Fundamentals and bubble

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A few of us were sitting in the sukkah the other day, discussing investing. Chaim (not his real name) was telling us that he had finally determined to make an effort to understand the world of investments, and had therefore decided to sign up for one of the courses on the subject that are advertised in the media. However, in making a few phone calls to elicit information, “I discovered that they all use intensely aggressive marketing to get you to sign up with them, which really turned me off.”
It will be readily apparent that Chaim is not a sucker and he turned his back on what he realized was an intensely commercialized field, which meant that the companies in it were primarily engaged in selling product than in making him more knowledgeable. Instead, he found a private individual, knowledgeable and experienced, who offered to teach investment analysis – effectively, corporate research and how to apply it – to small groups, for reasonable sums and with no ‘agenda’ of his own. Chaim said that he enjoyed these sessions very much and had learned a great deal from them – to the point that he was able to sift through companies and make his own decisions as to whether they were worth investing in.

David, on the other hand, took a different approach. He explained why he prefers to use technical analysis, at least in combination with fundamental research, if not as a full replacement. So far, so good. This is an old, but still vibrant and essential debate about how to learn about investment theory and which approaches to adopt, when and what are the relative advantages and disadvantages of each.

However, whereas in ‘the old days’ – meaning before 2007-09 – I would have been an enthusiastic participant in this kind of debate, I found myself pouring cold water on Chaim’s enthusiastic embrace of fundamental analysis. And whereas in the old days, I would have used the parameters of fundamental versus technical analysis, now I found it unnecessary to relate to technicals at all. The problem with fundamental analysis today is the problem with the markets as a whiole today, namely that they have ceased to function in the way they are designed to function.

Markets, especially securities markets, are no longer sophisticated mechanisms for price discovery – meaning that the prices generated by the activity in the markets is no longer a true and fair reflection of the value of the security being traded, whether it is a share or a bond. The cause of this systemic dysfunction is, of course, the massive and ongoing distortion being applied to the markets by the world’s main central banks – those of the US, the Eurozone, Japan, the UK and, last but certainly not least, China. By pumping into their financial sysems huge amounts of money for a period now exceeding five years, the central banks have prevented the markets from finding their ‘true’ levels and have instead created a bubble in asset prices.

The size and scale of this bubble is a matter of intense debate, but its existence is now admitted by almost everyone. The remarks of Andrew Haldane, a senior Bank of England official, were quoted in this column a few months ago, but more recent remarks by member sof the Federal Reserve’s Board ofGovernor’s have left no room for doubt that they, too, see the markets as distorted by their policies – and they are now openly arguing among themselves as to whether this distortion and the damage it does is still justified, as well as whether and when it will be possible to reverse these policies. The extraordinary reversal of the Fed from its promises to begin ‘tapering’, to its decision last week not to do so, are symptomatic of the extent of the growing problem in ‘policy making circles’.

But coming back to fundamental analysis, the reason why it is not a serviceable technique today is because the prices fo securities in the market no longer reflect, or relate in any way, to the fundamentals of the company underlying those securities. In more theoretical terms, the basic tool of fundamental analysis is the discounted future cash flow of the company being analysed. The discounting is done on the basis of the ‘risk-free’ rate of interest in the economy – in the US, that means the rate of interest on Treasury bills. But if that rate of interest is openly and officially distorted, for years on end, and with no clear idea of when the distortion will end, then the discounting mechanism becomes meaningless and its results are even more so. The stock market, and indeed the entire financial system, have been reduced to ‘garbage in, garbage out’, and no sensible investment conclusions can be drawn from it.

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