Beam me up, Scotty, the market looks risky

Just as a fish can’t detect the water it swims in, we have become immune to the inflation all around us. The unsettling fact is that we are immersed in a regime of central bankers who are convinced that propping up the financial markets will eventually feed through to the real economy, creating jobs and a new spontaneous — and virtuous — economic cycle. Everyone is a winner.

Supporting the financial system is understandable but there is a time and a place for it and that time has gone. It is possible to pinpoint the moment when we crossed the Rubicon from necessity to indulgence — it was September 2012. If you add up the change in the aggregate net worth (stocks, bonds, real estate) of individuals in the US you will see a rapid decline in wealth in the early years of the credit crunch.

But as the US pressed hard on the monetary stimulus — or quantative easing — pedal, asset values started to rise again until, by autumn 2012, the full total of dollar losses had been regained. Since then, net worth has continued to rise and now Americans are $13 trillion better off than in 2007 (see the chart below). That’s close to one year’s worth of gross domestic product.

But how can this change happen when all this information is already known in the financial marketplace? Financial market players habitually use phrases like “it’s all in the market”, meaning that it’s pointless reacting to a new piece of information because it has already been incorporated into share or bond prices.

Eugene Fama, who received a Nobel Prize last year for his efforts in the area, called this the Efficient Market Hypothesis. One of the more startling conclusions of his theory is that it is impossible to make money out of insider trading, which may come as something of a surprise to the market abuse unit of the Financial Conduct Authority.

But anyone who has worked in the financial markets for any length of time understands the reason why nice ideas like the Efficient Market Hypothesis don’t work all of the time — investment, like any human activity, is prone to manias.

Markets have the disturbing ability to be inefficient, feeding on what has just happened and exaggerating it some more. Suddenly what matters more is the last price movement rather than the laws of supply and demand.

During financial market manias it is the tyranny of the crowd that takes over and money starts to go to places it shouldn’t, pushing up asset prices in the process. This is especially true when policies like quantitative easing positively encourage

it. As Charles Gave, of Gavekal Global Research, drawing upon the work of the 18th-century economist Richard Cantillon, recently pointed out, the closer you are to the source of the new money propping up the system, the higher the inflating effect on assets.

Government bonds are the closest to the Federal Reserve, Bank of England and European Central Bank’s “new money’’, followed by corporate bonds and equities, which has led to their prices being the most artificially inflated.

The real economy is remote from the new money being pumped out by central banks and hence it has had little effect on prices of goods and services; inflation has stayed low, as we saw last week.

So, today we have a strange situation — a maniacal financial system feasting upon itself whilst being egged on by

state-sponsored reassurances that, if the price of any financial asset declines, a central bank will step in to put a floor under any losses. This is so much against any notions of an efficiently functioning market, based on information and rational thought, as to be breathtaking.

Exhausted by the lack of real value in financial assets, suddenly those with excess money turn towards their enthusiasms. James T Kirk’s phaser gun now looks like an attractive investment.

The alarm bells are ringing in the financial markets. Some fund managers and investors are starting to become unsettled by a set of conditions that looks, on the evidence, like the run-up to the big stock market declines of 1999 and 2007.

The anxiety is doubled as clients have become habituated to the idea that the value of all financial assets, since 2008, rise all of the time — the only difference between them is the degree.

To cope, some fund managers are actually removing money from the markets, raising cash in portfolios, to levels not seen in over five years, to protect clients from what some see as the inevitable decline in financial assets as central banks take away the punch bowl from the party. The Federal Reserve is due to end its support programme in October this year, although we may not know its exit strategy for all the bonds they have bought until December.

The best we can hope for is that nothing will happen and there is no dramatic recalibration back to “free market” valuations of bonds and equities. But personally, and in the meantime, if Lt Uhura’s dress becomes available, and it happens to be a size 10, then the problem of Mrs Cowley’s Christmas present has been solved, at least for this year .

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