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What drives markets? You probably think it is valuations. Cheap markets rise and expensive markets fall. You’re partly right. There’s plenty of evidence to show that the price of a market (preferably expressed by a Shiller, or long-term average, price/earnings ratio) gives us a pretty good steer as to what will happen to returns over the following ten-year period.
That’s why we started telling you to buy income-producing defensive stocks a few years back. And it is why we came over quite bullish on European stocks last year. In general, we approve of the time-proven and straight-forward investment strategy of buying cheap stuff, waiting for it to turn into expensive stuff, and then selling it.
But valuations don’t tell us much about what happens to markets in the short term. That’s about something completely different: it’s about money and sentiment. When I wrote in the first letter of this year that we felt more bullish about developed-world equities than we have in a long time, this is what I meant. Sentiment was exceptionally bad – that meant it wouldn’t take much to turn it around. There was also a wave of new money on the way from the Fed and from the ECB.
Late last year, the Fed started to ramp up its swap activity again. This is relatively complicated stuff, but the key point is that it effectively means the Fed is lending money to the ECB and printing dollars in order to be able to do so – and to the tune of well over $100bn so far. At the same time, the ECB is providing unlimited liquidity to Europe’s banks to keep them afloat. And they, understanding the deal, are using the money to buy sovereign debt.
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You can call all this whatever you like and there are euphemisms aplenty for it. But as Gavyn Davis points out in the FT, while this kind of quantitative easing (QE) isn’t quite the same as our QE (where we print money to buy our own government bonds), we should learn to call a spade a spade. “This is quantitative easing on a significant scale, and the lines between this form of QE, and the direct monetisation of budget deficits… are becoming increasingly blurred.”
Still, while QE might be blurring some things, it is having a pretty clear effect on markets – just as it always does. We’ve written here about how new money works like a hot potato in the markets. The ECB gives money to a bank. They use it to buy a bond. The bond seller uses it to buy a German equity. The equity seller uses it to buy an emerging-market fund. Round and round the money goes, pushing each price up along the way.
The point is this: the rise in the market so far this year is a great relief. And it probably isn’t over yet. But it isn’t yet about value and it isn’t about the end of the crisis. It’s about the wall of money. Something to think about if you start to be bamboozled into believing that 2012 is the year in which everything is going to turn out just fine.
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Merryn Somerset Webb
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