Either we're skewed or the markets are

PUBLISHED : Monday, 19 December, 2011, 12:00am
UPDATED : Monday, 19 December, 2011, 12:00am


This is a bad time for market purists who believe that financial markets provide the best reflection of what's really happening in the economy.

On the many occasions when markets offer a cracked prism through which to understand the economies they represent, the purists insist that markets do not have to reflect what's going on at the moment but are inherently forward looking and thus foresee the future.

Nevertheless, most markets do not offer a realistic picture of what's happening in the world economy right now, nor does their performance make for a convincing forecast. Let's look at some examples of just how flawed the vision supplied by markets is.

Exhibit One is the US dollar, which is frequently written off as having had its day as the world's most significant currency. At the moment the dollar is issued by a treasury mired in record levels of debt, which is freely printing money (this is politely called 'quantitative easing'), and the currency is backed by an economy registering growth at anaemic levels. Yet the dollar is not collapsing. Indeed, its value continues to rise against other currencies, mainly because there is no alternative to what is effectively the global currency of last resort.

Exhibit Two is the mainland stock markets, which recently slumped to a 33-month low. Yet this is one of the few major economies still registering significant growth, and inflation looks as though it is being tamed; last month inflation dropped to 4.2 per cent from 5.5 per cent in October.

However, any sliver of good news seems incapable of moving the mainland equity markets, which are trading on a staggeringly undemanding price-earnings ratio (PER) of about eight times. What's happening is that investors expect worse to come, and they might be right. However, the investment houses that churn out enthusiastic reports about the mainland economy are clearly not putting their money where their mouths are.

In the United States, where the economic picture could not be more different, the stock market recently dipped back into negative territory for the first time in a year and is trading on an average, but still modest, PER of about 14 times.

Exhibit Three is the robust condition of listed companies in the US and Hong Kong. Corporate profitability is strong and balance sheets look healthy, with enough cash in hand to keep them from being in hock to the banks.

So, a reasonable assumption should be that equity markets would be stronger in places where the economy is strong, and vice versa where the overall economy is in bad shape; but this is not happening.

Meanwhile, over in the money markets there is a hint of reality in the very high coupons attached to bond issues from the Greek and Italian governments. But why are 10-year US Treasuries yielding about 2 per cent compared with a norm of around 4 per cent? Indeed, in the perverse logic of this market, Treasuries would be 'healthier' with a higher coupon, but it is low not because of confidence in the government's fiscal management but because money is flowing into the dollar, as this is seen as the least worst place for it.

Also, if a recent McKinsey report is to be believed, there will be a structural shift away from equity markets into corporate bonds, since demographic trends will produce a larger elderly population with more money and less risk tolerance. And pension funds will be inclined to have heavier bond investments to secure more consistent returns.

Here is another good example of the way markets operate that has nothing to do with profitability but everything to do with the sentiment of investors and matching their needs to the flow of their cash.

All this notwithstanding, markets do tend to reflect reality in the end, but they take a while to get there. While they are inching in this direction, there is considerable opportunity for smart investors who shut out all the ideological guff about omnipotence and focus on what matters: profitability.