The market is propped up by a virtuous circle:

the banks borrow from the government and then, wisely sensing that it is not safe to make normal loans, invest in stock market indices, foreign currencies, commodities, treasuries. The banks have nothing to lose by risking capital in this way. After all, if the stock market crashes, they are toast anyhow, so why the heck should they care? The rise in asset prices makes the balance sheets of financial institutions look better, so the banks feel fortified to repeat the cycle — borrow more money from the government and so on.

The process goes on until it doesn’t.

To say that valuations are stretched is a serious understatement. Indeed, what we have created here is a parallel universe, an alternate reality. The underlying problem is that interest rates (the price of money) are not being set in our economy by a normal bargaining process between borrower and lender, where each one looks after his own interests. Instead, rates are set at a level that will get borrowers to borrow — and to hell with the lenders. The lender has no interests to protect, for the lender is the government, whose only interests are the interests of its citizens, and who cares about them?

The distortion of interest rates makes it impossible to know the true value of any asset. Heck, through the prism of 0% short term rates, everything appears cheap. Some day though, and maybe sooner rather than later, reality will intrude into this fantasy world and asset prices will adjust (suddenly) to a level where a *rational* lender is willing to lend based on the value of collateral. The adjustment from one universe to the other will require our space ship to travel through a vacuum, and as we all know from physics class, nature abhors vacuums.

Since the banks recognize the precarious situation with the economy, they don’t lend their ‘free’ money, they just keep funnelling it into equities. That is the only way they can turn a profit right now. Sort of like the movie “Weekend At Bernie’s” where those two kids keep propping up the dead man to keep the party going.

- Jonny Tellyarn

Related Posts:

• Making sense of the bailout and Vote against it
• On the basis of one time honored metric that I rarely see discussed, the market is extremely over valued.
• Recently I wrote that I thought the NAZDAQ would lead, not the DOW and S&P. Today an article that covers ETF’s had this.
• The following just released from the Bank for International Settlements (BIS Quarterly Review March 2010).
• A Must-Read: We are now on the cusp of a very serious money supply deflation.

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