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Greater Fool Theory: STRONGLY RECOMMENDED READING

Posted by Larry Doyle on June 13, 2009 8:14 AM |

Investing is often much more an art than a science. What moves markets both up and down often will defy any logical line of reasoning. That fact can and will frustrate many money managers.

While I traded on Wall Street, I was fortunate to experience many different types of markets and the driving forces behind them. Ultimately I learned that over the very long haul, fundamental analysis will carry the day. That said, for protracted periods the mere flow of funds and market psychology embedded in technical analysis can be powerful if not overwhelming.

I addressed this line of reasoning the other day in writing What’s Driving the Market. I find it particularly uncanny that the lead article in today’s Wall Street Journal, Stocks in the Black on Gusher of Cash, navigates this same line of reasoning.

I wholeheartedly agree with the analysis put forth by the WSJ. I want to juxtapose my writing with that of the WSJ to highlight a theory which readers will likely never see or hear from individuals involved in the financial industry. Coming from a family of lawyers, allow me to “make my case.”

In my piece on Thursday, I wrote:

From my perspective, the Fed and Treasury have created nothing short of a flood of liquidity throughout our financial system and economy. While the economic activity is anything but robust, this money is in the system. Banks are not aggressively looking to lend and will not cut interest rates or credit standards. The shadow banking system (securitization process) remains stagnant.

Thus, where does the money/liquidity go? Much like pools of water after a torrential rainstorm, the pools of liquidity in our system are looking to penetrate any available crack and crevice.

The WSJ writes this morning:

governments around the world are pumping money into the economy at a frenetic pace. Because businesses can’t put trillions of new dollars to work in such a short time, the money is finding its way into financial markets. Some investors have begun speaking of a “bailout bubble” being created in certain markets, and about a “melt-up” in demand fueled by the growing supply of money.

“All that money that was printed had to go somewhere,” says Joachim Fels, co-head of global economics at Morgan Stanley.

As anybody involved in finance can appreciate, “follow the money” holds not only for criminal investigations but also for investment purposes. Let’s continue “down the river.”

I continued my line of reasoning in writing:

Thus, much like that pool of water looking for a crack in a foundation and finding it, the pool of liquidity in our economy is being pushed into the market rather than remaining stagnant in CDs, money markets and the like.

Does the market represent good value at current levels? Not by any reasonable measures. But this market is not about value or fundamentals at this juncture. This market is purely a technically driven market in which the pool of liquidity is chasing stocks higher.

The WSJ proposes a similar thought process:

The money is gushing from direct grants, central-bank lending, tax breaks, guarantees and other items. China has announced plans for $600 billion in direct stimulus spending; Russia, $290 billion; Britain, $147 billion; and Japan, $155 billion, according to Strategas. Those countries and others are spending trillions more indirectly.

Some of the market gains, of course, reflect a bet by investors that the worst of the global recession is over, and that investments tied to global growth will be big beneficiaries. The heavy influx of money into the financial system has fueled those bets.

If the recession proves more lasting than the optimists believe, liquidity alone may not be enough to keep financial markets rising. American consumers, whose outlays account for more than two-thirds of U.S. economic output, have only begun to rein in spending and reduce debt, a process many economists expect to continue for years.

What are the risks in “following this money” and chasing the market? Do investors fully understand and appreciate the nature of the game being played? I am not so sure. The financial industry itself will merely promote higher prices as reason to “come on in, the water’s fine.” That is not to say that the market can’t or won’t go higher from current levels as money does get chased into the market. However, it is critically important for investors to understand the nature of the “game being played” along with the underlying risks.

I address those in my writing:

What remains the greatest risk to this flood of liquidity pouring into the equity markets? The technical flows so far outpace any sort of reasonable fundamental analysis increasing the risk that an equity bubble develops. What would cause that bubble to pop? Higher interest rates. What would cause rates to increase even further? Inflation and ongoing enormous fiscal deficits.

Rising equity markets may provide a degree of comfort at this juncture. I think it is critically important, though, to understand what is driving the market and what is further down the road on our economic landscape.

The WSJ offers the same:

The growing liquidity also is creating serious policy challenges. Senior economists, including Federal Reserve Chairman Ben Bernanke in congressional testimony on June 3, have begun warning that the government can’t keep piling up debt at current rates without creating severe financial problems.

In coming years, officials will need to raise taxes, cut spending, or both to mop up the ocean of liquidity they have created. That process could weigh on growth and stifle the market boom.

Meanwhile, yields of government bonds are rising in anticipation of heavy federal borrowing, and higher yields also hamper growth. On Friday, the yield on 10-year Treasury notes eased a bit to 3.783%, still well up from 2.203% in mid-January.

If the government fails to mop up the money, the consequence could be even worse: inflation and a collapsing dollar.

Past liquidity-driven booms haven’t ended well. In 1998, the Federal Reserve injected cash into the economy to rescue teetering bond markets. The unintended outcome: Technology stocks soared and then cratered. After the government turned on the spigot in 2001 to stave off deflation, residential real estate surged and then collapsed.

Now, although almost all markets still are far from past highs, bubbles may be starting to inflate again in speculative foreign markets and other investments linked to global economic growth.

I truly hope readers understand and appreciate the points highlighted both in my writing and the WSJ. Why? In brief, both works are laying out what is known as the Greater Fool Theory, which our trusty Investing primer defines as,

When acting in accordance with the greater fool theory, an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff.

This theory does not tell you how long the “river of liquidity” may run nor does it highlight which “boats” may safely make it back to dock, but it does hold that a market driven by these flows will eventually head over the waterfall much as it did in 2007-2008.

Please share your thoughts and comments so we can all most effectively navigate this river together.

LD






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