Sunday, July 26, 2015

When Authorities "Own" the Market, The System Breaks Down: Here's Why

Central planning asset purchases aimed at propping up prices destroy the essential price discovery needed by private investors.
Panicked by the possibility of declines that undermine the official narrative that all is well, authorities the world over are purchasing assets like stocks, bonds and mortgages directly. Central banks are explicitly taking on the role of buyers of last resort on the theory that if they place a bid under the market to arrest any decline, private buyers will re-enter the market once they detect that the risk of a drop has dissipated.
The idea is that once private buyers flood back into the market, central banks can unload the assets they bought to stem the panic. In this view, the market is not based on fundamentals such as revenues, profits and price-earnings ratios--it's all about confidence. If central banks restore confidence by reversing any drop with massive buying, this central-planning manipulation will restore the confidence of private investors.
When this restoration of confidence has been accomplished, private buyers will happily buy the central banks' stocks, bonds and mortgages. The central banks' portfolios of assets will shrink and the central banks will once again have "dry powder" to buy assets the next time markets falter.
This sounds reasonable in the abstract, but it doesn't work in the New Normal economy central banks have created. Let's consider a simple example to see why.
Let's start by recalling that prices are set on the margin, i.e. the last view shares, bonds or homes bought/sold. In a neighborhood of 100 houses, the price of each home is based on the last few sales which become the comparables appraisers use to establish the fair market value of all the nearby properties.
As the risk-on investment mindset switches to risk-off, house prices start declining. If the last home sold for $400,000, the next seller will expect at least $400,000. But since the mood has changed and risk has re-emerged, buyers are suddenly scarce. Homes listed for $400,000 don't sell. Eventually a house sells for $350,000 because the seller just needed to get out.
Suddenly, the value of the other 99 homes is in question. Home prices are sticky, meaning sellers refuse to believe the value of their home has declined. So listings of homes asking $399,000 pile up while potential buyers are wondering if $350,000 is a bit rich and perhaps $340,000 is the "real value."
Then two houses sell for $325,000. Maybe it was a divorce, or a transfer to another state. For whatever reason, the sellers needed out.
As few as 5 home sales revalues the entire neighborhood. Price is set on the margin.
As prices plummet, authorities decide to prop up valuations by directly buying homes. The next five homes are bought by authorities at full asking price.
The authorities expect new private buyers to come in and buy the next batch of homes, but the bubble-mindset of prices are only going up has switched to the fear-mindset of let's wait, prices are falling--and one of us might lose our jobs.
Now the authorities are trapped by their policy of central planning distortion of price discovery: since sellers sense prices are being manipulated (or the news that authorities are buying houses to prop up the market leaked out), they don't trust the price accurately reflects market valuations.
Pretty soon, authorities own 20 houses. Private buyers have vanished, and sellers are realizing it might be their last best chance to sell for $325,000, because if authorities stop buying homes, the price could revert to pre-bubble valuations--at $250,000 or even less.
At $325,000, the homes are poor investments for investors. With property taxes and junk fees soaring while rents are stagnating as layoffs increase, there is no way to make money buying a house for $325,000 once appreciation is no longer a sure thing.
The moment authorities stop buying, the price of the next house sold will be substantially lower as prices re-set to historical norms. This repricing to $250,000 saddles the authorities with immense losses, as they now own 25% of all the homes bought at $325,000 each.
By propping up the price, the authorities have injected false information into the market, and as a result, nobody can trust that current prices are real. If the price of the home might drop $50,000 next year when authorities finally stop buying, why buy now?
With prices distorted and trust lost, where can private investors put their money? Certainly not into houses that might drop in value once authorities cease being buyers of last resort.
In effect, central planning asset purchases aimed at propping up prices destroy the essential price discovery needed by private investors. With authorities buying assets, investors have no place to put their money that isn't exposed to sudden policy changes by authorities.
With investment information and feedback now distorted, private investment dries up, leaving productivity and growth stagnant.
In system language, the markets are now tightly bound to central planning policies: any change in policy has an immediate and potentially disastrous effect on the values of assets.
This is why buying assets to prop up prices is a one-way street: once you distort markets to prop up prices, you destroy information, independent price discovery and trust-- all the essentials of a market.
What authorities have created is a facsimile of a market. It looks like a market on the surface, but only gamblers and fools risk capital in markets based on false information.

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