" ... '[T]e market' is rapidly becoming something of an endangered species. Your mission, should you choose to accept it, is to try and identify any asset of significance that isn't experiencing huge and artificial distortion to its price by forces that we might term 'the monetary authorities' and their huge and daunting printing presses."
– Tim Price, director of investment, PFP Wealth Management, London
Trust a man named Price to get to the nub of the current valuation quandary. More and more assets (be they financial or real estate) are being priced by something other than long-term valuation. The fluidity of the capital markets is being blocked, plugged and restricted by factors related to government policy and, as is always the case when governments get involved, valuation goes out the window.
Accommodative monetary policy in the U.S. and Europe has been made necessary by fragile, over-leveraged economies and out-of-control government deficits. Nevertheless, near-zero short-term interest rates are reaching well beyond the needy, and rippling (or should I say crashing) through every nook and cranny of the capital markets. Cheaper-than-necessary credit causes severe imbalances – excessive risk-taking, rising debt loads and chronic overbuilding. A case in point is Canada's red-hot housing market, which is not being driven by a booming economy, but rather depression-like interest rates.
Countries have historically adjusted to changing economic conditions by turning three dials – interest rates, currency and government policy (spending, taxes, bank reserves). Part of the current distortion is that too many countries don't have the currency dial on their dashboard and are being forced to manage with the other two.
Europe is a prime example. It operates under one currency despite its cultural and economic diversity. Countries that desperately need to retool their competitiveness, like Greece, are being forced to seek approval on austerity measures, something a free-floating currency would have taken care of unilaterally.
Countries that have pegged their currency to the U.S. dollar are forced to live with America's monetary policy. China's economy couldn't be more different than the United States, but it operates with the same undervalued currency and low interest rates. Perhaps it's not surprising that it now finds itself with an overbuilt, debt-dependent real estate market.
The hand of government
While interest rates and currencies are the two biggies, a heavier government hand is also distorting markets in other ways. Subsidies, bailouts and loan guarantees all affect the competitive balance. Also, the percentage of companies being run or controlled by government is growing as the developing countries make up a larger part of the world economy. State-owned businesses play a prominent role in the resource and banking sectors particularly. Chinese banks are public companies, but really act as a policy arm of the government.
As investors, we've got to be aware when assets are trading away from their long-term valuations (above or below) because of socio-political influences. It may mean being more cautious when buying a company that's benefiting from the good graces of government policy, and conversely, being more aggressive if it's been hammered by one-time government actions.
A not-so-free market is worrisome to be sure. As Mr. Price's comment highlights, we're in an unusual period when it's hard to find assets that aren't being heavily influenced (read: propped up) by monetary policy. As a result, we have to be prepared for more market shocks caused by pricing distortions, as well as the eventual return to a less stimulated environment. Governments are running out of firepower and will have to let their economies sort themselves out on their own. (And, yes, that means mortgage rates will be 6 to 7 per cent again, and utilities will lose their safety premium and trade at 12-13 times earnings).
But all is not lost. There's money to be made by investors who aren't locked into tracking the broad indexes and can take advantage of mispricing. There will be policy changes that lead to distress sales (this week, Barclays Bank felt obligated to sell its remaining stake in Blackrock Investments, arguably one of its best assets) and in general, a less manipulated economy will create space for profitable, well-financed companies to play a bigger role.
The best risk control measure in times like this? It's the same one we always use – Don't own overpriced assets.