a mandate of controlling consumer inflation and ensuring the employment numbers look decent. With the key gauges on how well they are doing their jobs being the very questionable Consumer Price Index and Unemployment rate, their course of action is clear. Focus on the CPI and try to stimulate the economy into creating more jobs. So what do they do? They inject liquidity into the banking system with their creation of QE and LTROs.
If you tell me that the ECB did not instruct the banks out there who took money during LTRO part 1, to pump the money back into the sovereign bond markets, I will tell you that you are very naive. It is by no coincidence why the sovereign yields of Italy and Spain have fallen so significantly since LTRO was introduced. This will make it look like there are more buyers of Italian sovereign bonds and making the market place look more real with more than one buyer and that being the ECB. However the truth is, the financier for all the buyers of such bonds remain the ECB. This action has brought a false sense of security to investors and injected the much needed optimism into the markets.
With all these QE and LTROs going on in the developed markets, the amount of liquidity sloshing in the markets is unimaginable. I would put the figure to be more than 4 trillion dollars and if you factor in the multiplier effect plus the increased velocity of money in the system, we could be seeing much more than that. What is possibly going to happen here is asset bubbles forming. Yes you are reading it right. Not a bubble but bubbles. Usually when there is an excessive move in a certain asset class, we will witness a bubble forming and eventually bursting. We have seen a few in recent decades, Japanese property bubble, Tech bubble, Subprime bubble etc. What do we know about them? They all happened at different periods. My conjecture here is that we are going to enter into a period of concurrent forming of bubbles if liquidity continues to be pumped in so freely. I will term this as "FOAMING". Whereby the asset classes will all move in tandem and inflate into bubbles thus causing a foaming effect and we all now how foam dissipates in the end. The little bubbles will all burst together just like how they were formed.
Why are the central bankers doing all these actions when they know that this will cause asset bubbles? Because they are not judged by Asset Inflation but Consumer Inflation. There is no API (Asset Price Index) so they are pretty safe. Asset price inflation will create a money illusion which in turn will create a wealth effect for market participants. Why won't consumer inflation rise as asset inflation occurs, you may ask. The reason being that asset inflation will only help the rich and the extra liquidity in the banking system is only going to go into the coffers of the wealthy who are credit worthy and are willing to take the risk of leveraging up to invest. The "marginal propensity to consume" for the wealthy is significantly lower than that of their "marginal propensity to invest". I believe that the central bankers are trying to inflate assets to such an extent that people will get the impression that everything is hunky dory and forget that Spain has a unemployment rate of more than 40% amongst their younger labor force.
Consumer prices will remain tepid as the poor do not have the money to consume more so the central bankers are going to report low CPI numbers and probably give themselves more room for further liquidity pumping activity. I personally regard these liquidity moves as short term fixes and basically trying to sweep all the problems under a rug and hope that the rug sticks. What worries me is that they have opened the equivalent of the "Pandora's box" for the financial markets. If I am right, they are going to have a big problem down the road when they finally decide to withdraw the liquidity they have made available to the markets.
Excerpt from Wikipedia: Pandora's box is an artifact in Greek mythology, taken from the myth of Pandora's creation in Hesiod's Works and Days.[1] The "box" was actually a large jar (πίθος pithos)[2] given to Pandora (Πανδώρα) ("all-gifted", "all-giving"),[3] which contained all the evils of the world. When Pandora opened the jar, all its contents except for one item were released into the world. The one remaining item was Hope.[4] Today, to open Pandora's box means to create evil that cannot be undone.
So you may ask, which assets will inflate first? Of course, it is natural for the inflation to happen in the safest assets first, which is of course high grade bonds where investors can leverage on the low interest rates till 2014 (thank you, Ben Bernanke) and earn the yield spread. After that we will have to move to the assets that has no real science to valuing them. Things like commodities. Why? Because commodities are valued more on perceived value than actual value metrics like price earnings ratios or price to book ratios. There is no way to determine accurately what the price of a bushel of wheat is worth in terms of price. When there is no valuation metric for the asset, it is easy for people to use nice convincing stories to justify ever rising prices for that particular asset class.
Whatever I have written today is not something that will happen over the next few months, I believe this whole process of FOAMING will take years and it is important to bear this in mind while investing now. We have no choice but to try to ride this wave because I believe that asset prices will go through what I call above trend inflation and if we do not try to ride this wave we will be left behind as the value of money continues to depreciate implicitly. This is the situation that can be most aptly described as "damn if you do and damn if you don't".
Ok it is getting a little late. Will try to post more regularly, I promise.
Have a great week ahead!
Best,
SVI
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