Monday, July 27, 2015

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

"Submitted by Charles Hugh-Smith of OfTwoMinds blog,
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."

at http://www.zerohedge.com/news/2015-07-27/when-authorities-own-market-system-breaks-down-heres-why

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