Chiangmai Mail - Vol. IX No. 4 - Tuesday January 26

Many analysts have thought most assets have been overvalued for quite a while now and that the politicians have had to keep interest rates at virtually zero whilst pumping money into the economy as if there was no tomorrow so as to keep their respective countries going.
Bill Gross of PIMCO is definitely in this camp. He believes most of the developed countries, especially those in the western hemisphere, have been “significantly and artificially influenced by asset price appreciation for decades.” This is definitely the case in recent years when people have refinanced assets and gone spending. Put another way, all the supposed growth we have seen over the last decade has been done by borrowing and not the usual method of increasing production. People have gone for the quick buck and tried to make money via the markets and not the economic foundation that is in reality their reason d’etre. These days people look for market growth and not the more basic things like GDP growth or falling unemployment.
What does this mean? Well, the implication is that people feel good when the markets are up and bad when they are down as this could be affecting their pockets directly. They do not really mind if an economy is not doing well providing any downturn does not cause them to lose money.
Now, in the good old days, the health of the stock markets and GDP went up and down hand in hand. This is not the case now. The new economy which has come about has seen an increase not only in share and stock prices but in all asset classes. In many cases more than the economic growth is needed to justify these rises. Let’s remember it is only less than fifteen years ago that the Dow Jones was at 4,000. Last year it went over 14,000. Was the production there to justify this? Obviously, the answer is a deafening NO. If one went with GDP growth as opposed to market sentiment then the market should be less than 8,000 not over 10,000. As said before, this is not just applicable to equities but also most, if not all, other asset classes.
If you look back to what has happened since the end of World Was II, you will see that in the early years it was usually economic growth that led the way and not increases in the price of assets. We got richer the old fashioned way - by actually making things.
However, as Reagan and Thatcher came to power, things began to change. With fancy finance and the use of things like derivatives and leverage assets started to come to the fore. With the occasional blip, as in the beginning of the 1990s and 2000s plus last year, put aside the rise in the price of assets has definitely outstripped manufacturing. Put another way, over the last thirty years, it would have been better to invest in the markets than it would have been to put your money into anything that actually produced something or helped better a child’s education.
Basically, thanks to finding it so easy to borrow, people were able to push up the price of assets to over one hundred percent of what they should have been. It is immediately apparent to what this implies. When the Dow Jones is at 14,000 then it should have been half that. It is presently around the 10,000 mark and the real value should be 5,000. A house worth USD200,000 is actually worth USD100,000. Commercial real estate should be for the de-leveraging chop as well. Bonds (high yield and corporate) are not immune either as they were also overpriced.
This is where the problem starts as those in charge realise that the value of assets now has to be supported so as to make sure that the GDP results to come are in positive territory. Unfortunately, the borrowing society that we have created cannot go away overnight. Therefore we have to support the present situation which is why we are going to have low interest rates and government bailouts, in various forms, for the foreseeable future.
PIMCO has calculated that assets in the USA have been overvalued by USD15 trillion but still have to be supported to keep the economy’s head above water. It is interesting to note that China is also throwing money at its economy but they are creating more production outlets so that exports will continue to drive its economy and try to increase its domestic markets at the same time. Luckily for them, they do not need to maintain a false economy.
The most important thing for the US, though, is that interest rates are kept as low as possible. Bill Gross believes that, “nominal GDP must show realistic signs of stabilizing near 4% before the Fed would be willing to risk raising rates. The current embedded cost of U.S. debt markets is close to 6% and nominal GDP must grow within reach of that level if policymakers are to avoid continuing debt deflation in corporate and household balance sheets.” If he is right then we are going to have these low rates well into 2011 and the Fed will want to see sustainability and reliability before starting to increase interest rates.
Getting risk spreads back to normal is vital for future growth. However, this could cause unwanted volatility as without the governmental guarantees and low interest rates investors would not spend money again. Practically zero rates forces people to buy.
Is it important for rates to stay low or should the relevant governments let go of the reins and let nature take over? The latter should have been done when the present crisis began but it is too late for that now since, as mentioned before, asset appreciation has been artificially elevated for decades. So as to prevent prices falling these low interest rates must be maintained for quite some time yet.
Bill Gross reckons a good way of looking at this is by studying the bond markets. At the moment he believes the total bond market will yield no more than 3.5%. If anyone wants more than that then they will have to take more risk via equities, distressed mortgages, etc., and hope we are in a V shaped recovery. This is just not the case. The risks outweigh whatever the rewards may be.
To go with Gross, “Investors must recognize that if assets appreciate with nominal GDP, a 4-5% return is about all they can expect even with abnormally low policy rates. Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets - while still continuously supported by Fed and Treasury policymakers - is likely at its pinnacle.”
Ever since the recession began and it became clear the authorities answer was quantitative easing, the Bears have kept reminding us on such facts as continued debt, massive public spending and rising unemployment. The markets have ignored this and gone up for the last eight months. Recently though, some indications have begun to appear which support these arguments. For example, the Vix Index, which measures volatility in the major equity markets, has gotten worse.
Financial shares have also gone down when compared with the rest of the market. As a senior economist said last week, “The bears are right and the rush to issue paper, the higher oil prices and the continuation of contraction in bank lending, have finally broken the markets’ back.”
Not all is doom and gloom though. Certain asset classes will fare better than others and by having a liquid, multi-asset allocation portfolio you should protect yourself against sudden losses and also beat the bank.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Paul Gambles on paul@mbmg-international.comm

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