“The markets can remain irrational far longer than you or I can remain solvent”

John Maynard Keynes.

This was the reflection of the great economist after his initial foray into market speculation nearly left him bankrupt. As an economist after the First World War he believed that the outlook for the dollar was good, expecting it to strengthen against struggling European currencies. Initially he made good money shorting (selling) currencies like the deutschemark, while going long (buying) the dollar. As his confidence grew he amplified the bets by borrowing, or in modern parlance employing leverage, to increase his exposure. So when the dollar fell and the deutschemark enjoyed a three month rally against the fundamental trend he (correctly) he was wiped out.

So why is this lesson still so important today? Well put simply when we look at the economic fundamentals we see a very weak outlook, with massive uncertainties, yet equity markets are partying like it’s 1999 (well ’97 & ’98 to be more accurate with the FTSE around 5350). So the question we pose is; are we missing something fundamentally positive or is the collective wisdom of the markets wrong.

Well in one respect it seems easy to justify the exuberance, reflecting on the fact that we are currently at market levels first reached over a decade ago. Looking at current valuations market bulls will tell you that the recent earnings season has proved positive with many upside surprise; however when expectations have been cut to the bone it is easy to beat them. Furthermore a headline PE ratio of around 18 for the FTSE 100 is not cheap by historical standards

Alternatively you might like to believe the following fan chart on expected GDP growth, taken from the latest Bank of England quarterly inflation report.

This predicts a rapid return to robust, above trend, economic growth as early as next year and aligns with the views of the optimists, like Fidelity’s Trevor Greetham writing in the FT today. He sees the extraordinary stimulus reigniting the economy in a traditional v-shaped recovery. Having discussed these views with him recently and with all due respect to Trevor, who is both very pleasant and very bright, I think the only comparable periods historically are the 1930’s generally and Japan in the 1990’s. While the extraordinary stimulus has stopped the worst of either of these scenarios repeating themselves the chart above looks delusional. After all growth above the rate we experienced in the debt fuelled property bubble madness of the last few years. Erm…………. clearly that isn’t going to happen.

Unemployment is growing (although the pace has recently slowed – briefly we anticipate), bankruptcies are increasing and we have a broken banking system, which among other things, has not yet admitted to around £300 Bln worth of dodgy loans to UK commercial property which are being rolled over because they dare not foreclose. Oh and I didn’t mention a national debt spiraling out of control, which will either require massive government cuts, destroying jobs and risking fragile growth. Or worse if we don’t cut we risk a bond market rebellion which will force interest rates higher, increasing the woes of the debt burden, which mixed with a falling currency will force up inflation, again risking fragile growth.

To be fair the BoE is hobbled in its outlook by using market interest rate predictions (based upon the view from sell side investment banks with massive vested interests) and by the assumed impact of QE (which is in fact not filtering through to the real economy) and more importantly on the budgetary assumptions of a government living in denial about slow growth and ballooning deficits. It is probable that the BoE’s real view was more accurately represented by the very low key performance of Mervyn King at the press conference last week (yes, I watched and yes, it was dull), who repeatedly emphasised the risks to growth.

Interestingly the minutes from the bank’s monthly interest rates meeting released this morning point to a mix of views, perhaps the most surprising that the Chief Economist, Spencer Dale, opposed an extension to Quantitative Easing. This was in part due to inflation risk but more pointedly to the “risk that further substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify”.

And perhaps here we see it dawning on the BoE that markets are getting ahead of themselves, not on the back of realistic valuations but on the wall of liquidity that QE has unleashed on the financial sector. With money supply to the real economy still suppressed we are seeing a growing disconnect between markets and fundamentals. True we still see terrific value available in certain companies but fear that even these may suffer if the market undergoes another sharp correction.

Our best hope in the short term is that markets find some stability and we can see a steady rotation in sectors allowing high quality value to rally, while the geared cyclical stocks can deflate gently to more realistic (and rational) levels. Hopefully markets will be kind, although unfortunately that has not been the common experience in recent years.

And finally…..

Not a joke this time but a note to inform you that we will try to produce shorter notes more frequently. There are an increasing number of good journalists’ blogs out there which can rapidly cut to the chase but in these febrile times we see the financial news as it happens, flashed up onto our screens, and have access to some of the sharpest commentators in the financial world. So it makes sense to speed up delivery of the important ideas you might not see elsewhere from the perspective of those immersed in markets and economics.

This also helps the author who in writing these notes tries to edit down masses of ideas to a reasonably succinct, broad outlook. This can take time and sometimes the spontaneity and relevance is lost resulting in unsent issues.

This note will shortly be followed by some commentary on the US economy and why the recent data releases on GDP and jobs, which have been interpreted with some good cheer, were actually rather difficult.

That piece will include a much needed joke.