Trust Restored!
The S&P stock index has doubled over the past three years, since making its low point in March 2009 in the wake of the 2007-2009 financial crisis. After this protracted advance, it is hardly fashionable to utter a bearish word about stocks. In fact, the apparent progress that the US has made in repairing the damage inflicted by the bursting of an unprecedented bubble of debt and speculation seems to have renewed many Americans' trust in the markets, the economy, and the health of the financial system.
Well, Not Really
All of this celebratory hullabaloo is mere appearance, of course, and a look beneath the surface reveals that trust is still the issue. Crises triggered by extremes of debt always play out over many years. The underlying causes of the present crisis have barely begun to be addressed. So far, they have merely been papered over by an official policy of "extend and pretend", and the financial system has been kept alive only by extraordinary monetary policy.
These extraordinary policies have entirely destroyed the trust necessary for prudent investing.
No Way to Assess Investments
There is no way for investors to make prudent investing decisions, because prudent investment analysis is now impossible. Analysis requires plausible, trustworthy assumptions about future cash flows. This means assumptions about factors such as interest rates, asset values, bond coupons, etc. over the lifetime of the investment. Can you really trust any set of assumptions about these things today?
Chaotic Policy
In today's world, the future value of every security and every real world asset depends totally on unpredictable, even chaotic factors. As Doug Noland reminded us in his Credit Bubble Bulletin: "How does one go about modeling future cash flows and valuing assets when there is every indication that the current monetary backdrop is both unstable and unsustainable?" There is no way to know how far central bankers will go in their program of money creation. If you cannot make reasonable assumptions about the range of future interest rates, or even the value of your own currency, how can you seriously evaluate any investment proposition?
It is useless to evaluate the future of a firm, and industry, and even the economic growth of a nation when the future of every one of these things depends on policy decisions made by bureaucrats and politicians. The whim of individuals is unpredictable (unless you own the bureaucrats and politicians).
Broken Financial System
There is also the risk that events will be taken out of the hands of central bankers, because they have no more options left. Mohammed El Erian addressed the St. Louis Fed recently, saying that central bank actions are having "declining effectiveness" and the bankers must hope for a handoff to other actors. This can only mean fiscal actions by the legislative branch, which is hardly likely to occur in an age of constrained budgets. If the bankers are reduced to hope, the system is truly broken, and we are reduced to passively waiting for the next speculative financial disaster. A ticking time bomb is hardly reason for trust in the future.
Broken Fiscal System
The federal budget deficit is out of the headlines at the moment, but the debt burden continues to mount. Growth is insufficient to raise tax revenues in this low-growth era, and the burdens of government are growing in every sphere -- old age, unemployment, infrastructure deterioration, increasing international competition, etc. The US is fortunate that European troubles are in the headlines now, and the US is viewed as the best of a bad lot among the nations of the developed world. The fiscal trajectory of the US is unsustainable, and it is just a question of when concerns will reemerge, and how severe the crisis will be. Whether the outcome is extreme austerity, a rise in real interest rates, or more financial repression, it will be accompanied by a crisis of trust.
Broken Markets
The future of an investment is always clouded with uncertainty, but at least we can see the price at which we buy a thing. We want to "buy low" and so we use various metrics to assess present prices. But what use is this when the market's price-setting mechanism is broken? Market manipulation is now the rule, not the exception. If risk-free interest rates are artificially low, it costs nearly nothing to borrow money to speculate in risky assets. If governments purchase mortgages or Treasury notes or other assets in quantity, we lose trust in the prices of those classes of securities. When market prices fail to communicate the visible risks in the most common of securities, what trust can we have in any asset price?
A Connected System
Meanwhile, the European debt situation continues to deteriorate. Now that Greece has restructured, Spain is starting to come apart, and politicians are once again making pretenses that they will be able to cut budgets and generate revenues to resume a stable path for that country. As we saw with Greece, this is only a game, and it is only a question of when and where the pain will fall -- haircuts for bond holders, austerity and unemployment for the common people, or political disunion for Europe. In a connected financial system, the fallout will touch everyone, even in the US, yet another reason to lack trust.
The Reciprocal of Trust
I have no idea what to do when politicians fail to properly manage the world's fiscal and monetary affairs, but at least one person has a decided opinion. Jim Grant was back in the financial news recently, reminding us that, in his cosmology, gold is the reciprocal of trust.
