3 Lessons on Market Distortion

This week's headlines tell a valuable tale...

THREE headlines from this week each tell us something important about global markets, writes Chris Mayer for the Daily Reckoning.

More and more, government is a big player in markets — creating distortions, along with pitfalls and opportunities.

Item No. 1: The market says one thing. Earnings say something different

The stock market rallied last week on news that the European Central Bank will "save the Euro." Basically, the ECB said it stands ready to buy bonds in unlimited quantities. To finance this, the ECB will essentially print money. This follows talk about how the US Federal Reserve stands ready to goose markets further — by printing more money.

In essence, the actions and chatter of central bankers are what are driving the rally since that little bottom we had in June after the market sold off about 9%.

Earnings are not driving the rally, that's for sure.

The S&P 500 just registered a 0.8% growth rate in earnings for the second quarter, according to the Financial Times. The consensus for the third quarter is negative for the first time in three years. The ratio of companies saying they'd miss third-quarter forecasts versus those that that said they'd meet them was 3-to-1. That is the worst ratio since the fourth quarter of 2008, which came on the heels of the Lehman Bros. bust. "Historically, we have only seen numbers like this during times of recession," says Christine Short of S&P Capital IQ (which tracks earnings) in today's FT.

Yet the market hits a four-year high.

Take-away: Trust earnings. The market can go only so far on the gas of central banking. Don't believe prices reflect what's happening with the underlying companies. The market is too optimistic.

Item No. 2: Gloom spreads in China despite the best efforts of officials

The FT reports that a third of publicly traded Chinese companies reported cash outflows for the second quarter. One headline seems to say it all, "Cash Squeeze Tightens Abroad Sections of China." Another says, "Fragile China."

Local governments have amassed piles of debt. The FT says these debts represent one-quarter of Chinese output. Yet China continues to announce ambitious plans to build railways and highways.

But one of the most-damning things I've come across on China hit my desk over the weekend. I seldom link to other articles in full, but this one is worth a read when you get a chance:

"In China, Silvercorp Critic Caught in Campaign by Police"

It is the story of a researcher in China who police arrested — and detained — because he works for a fund manager who writes negative reports on Chinese companies. (The researcher is a Canadian citizen, by the way, yet sits in a Chinese jail on flimsy evidence and no due process whatsoever. I can't believe the Canadian government lets that stand.)

Chinese companies have had lots of fraud issues, as you may know. Investors have uncovered discrepancies and outright frauds in US-listed Chinese companies. This sent the stock of many such companies tumbling.

This in turn, hurt these companies' ability to tap Western markets for more money, which hurts their ability to pay local taxes. And that hurts the local governments who labor under a pile of debt. It's all an ugly, corrupt circle.

Take-away: If you are in China, you have to write positive reports or you get arrested. That's the message here. There is no respect for independent research in China. There is no value on transparency. In fact, the organs of the state work against such things.

So in a reversal of my normal preference for "boots on the ground" research, I say you can't trust anything coming out of China. Oh, and if you own Silvercorp, dump it. Avoid China as a general rule.

Of course, this has broader implications, as we've talked about before, especially for commodity markets (because China is such a large consumer of commodities). If the Chinese market is really propped up by government stimulus, then commodity markets are too.

This warning does not apply to precious metals, which I think are moving higher.

Item No. 3: The US government is selling its AIG stake

Front page on The Wall Street Journal: The US government says it is going to sell $18 billion in AIG stock. This will cut its stake in the big insurer by half.

This is a reminder that the US government is still in the business of owning major stakes in big companies. It still owns stakes in Fannie Mae and Freddie Mac — which the government spent $188 billion on. It still owns big stakes in GM and in Ally Financial, which it spent $68 billion on.

These are companies that would have otherwise gone through the bankruptcy process — as would have a long list of institutions. What the bailouts did was preserve the same bad actors that got us into trouble in the first place. The corrective tonic of bankruptcy never got to do its full work.

Even after its rally, AIG still trades for about 56% of book value. Bruce Berkowitz at Fairholme owns a big chunk of it and calls it his best idea. Berkowitz is not immortal. He's taken some licks and his reputation is not what it was. But I think he makes a good argument for AIG.

Here is what he wrote in his second-quarter letter:

"Our best idea remains AIG common (35% of the fund) with a reported book value of $57 per share. There are few occasions when systemically important franchises sell for half of book value and are profitable. This is one of those times."

Book value is now $60 per share. On the Fairholme Funds website is a 21-slide case study on AIG from February. Though a bit dated, it still holds. AIG sells for less than 60% of book today. Yet peers trade for 80-100% of book. And the long-term average for the sector is 130% of book.

AIG is solidly profitable now. What's holding it back, at least in part, is the fact that the government is looking to sell. As the market absorbs $18 billion-plus in sales, this will probably tamp down AIG's share price.

Take-away: The US government still has large stakes in several financial companies. It is still a source of great distortions. However, as it sells these stakes, the overhang from its ownership will disappear. So too might the discounts these stocks trade for. 

It's a weird market we're in. I can't recall a time when government actions seemed to drive prices as much as now. I don't like it. But there are ways to navigate your portfolio through the mess.

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