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Quantitative Easing Vs the Fundamentals

Quantitative Easing Vs the Fundamentals

It used to be, that when you felt that a public company was performing well, it was reasonable to invest in it. A cautious investor would analyze the company’s performance over time, its financials, the market in which it operated, and – with the fundamentals in hand – make a decision to invest or not. I’m talking simply about buying shares.

When Warren Buffet considers investing in a company, he analyses its fundamentals. If he does not find a direct correlation between the company’s fundamentals, demand in the market, and the product that the company sells, he simply doesn’t invest.

However, these days it seems to me that shares are mostly bought and sold according to sentiment, and not in-depth analysis. Shares are traded mostly by derivatives, and driven by sentiment. This is what generates the “herd mentality” and increases volatility in the stock market.

This is because investing in companies today has become about short-term gains. This approach casts the value of a company – i.e., the value of its shares – in unpredictable flux. The degree of volatility of the value of any given company’s shares over the past few years has made decision-making about long-term investment difficult to do based only on a company’s fundamentals.

Quantitative easing exacerbates volatility

Volatility is ever present in the market. It is a given. However, there is something exacerbating volatility these days, and that is the quantitative easing policies of governments. Quantitative easing is a way of increasing credit in the market. By buying large quantities of financial instruments, such as private sector bonds, the government hopes to spur financial activity by providing companies with cash flow. It is a way to inject cash into the market.

The added cash, estimated at $2 billion in the US and another $2 billion in the eurozone, has oddly created a surplus of “cheap” money. The problem is that though this measure is intended as a stimulus, it can backfire.

Excess cash in the diamond industry

A similar situation can be observed in the diamond industry. A large number of banks, required to provide credit to support exports, are providing money in quantities that far exceed true market needs. The measure intended to stimulate exports has resulted in excess money in the market, and thus, has backfired.

The financing was meant to inject necessary cash to stimulate real growth while manufacturers kept a careful eye on demand. Instead it has resulted in an excess capacity of capital, which has led many manufacturers to focus on maintaining the flow of credit. The goal was meant to be to generate income by serving market needs. Instead, it has become to maintain credit by generating business activity at any cost – needed or not, sustainable or not.

Rapid speculation

The financial markets have turned to rapid speculative activity based on the VIX “fear index” instead of relying on the fundamentals of long-term market investment. Similarly, the diamond center where most manufacturers and credit sources are located is focused on “playing the market” instead of supplying goods based on consumer demand.

In the stock market, the game is to push the price of a share up or down as quickly as possible in order to generate a profit. In the diamond manufacturing sector, the game is to protect and generate bank credit.

Too far from the fundamentals

This assertion requires some proof, so here it is. The large companies built on solid foundations, those that are Sightholders and contracted ALROSA clients, made large purchases in January, buying an estimated $1.25 billion worth of rough diamonds. However, even though they have the manufacturing capacity to polish those goods, they preferred to sell most of them instead, according to market players.

Why? Because they probably estimated that there is limited demand in the market and that the cost of rough is still too high. They understand, as seasoned business operators, that most of these goods will result in a financial loss or in low profit polished diamonds. Therefore, they choose to sell the goods and profit from trading rough.

ow else can one explain why in mid-December rough diamond suppliers were practically begging to sell a box of De Beers’ assortments while three weeks later they were selling for a 6-7% premium?

And this is the heart of the matter. The rough diamond trade is moving away from its fundamentals rooted in polished diamond price transactions and the volume of its demand. If the trade remained attached to the fundamentals, a profit would always be possible.

The man who bought the American national rail company was asked why he invested his money, given that the company was going bankrupt. His answer was simple. He said that even if he only ripped up the tracks and sold them for iron, and would still make a profit. That is a purchase based on solid fundamentals.

Mood and sentiment driving trade

Another aspect of sentiment in trade is mood-based purchases. Just as moods impact trading on Wall Street, so too does it impact trade in rough diamonds. If the market is pessimistic, trade sinks and the willingness to pay more for rough sinks with it. When the mood improves, willingness to buy rises, and the willingness to pay more for rough rises with it. This, as we saw last month, is entirely disconnected from real demand. Trade is based on sentiment, and not on the fundamentals of supply and demand.

This trend is contributing to the growing volatility of prices in the diamond sector – where volatility was traditionally very low. Fiscal crises used to occur every five years. But they have become more and more frequent – annual at first, and now almost every month. They are being triggered by the fickleness of mood and excess financing in the hands of small and mid-size companies with survival and short-term planning as their lone strategies.

Sentiment and excess financing

In a market flooded by excess speculative financing, it is difficult to predict the direction and trends that market players will take, or the prices of polished and rough diamonds. In such an environment, business becomes dangerous and harder to grasp, because the players distance themselves from the fundamentals of the industry.

For example, In India – a major diamond center – excess credit has generated a trend of sentiment-based trade. This trend drives volatility, and distances diamond players from the industry’s fundamentals: supply and demand.

One may wonder how it is possible to sell overpriced rough diamonds to be made into under-demanded polished diamonds. After all, every seller needs a buyer. Buying such goods for manufacturing will surely turn a loss. Such rough diamonds are like candles without wicks. As long as they are only bought or sold, it’s OK. But at the end of the line, someone will try to light them only to discover that they received a raw deal. It is no different in the diamond industry. At the end of the line there is someone who will try to polish the goods only to find that they are unneeded, and that they can only be sold for a loss. Oh well, at the very least he can secure his credit line by simply shipping them overseas.

The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser. 

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My Work: Ehud Laniado
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