Market Pundits Gone Mad

I saw something appalling and absurd the other day. I became grumpy and grouchy. The mini hibernation is over.

This is the news that got me out of the bed. Some market experts are now advocating that the Federal Reserve Bank, the central bank of the US and accordingly the keeper of the global financial order, start buying stocks in the equity market.

Why?

They say we need the markets to stabilize. This is mad. The Pavlov’s dogs are now barking “save me” every time there is a market hiccup. I won’t talk about whether the Fed should buy stocks or not. What I will discuss here are some of the consequences of this action the geniuses are advocating for.

The Markets Should Reflect the Fundamentals (Not the Other Way)

The ultimate valuation of the financial markets should be determined by the risk and opportunity that the instrument represents. As such, the first order of evaluation should be the fundamental research of the economy, markets and companies.

Then, one needs to conduct an analysis of its credit worthiness (bond markets), supply and demand (commodity markets), and earnings and growth potential (equity markets). Just like anything in life, to do it right involves a thoughtful effort and honesty about the findings.

Throughout financial history, the gap between the fundamentals and market valuation always closed over time with the fundamentals playing the anchor role. Due to sentiment, money flow and technical factors, there can be deviations of valuation relative to fundamentals, but it does not last.

Like the million dollar tulips eventually going down to zero or subprime mortgage being valued like AAA rated bonds, the gaps eventually closed.

Now people want the FED to buy not only the government bonds but the corporate bonds of all credit spectrums and the equity market. The logic behind this is to restore the market sentiment, and that this will help the economy to recover.

The real March Madness is suspended but folks, now there is March Madness brewing in the financial markets.

The Federal Reserve Board Asset Management Company, usually the mandate of the central banks sounds very noble in writing–achieve price and economic stabilities. Their mandate is not achieving financial market stability and making sure it goes up all the time.

Now along with the new role of satisfying the insatiable market appetite for more money, they have become independently proactive in appeasing politicians and markets. They seem to enjoy the limelight. They are already the biggest financial instrument holders in the world.

They own a ton of the government bonds. Their portfolio is now being asked to include risky corporate bonds and equities. A direct implication of such action will mean a distortion of risk pricing. Like the Italian government being able to borrow at a cheaper rate than the US government, the markets won’t be able to properly price risk.

A temporary dislocation is explainable but a permanent distortion of risk pricing mechanism can create another Japan or some unhealthy European country. There is a price to pay in the medium-term for the FED to play in the risky spectrum of the market. Some market participants only see today’s benefit.

The USA Inc.

There are many implications of the FED’s purchase of equities. First of all, there are moral hazards, market regulation considerations and compliance issues. The second and more serious implication is that this action is a quasi nationalization of the USA Inc.

What if the economic downturn is deeper and longer than we hope for it to be?

Will they continue to buy the equity market by doubling-down with the dollars they have to print?

How will they manage risk?

How will they deal with bankruptcies and the recapitalization of the companies?

Who will be responsible for market timing decisions, both entry and exit?

The economic volatility manager will have to become a manager of market volatility. If the FED’s purchase of equities proceeds like some are recommending, the guardian of the global financial order will add to their mandate other new duties.

They will become the “largest owner” of US-listed companies on top of their distinction of having the world’s largest bond portfolio. All the risky companies should issue junk bonds and offer their equities because Uncle FED is buying everything and they are paying premium prices.

All the King’s Men Couldn’t…

One of the amateur arguments for government intervention in the equity market is that it is down so much from the peak. This assumes that the “peak” has some theoretical right valuation reference.

Well we did not have the scenario of a truly global economic depression when the “peak” was reached. So the “peak” is a meaningless reference point now.

If the slowdown is long and deep, the potential for bankruptcies and default is high. Instead of spending energy figuring out where the new “fair value” level of the markets could be, people want the FED to simply push the “reset” button again and make this nightmare go away. People want this free insurance against market decline.

Well, the way I see it, this insurance ain’t free.

It will change the global financial and economic order in a meaningful way. People knew the risk, but they either ignored it or did not analyze it.

Now they want the FED to put the broken egg back together.

C’mon man, don’t spam with nonsense. It is already noisy out there.

Hainan Free Trade Port Lecture a Resounding Success
David Chon is a Korean-American from New York working in Hainan. He has over 30 years of global finance and investment experience. He is currently investing in businesses in China.

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