Global Reset to Fundamentals and the Attack on Capitalism

As we watch the markets throughout the world plunge trying to find a trading range, we are witnessing the global market reset to economic fundamentals.  Before you think this is unambiguously bad (the reset) consider that this entire event spanning the last two to three years was set in motion by government policy actions and the flood of liquidity beginning after the September 11th attacks.  The market is simply correcting now what government policy actions have caused, a massive destruction of the mirage of paper wealth they created.

As numerous bubbles break in areas such as housing, agricultural commodities and oil, the market is finally trying to realign with the actual market fundamentals of supply and demand.  The fact that all of these bubbles are being purged at once bodes well for the long-term.  The change we are witnessing is all about future expectations and is largely self-fulfilling in the short run; in the same way it was on the upward trajectory.

Since the bubbles were so unrealistically inflated, the puncturing and deflation has spurred panic and what may very well be an over-correction in the next few weeks.  When the market corrects hyper-exuburance, the panic flows from the realization that a kind of mass hypnosis was in place to which the fundamentals of supply and demand were "constructed" to fit the exuberance. 

Once all of this "constructed-conventional-wisdom" is thoroughly undermined, finding a new footing, a new conventional wisdom, takes some time and is played out in the volatility that we now see everyday.  By the way, a volatility that will reap more damage until a new consensus develops. 

You could really watch the unreal ascension of oil prices, commodity prices and especially building materials (another commodity) like steel and concrete etc., up every two weeks or more often under the banner of China and emerging market demand. You have a foundational truth (increasing demand by China et. al.) projected or better said, exaggerated into the long-term future not even at straight line rates but at exponentially increasing rates.  Couple that with very aggressive hedge fund trading, which moved to commodities to escape the downdraft in the housing market and stocks in general and you have a really ridiculous and unsustainable inflation of commodity prices (as was pointed out here on July 7, 2008:  http://www.swinecast.com/the-moving-bubble-and-the-impending-fall-of-oil-prices). Here is the salient portion from the above on July 7 of this year:

"We now are approaching the early-mature portion of the commodity bubble. When I see forecasters talking about $200 to $500/barrel oil, I know the end is at least in sight. This talk is equivalent to zero down mortgages and signals the last gasp of the sucker money (the last one in and the first one to lose).   No one can explain the huge risk premium that is now incorporated into most commodities.  You can explain some of it with market fundamentals and the weaker dollar but that gets to about half of the run up.

For this reason, I expect oil prices and the prices of most other commodities to soon begin to waver and then retrace their gains of the last year fairly dramatically.  Subsidy elimination by China and the rising inflation in the global growth countries will begin to put the brakes on future demand."

If the demand being projected in August 2008 for the future were really true, instead of containing a substantial amount of "herd instinct", the prospect of sending most commodities into the nether-reaches of a "stocks-to-use" crunch would have sent market prices ever higher, as happened. 

In the meantime, wealth was redistributed, especially through debt cancellation, outlook (in this sense psychological outlook) destroyed, spending reigned in, unemployment reduced to real need levels and the ever present (but always unanticipated for some reason) increase in consolidation of firms within industries. 

Only firms "too large or too important to government policy to fail" such as ethanol distillation and those able to substantially manage risk emerge to fight again.  Those firms which saw this coming early, including some of the banks, are now preparing to and executing mergers and acquisitions of large, failed, former competitors.

The idea that this is a failure of capitalism is patently ridiculous but getting a lot of play by people who think they are smarter than markets.  Government and its role in "guaranteeing" unsustainable investments and then flooding the market with liquidity to execute them set the stage for all of this and the incentive to grind out maximum throughput of government guaranteed mortgages (for instance), mortgages that would have never in a million years be made without these guarantees, brought all of this to a fever pitch. See: http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260  Its all about tragically ineffective incentives for investments, created and bolstered by government, that the market by itself would have never undertaken, whether it be in housing or in ethanol that is being purged. 

That would be fine if the lesson were learned but as we speak, there is scampering to figure out how to profit from the next unsustainable government policy being driven into the markets.