Defenestrating Thoughts from the Bivouac

We’re not making it up,” Bernanke told the House Financial Services panel. “We’re working along a program that has been applied in various contexts,” he said. “We’re not completely in the dark.” (Source)

Sorry Ben, but the truth of the matter is that you are making it up as you go along and you are completely in the dark. And while you twiddle your thumbs trying to figure out what to do, the whole system is falling apart.

Let me explain. :-)

At the root of any healthy economy is the ability for the market to price and value assets. Market risk is an expected part of this and priced in. The riskier the endeavor, the higher upside. The safer it is, the less upside.

But what’s not expected is the amount of uncertainity coming out of Washington. Our policy makers’ inability to commit to something and stick with it is making it hard to price assets and, as a result, all the remaining money out there is sitting on the sidelines.

The policies being discussed are game-changing and as a result the spreads are now wide open. As an example, in a normal market, if the buyer thought something was worth $8 and the seller thought it was worth $10, they would probably settle on $9.

But in this market, the buyer thinks the asset is worth $1 and the seller thinks it is worth $100. There’s no way that bid/ask gap will close. And as a result, no transaction occurs and the remaining capital we have sits on the sidelines.

Let’s look at some examples.

First at the micro-level: houses aren’t selling that well now. One of the reasons is that sellers expect a government policy that will reinflate all the prices. In fact, a home down the street from me just got listed at more than 20% of what a comparable house sold for a few weeks ago. Buyers, however, are seeing prices drop and expect them to continue to drop.

Since both parties are waiting for game-changing government policies or decisions, neither is moving from their position and no transaction occurs.

Now at a higher level: let’s look at bank paper. The banks think that the government will bail them out by buying the paper at above-market rates (again) and the buyer thinks that the government learned its lesson and will now shift to a policy of cramdowns. As a result, the buyer is looking for prices like 15 cents on the dollar while the bank is expecting a full dollar (or more).

Government shooting from the hip is keeping these spreads wide; which results in no transactions.

Finally, let’s look at a very high level: no one can really price any company stock right now by looking at their balance sheet. No one knows what the assets (inventory, bonds or every cash!) will be worth on the open market or how their business model will fair tomorrow. And it’s not because of the economic uncertainty, it’s the policy uncertainty. One bill signed into law could turn billions of dollars into nothing in a flash. There is no way to price in that sort of risk.

Now I could buy some bank stock, but tomorrow a major bank could be nationalized. So if I bought a stock in a big bank, I’m wiped out (common shares are worthless if a bank is nationalized). If I buy stock in a small, local, healthy bank, I lose since a weaker competitor just got a bailout.

Or I could buy some car stock. Of all the auto companies, Toyota and Honda are the most likely to appreciate, but their incompetent competitors could get even more handouts. Which would reduce the value of my investment. Or I could invest in GM. But they could be nationalized and I’d be wiped out.

Given all the governmental policy uncertainty, no one is making a move. And this is the core reason that equity and credit markets are deteriorating.

So far every time Obama talks, the market tanks. Here’s why: the market needs specifics on the plan. The time for vague promises of “pretty pink ponies for everyone” ended on the campaign trail. We need to rebuild the economy and that absolutely won’t happen until the rules of the game are made clear.

Remember, the capital we have left in the market is owned by people who were prudent and avoided the market crash. These people are smart and they certainly aren’t going to invest their money in anything if the stroke of the President’s pen could make their investment worthless in a blink of an eye.