There are many analogies that have been coined to characterise the action of stock markets.
One of the most famous and apt is Ben Graham’s description of their action as being similar to a “voting machine” in the short term, but like a “weighing machine” over the longer term. This is a very helpful way for investors to understand how the emotional component of stock-price moves can obscure true underlying value, but however severe any move may be, this is only likely to produce temporary deviations from the intrinsic value of a given investment. So, by implication, the art of investment is simply that of identifying opportunities where the “voters” have taken an overly dim view of a given situation, opening up a substantial gap between its current price and its intrinsic value – and waiting. The great economist and active investor John Maynard Keynes cast a slight dampener on this approach, which could be summed up as a long term “buy value and hold” philosophy, by observing that, however sensible, stocks can remain undervalued for extremely long periods.
Why am I making these points? It is because I think that there is another analogy for markets, which at times like these may be more appropriate. The analogy is that of a Tempering Forge – a mechanism by which things are stressed but yet made stronger. This is the function that it is particularly visible today in currency and sovereign debt markets.
Sovereign risk has come to the fore as speculative flows have challenged the ability of the most indebted and profligate governments to repay their obligations – with Greece the first to come under scrutiny. What is happening here? In the absence of an ability to punish the currency of offending debtor countries directly (at least those that are part of the Euro) – which is the usual method of extracting revenge for such misbehaviour - this pressure is manifest in falling government debt prices of those countries. Two factors lend some encouragement that this process is orderly, however. Firstly, debt spreads have now only re-established levels seen in the late ‘90s – hardly a sign of systemic fragmentation. Secondly, a stabilisation of the Euro, after initial weakening, suggests that Europe will find the right “price” to extract Greece from its difficulties whilst also sending a strong message that this is not a road that other Euro members should be quick to follow.
Nevertheless, Europe does have a difficult balance to strike. The danger is that, with Greece as an example, financial markets “scare” European governments into a phase of “competitive deficit reduction” at a time when the economic recovery is still fragile.
