November 14, 2011

Financial Totalitarianism

Trying to make sense of this financial world through traditional stock fundamental measures is futile these days. Playing the money game has become a binary flip of a coin on the last dollar: either you invest in assets (all in) or in cash (all out). This duality simplifies the plethora of alternatives that normally overwhelm the investor. "Correlation-One" Markets that rise and fall at unison. The value of your investments is determined by the latest decision of a policy figure.

Take the value of your money, for example. The value of your money measured in assets (or how many barrels of oil, bars of gold, pairs of Nike shoes or heads of lettuce can you buy with a fixed amount of green stamps called "money") is established by its relative abundance (or at least its perceived abundance), which in normal times is determined by the decision of a counsel of elders in which we have trusted our savings (the central bank). We never think of it this way, but our wealth is defined to a great extent by "royal" (or totalitarian, if you will) decree every time Draghi or Bernanke gather in their respective conclaves and spew out white smoke to declare before hoards of financial reporters crammed in a room: your green stamps will buy 2-3% less lettuce the following year. The population abides to the royal decree (depending of course on the credibility of the elders in question) and adjust their expectations accordingly. It is indeed a very well choreographed dance. One party leads with its cue and the counterpart harmoniously follows fulfilling the inflationary prophecy of its monetary central planner.

So our wealth is determined every time a policy figure opens his mouth. Interesting. I don’t know about you, but that is pretty much the definition of Political Risk. This is akin to the risk a transnational company faces when they decide to invest in Venezuela or Bolivia and Hugo Chavez or Evo Morales declares that he will expropriate their Venezuelan plants and give them 30% of the value of the assets they installed in his personal backyard, err, country. You might ask: Why investing in a politically risky environment with the contingency of value-confiscation by the local autocrat (be it the current Dictator or the MIT-trained PhD in charge of the central bank)? Well, as long as the investor has confidence the return will compensate for the confiscation, that is ok.

Notice the Key word: Confidence.

Normally, the conclaves’ ever-ending short selling of their respective currencies would create the incentive (via punishment of cash holders) for the population to always want to hold anything other than cash. One problem arises in times of "Correlation-One" Markets though: there is no Confidence investments will compensate for the confiscation rate the local autocrat imposes. The same psyche prevalent in a bank run is prevalent here: the return of your capital precedes over the return on your capital. Everyone prefers cash to assets. Everybody races to hoard that currency which stores value the best, because they want to keep the amount of lettuce they can buy as stable as possible. Problem is, that hoarding urge sends everyone running for the usual suspects creating bubbles: Gold, Swiss Franc, US dollar... and that hoarding affects precisely the variable the monetary planners want to regulate: the relative abundance of money. So in a confidence crunch, the paradox of thrift renders the bank multiplier useless -in fact detrimental-, and the money’s relative abundance goes down sending its value higher. The incentive to own assets instead of cash is no more and deflation ensues. Economic activity plunges. The counsel of elders’ effort to punish the cash holders is nullified by the frantic search for cover. Suddenly, people is so scared they don't care their money buys more lettuce -they never use it to stock up. All they want is cash, cash, cash -an irrational behavior, considering you can't cook bills.

We are in a Crisis of Confidence. And with good reason. Italy owes the world €1,900,000,000,000 (€1.9 Trillion) and if that sovereign paper "Greeks-out" (and we apply a 60% haircut the way SocGen & BNP did) we will have have created a €1,140,000,000,000 (€1.14 Trillion) hole in the Europe's banks. That capital whole would wipe out Europe's biggest bank (Spain's Santander) 16.7 times. With Italy's 10yr at 7.23%, we are awfully close to sovereign debt market shutdown for Italy.

The monetary planners are fighting this by inflating their balance sheets and selling their currency in one huge massive push to make investors own anything but cash. The ECB, traditionally very vigilant of its reputation as guardian of the Euro's value, finally ceded and has spewed out its latest decree: "you will buy less lettuce with your Euros". That change in music in Europe is more than welcome. The lady has changed dance partner, and the new partner has sent his cue.

There are a lot of things that need to happen for confidence to come back, but at least the first one is there. Papademos' good reputation in Greece and Monti's succession of Berlusconi definitely help.

These days, our wealth is determined every time a policy figure opens his mouth or takes a decision. We live in the days of Financial Totalitarianism. One unilateral decision, one decree, and you wealth decreases immediately. Forget about P/E's.

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