Delusion [dih-loo-zhuhn] — noun

A fixed false belief that is resistant to reason or confrontation with actual fact.

Delusional seems to be a fair appraisal of how markets have behaved since the apparent end of the global financial crisis. Despite myriad  indicators that financial markets will fall into another malaise, it appears that Mr Market remains in a state of blessed optimism, ignorant of the grey clouds appearing on the economic horizon.

Even Australia’s so-called miracle economy is not immune to the risks of economy calamity, even though most Australians appear to have altered the old saying from “this time it’s different” to “this time we’re different”.

Of course, the horror of corrections is that most investors rarely see them coming. If they did, there would never be an asset bubble in the first place. The result is a rapid transformation from greed to fear, which leads to a drastic loss of business confidence and the intrinsic value of assets going switching from over-valued to under-valued. As Benjamin Graham famously noted, “sometimes Mr Market was very happy and positive about the future and was willing to pay handsomely to buy shares. At other times, Mr Market thought the sky was falling in and wanted to give those same shares away at bargain prices.”

With the Australian stock indexes approaching 5000 and the Dow Jones almost 11,000, investors are ignoring a multitude of potential black swans, not to mention the obvious stuff.

A US double dip

The US recovery has been one part smoke, two parts mirrors. Largely spurred by government spending. While Keynes may have approved, the notion of borrowing from a major trading partner (or in the US’ case, printing money) to fund a recovery and prop up failing banks and car companies doesn’t build a solid foundation for growth. The US S&P500 index is trading on price-earnings multiple (based on 10-year average earnings) of almost 22 times — 37% higher than its historical median level. This is at a time where unemployment (even on the flawed public data) is about 10%, and the long-term unemployment rate continues to increase.

At the same time, the only thing stopping US house prices falling back off the cliff has been unprecedented government support of the mortgage market and the housing market (through grants to buyers), coupled with ongoing support of banks and other zombie enterprises. The foolishness of the US stimulus spending is slowly emerging — for example, one TARP beneficiary, General Motors, which is now 61% owned by US taxpayers, still requires $US12.3 billion for its pension fund in the next four years, and lost $US4.3 billion over the past six months.

Meanwhile, Thomas Hoenig, a member of the Federal Reserve board, yesterday warned that if interest rates remain at virtually zero (as they currently are), the “the outcome too often is greater inflation, significant credit and market imbalances, and an eventual financial crisis”.

Regardless of impact of Australia’s new best friend in China, a US market shock will have a profound effect on the Australian market.

Beware the little PIIGS

While it may have temporarily slipped from the headlines, the diabolical Greek situation is back on centre-stage, and appears far from being resolved. The problem for Greece is quite simple — it spends more than it earns, and the people who live there aren’t especially keen to get their personal (or public) balance sheets in order. The smart money is well aware of this — the cost to insure Greek debt is now more expensive than Iceland, itself an economic basket case. Greece is now required to pay more than 4% more than Germany on its borrowings (and it still is about $40 billion short on its funding requirements this year). This means the country is required to tip more of its precious capital into merely paying off interest. Oh yeah, let’s not forget Portugal, Spain, Ireland and Italy who will face similar calamities shortly. (One analyst deemed that Ireland had a 43% chance of being unable to pay its debts).

If Greece is the equivalent of Bear Sterns, that means the world is waiting on the next Lehman and Citigroup.

Chi-bubble

Australia’s saving grace has long been its close relationship with the world’s economic engine room, China. Then again, some may claim that trusting our nation’s to a trading partner, which has virtually no freedom of press, minimal civil liberties and is happy to imprison a steel company executive as retribution for a reneged equity investment, may not be a wise idea. Then there is the fact that China’s asset prices have undertaken a rapid appreciation, supported by very lax lending and extraordinary stimulus.

As Edward Chancellor, investment manager at GMO (an associate of China-bear Jim Chanos) noted, “China’s current situation is reminiscent of the late stages of the dotcom bubble, when investors extrapolated past rates of growth into the future and were bedazzled by the size of the prospective market. As with the internet frenzy, a surge of investment creates a demand that appears to justify the most optimistic predictions. China has become a field of dreams; a build-and-they-will-come economy.”

Trusting China to deliver permanent growth is a little like trusting a kidnapper to deliver the hostage when the loot is paid. Sure, it might happen, but it requires placing faith in someone who shouldn’t really be trusted.

Housing Ponzi

Even if the overseas risks don’t translate to the Australian economy, we have our own little bubble, known as the housing market. Courtesy of low interest rates, populous government policy and permissive bank lending (largely using foreign sourced funding), Australians have devoted billions of dollars of capital to residential housing — money that should have been invested in income-producing assets such as businesses, or research and development.

If the Australian housing market returns to historical levels compared with income (and history suggests this will happen eventually), the Australian economy is likely to experience a similar shock to the early 1990s.

It’s human nature, especially after two decades of relative economic bliss, to be optimistic about our economic future. The problem is, sometimes that optimism can sometimes be delusion, which can be somewhat hazardous to your financial health.

Adam Schwab is the author of Pigs at the Trough: Lessons from Australia’s Decade of Corporate Greed — become a fan on Facebook