Cracks in the Foundation
Step away from watching the markets hour by hour and eventually you’ll notice something. What you’ll notice is that most of the news is garbage. Websites and cable news channels need a constant news flow to justify movements in stock prices. But most of the time there is no connection between the news and the price action.
Your editor makes this observation after being away from his desk for two weeks. During that time, we were only intermittently in touch with hourly news flow. We didn’t miss it a bit. And it turns out we didn’t miss anything important either. The status quo prevails.
And what is the status quo? Well, for one, let’s not make the mistake of calling the market a market. It isn’t. A market is where you have a buyer and seller willing to exchange goods and money at a mutually agreed price. That price is ‘discovered’ by aggregating all the bids which buyers are willing to pay and the asks which sellers require.
Price discovery is ruined — and markets don’t function — when you have a serial intervener in the form of a central bank. That’s what we have today. For example, markets reacted in Pavlovian fashion last week when European Central Bank (ECB) President Mario Draghi said he’d do ‘whatever it takes’ to save the euro.
What does that even mean? Does it mean Draghi will print money to buy Spanish and Italian government bonds? Does it mean he will don Lycra and learn to leap tall buildings in a single bound? Does it mean anything at all when it comes to resolving Europe’s structural economic problems?
It’s a giant pile of nothing, to be frank. You should ignore it. And while you’re at it, ignore the Dow Jones Industrials index too. As we said in our remarks in Vancouver a few weeks ago, the Dow communicates no useful information about the underlying health and direction of the US economy. It’s a narrative device designed to promote stock buying to the investment public.
What is worth paying attention to? Well, the Reserve Bank of Australia (RBA) has a busy week ahead. Tomorrow, the RBA will announce any changes to short-term interest rates in Australia. On Friday, it publishes the latest Statement on Monetary Policy. You won’t want to miss that.
You should especially keep an eye on the latest index of commodity prices and the Aussie terms of trade. As commodity prices come down from all-time highs, a lot of mid-tier and small-cap miners are going to have trouble finding money for projects that only work when commodity prices are high. It’s a ‘funding hole’ that the front-page story in today’s Australian Financial Review talks about.
You can see from the RBA’s two charts below that both the terms of trade and commodity prices are coming off startling highs. If both data sets are mean reverting, then a nasty correction is ahead. For Aussie investors, that means you should be prepared for stocks making new lows. What will be the catalyst for these new lows?
Click to enlarge
Source: RBA
Well, we could be wrong about the whole thing. But after two weeks abroad, our sense is that investors are still pricing in lots of economic growth. Australia is a proxy for global growth. Finished goods can only be manufactured with raw materials. The whole chain of global value added begins here.
It’s hard to have growth when the whole economic system is burdened by debt. Until that debt is extinguished — through default, repayment, or restructuring — we have a hard time making the case for stocks (at least as an asset class, individual shares may do well as outliers). Everything done in Europe to keep government bond yields down is an exercise in avoiding the reality that debt must be repaid.
The status quo is to avoid pain by avoiding reality. How long can you live in imagination land, if you’re a central banker? Quite a while, apparently. But not forever! Let us tell you why.
Back in Colorado we visited the Flatirons Crossing mall in Broomfield. The mall is struggling as America’s consumer economy deleverages and cuts back on spending. But it’s also struggling because it was built on bad foundation. Literally.
The soil underneath the mall is bentonite clay. It’s a type of soil that expands with water. That means it’s a bit unstable. The mall owners know that now. Numerous structures throughout the 140,000 square metre facility have cracking drywall, buckling concrete, and shifting steel beams. Some of the structures have already been demolished.
This isn’t even a metaphor. If you build on shifting soil, your foundation is rubbish. An economy based on consumption through debt can’t generate wealth. A society based on satisfying all its wants and desires by accumulating debt is not a productive society that looks ahead. It’s about gratification now, the future consequences be damned.
But that attitude of consume now and pay later seems to be changing in America, at least at the household level. These social moods go in cycles. At the grassroots level, Americans are revising their expectations and living within their means. It’s the government that continues to live high on the hog.
That said, boy is America cheap. Your editor went out for a couple of pints with a friend. When the bill came, it was $18. We sent it back, sure there was an error. But there wasn’t! The same four beers in Australia would cost you $40. It’s the sort of inflation in cost of living that you only notice when you leave a place.
Regards,
Dan Denning
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Dan Denning
Dan Denning is the author of 2005's best-selling The Bull Hunter. A specialist in small-cap stocks, Dan draws on his network of global contacts from his base in Melbourne, Australia, and is a frequent contributor to The Daily Reckoning Australia.
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Great article. Of course the underlying problem is valuation itself, which is entirely subjective–and often amoral–subject to influence by officious proclamations and manipulated indices, as you indicate.
I’ve always been baffled by the gold standard, myself, as gold is no more attractive to me than a shiny roll of aluminum foil–and less useful. And it isn’t as though the supply of gold were fixed or known, so how could the prices pegged to it be guaranteed stable–or foreign currency exchange rates?
Is it too late to barter? That seems the only truly moral control of money: have none at all.
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#1 point from this article not highlighted enough
A-> There is not 24 hours of news, nor is there 7-8 times that news (which includes just the US cable news channels. )
B-> there definate isn’t enough just for the US financial new channels
C-> the market wants information. And the quality of information is much much lower then the quantity of information.
the Euro was ALWAYS a terrible idea especially when you have the whole of the EU buying in (and not exluding one of the most productive economies -the UK)
The group OUTSIDE the Euro always had better economic performance then the Group in the Euro (and if you were to take out economic productivity from France and Germany the eurozone has always been losy)
Prior to the Iraq war (and in the runup to the Iraq war) the Euro’s value was only as a hedge on the dollar.
The yuan and the rubble aren’t good alternatives (and still aren’t) for investment. The yen is a joke. So it was the Euro and Gold as hedges on the dollar. So during this period of value european regimes took their worst excesses and took them further. The Euro was killed in 2009… it just hasn’t had the decency to die yet.
Because there is no alternative currency to the dollar that can meet the global capital needs capital is hiding in commodities which is worsening the mailase of the global economy.