Santa Rally? Ho, Ho, Ho.

For those of us who own equities in our retirement funds, the latest dive in stock prices is somewhat disconcerting. However, the question remains: how significant is this weakness on the rest of the economy? I am in the camp that downplays the significance of the information embedded in stock prices: although very useful in theory, in practice, stock price movements are driven by the herd psychology of investors. Even so, it raises the issue of a recession odds for 2019.

Understanding Why Governments Cannot Use Stock Prices As A Policy Tool

Professor Roger E. Farmer proposed in his book Prosperity for All (link to my review) that  governments should set up a body to control equity prices as a means to smooth the economic cycle. In this article, I explain why a government could not hope to control the level of stock prices in a meaningful sense.

(This was a discussion that I deferred from my review. I expect to write a final article that explains why that even if the stock market could be controlled, it would not be useful for policy purposes.)

Of course, it might be possible for a government with a large sovereign wealth fund to influence the stock market. However, unless it could convince other investors that it was investing in fashion designed to provide strong returns, other investors would probably ignore the government's attempt to jawbone stock prices. If it wants to engage in economic stabilisation, there is no reason to follow the government's preferences.

Book Review: Prosperity For All

Professor Roger E. A. Farmer has written Prosperity For All: How to Prevent Financial Crises, in which he lays out the case for creating a sovereign wealth fund whose objective is to stabilise financial markets. If we can eliminate financial crises, we can avoid the rise in unemployment that results. Although that is an interesting concept, I was highly skeptical about the idea before I read the book -- and my skepticism remains after reading it. Instead, the discussion of macro theory within the book is why it is of interest.

Book Review: Stock Market Trivia

The book Stock Market Trivia (Including a Special Section: The Weird Words of Wall Street by Fed Fuld III is entertaining, and would be of interest to readers who are not familiar with finance. As the title suggests, it is a collection of trivia (along with a couple of quizzes) based on stock markets. It could also be a distinctive holiday present.

Update On Profits And Inflation

In the post-war period, there has been a strong secular relationship between inflation rates and the share of national income. In summary, corporate profits were at their lowest share when inflation was the strongest. As I noted in Low Inflation, High Profits, this relationship call into question the political neutrality of central banks' low inflation mandates. However, this is a topic of discussion that does not come up too often.

Equities Are A Burden On Future Generations

One corollary of the analysis in my recent article is that government bonds are not the only source of potential inflationary pressure that is inherited by future generations – corporate equities also have the same effect. In fact, they would appear to be an even greater “burden” than government bonds. Although we see “(government) debt clocks” ticking away, warning us about government debt, the risk posed by the equity market attracts no hand-wringing.

Links: HFT

There has been a fair amount of discussion of High Frequency Trading (HFT) as a result of Michael Lewis' new book. For example, see the discussion on Leo Kolivakis' blog on the HFT debate. I was never directly involved with HFT as part of my job, but I see the effects in the trading of my personal retail trading account. I think the views of "Kid Dynamite" (who used to work on Wall Street as an equities trader) is the closest to my position:  HFT may be causing problems for big existing institutions, but it's largely a non-issue for retail investors (but speculators may be unhappy). But the rise of HFT means that you should never use market orders, only limit orders.

The Equity Buyback Puzzle

In the United States, corporations now have the tendency to return profits to shareholders via stock buybacks. The explanation that is usually given is that this is for tax efficiency. However, in this article I show that this complicates the valuation of equities. Once the expectation is that money is returned via stock buybacks, there is no way of valuing the equity of the firm without referencing the market price at which it is bought back. If management destroys value with the buybacks, the fair value of the stock is lower. Additionally, it is necessary to incorporate the stock holder’s strategy into the valuation exercise – stockholders need to sell when management is buying back shares. This ambiguity of pricing reinforces Keynes’ argument that equity pricing is a form of beauty contest – but the judges that matter the most are in corporate management.

Stalking The Tenbagger: Peter Lynch Book Review

In this article, I am reviewing the concepts in the book "One Up On Wall Street" by Peter Lynch (one of the prominent equity mutual fund portfolio managers during the pre-2000 bull market).

The book is somewhat dated (the second edition was published in 2000; the end of that equity bull market), but I find it interesting as it presents a view of investing that is almost diametrically opposed to how I analyse markets. Peter Lynch advocates bottom-up, macro agnostic, growth investing. Meanwhile, I look at markets from a top down, macro-driven perspective.

Bubble Or Business As Usual?

I have seen a fair amount of commentary arguing that the Fed is fostering a bubble or “financial imbalances” (as cited by the dissent of Esther L. George in the FOMC statement) with its policy of Quantitative Easing, Although the price movements of risk assets (the stock market and corporate bond spreads) may appear crazy and bubble-like, they are only following a pattern of behaviour that has been in place for decades. The fixation on the size of the Fed’s balance sheet is just the latest excuse that strategists have latched onto to explain price action that probably was going to happen anyway.

As the chart above shows, the S&P 500 stock price index (which I use as a stand-in for other risk assets like corporate spreads) has two regimes of behaviour:

1. A relatively steady upward march, with a few intermittent dips that rapidly reverse (green arrows). Hence “buy the dips” remains popular advice in financial folklore.
2. Occasional crashes that do serious damage to equity returns; typically associated with financial crises (red arrows. Note that I have not added red arrows for some episodes, like the 1987 crash, in order to keep the chart clearer.) Bulls who "buy the dip" too early here get crushed, adding to investor panic.

We are currently in an upward march phase, and the bears are being steadily squeezed. Hence, the widespread complaints of there being a “bubble”. But that is exactly what has happened during every other bull market, so this is only news if you focus on short-term noise and ignore longer-term trends.

This stock market behaviour may seem strange, but it actually reflects the weak form of market efficiency (which says that it is difficult to beat the market; I do not think that the markets have other mystical properties that are associated with market efficiency).

During a bull market, bulls will outperform bears. Realised credit losses are low, partially because refinancing is readily available, even for the dodgiest borrowers (“a rolling loan gathers no loss”). Investors that apply leverage to their portfolios of risk assets will handily outperform their more conservative peers. This creates a natural selection effect, with the assets under management by the bulls growing much faster than assets managed by conservative investors (either due to the higher returns, “career risk” among the bears, or performance chasing by investors).

This process continues until there is a critical mass of over-extended bulls. Once this occurs, almost any disturbance will force liquidation of positions, but with most investors now on the same side of the trade, pandemonium results. In many crises, it has taken direct intervention by central banks to put a floor under asset prices.

The reason why I view this as being an example of weak-form “market efficiency” – despite the fact that this behaviour is arguably crazy – is that this pattern of pricing cannot be beaten by investors in aggregate. If investors attempted to beat this cycle by keeping prices less volatile through the cycle, the performance by renegade investors who applied leverage to their portfolios will look even better (higher returns, low volatility). This state of affairs will continue until the bulls have regained the majority control of assets, and then cause a crash when they get overextended. A small investor could conceivably be able to read the cycle and time the market to get excess returns, but investors in aggregate cannot.

This financial market behaviour overlays a very similar dynamic that occurs in the real economy. Firms that expand using leverage will gain market share during the expansion at the expense of their more conservatively managed peers. Thus the real economy also has a selection mechanic that favors the use of leverage by firms. The financial market behaviour reinforces this real economy trend, to the point that financial market instability is now a major driver of real economy instability.

I associate this mode of analysis most closely with the work of economist Hyman Minsky, although the original source was Keynes’ views on the business cycle. This article by Randall Wray discusses Misky’s thoughts on the evolution of finance from near the end of his life in the early 1990s. Minsky argued that the instability created by the Savings and Loan Crisis was not just the result of deregulation; the changes seen in finance were a reflection of forces that are internal to capitalism (what I refer to here as “natural selection”).

It is fairly easy to justify a rally in risk assets right now. Global holdings of financial assets are dominated by institutional investors and/or individuals who face considerable pressure to meet post-retirement cash flows. Government bonds offer yields that are far below the returns desired to meet those actuarial needs. Meanwhile, equities offer much higher long-term expected returns than government bonds under almost all the assumptions for future earnings growth used by investors. Corporate bond spreads may be low, but they are still positive, and realised defaults will probably be small as long as the cycle does not turn. Additionally, corporate profits are high and cash distributed to investors largely ends up being reinvested in risk assets. This creates the “melt-up” dynamic that we are seeing.

However, this explanation does not satisfy most strategists, as it does not explain why equities have had their bear markets since the mid-1990’s (since the same factors were in place then), nor are there indicators that measure how overextended investors are (the details only emerge in the crisis post-mortem). Thus they seize on whatever justification they can find to explain the rally; in the current cycle, it is allegedly the Fed driving the cycle. However, I argue that it has historically been the case that it has been investor positioning that kills the cycle, not the level of Fed Funds (or the size of the Fed’s balance sheet).

Given that I feel that this manic-depressive market behaviour is the result of forces inherent to capitalism, I do not see any easy way to moderate it.

• U.S. policymakers do not even have a good reading of the level of labour slack in the economy; it seems unlikely that they could hope to sensibly regulate the pricing of long-duration risk assets.
• Regulations could eliminate some of the worst excesses in High Frequency Trading, but regulations are not going to change the actuarial realities faced by institutional investors.
• Forcing underwriters to hold equity in securitisations they create will not restrain the behaviour of investment bankers that are bullish on asset prices. In other words, such regulations will just create a dynamic that the most gullible investment bankers will end up with the greatest market share.
• I do not see any major political party in the developed world endorsing the nationalisation of fixed asset investment, which was Keynes’ solution to the cyclicality induced by financial market speculation. In any event, such a move would probably just mean that recessions would be induced by government policy errors instead of being the result of private sector mistakes.

As noted in the article by Randall Wray, if the economy is financed by conservative bank loan officers, the effect of the financial cycle could be reduced. Since traditional banks cannot get loans of their balance sheets, loan officers have to take into account potential downturns when extending financing. Therefore, returning to a traditional banking system, as was the case in the 1950’s, does seem like a solution. But as Minsky argued, this traditional banking system was replaced by “shadow banks” as the result of competitive pressures. It does not seem obvious that this evolution can be easily reversed.
 
(c) Brian Romanchuk 2013

Low Inflation, High Profits

The current environment makes it difficult to worry too much about inflation. However, the relationship between wages, inflation and profits is an important driver of the current structure of the economy. (And as I note at the end of this article, the relationship between inflation and profits raises some doubts about equities as an inflation hedge.)

Binyamin Appelbaum raised an interesting point in this article about inflation and wages:

If the Fed drives up inflation, prices would rise first. Even if wages follow, the very people who most need help would feel the short-term pain most acutely. It would feel something like a temporary national sales tax.
 

Second, there’s no guarantee that incomes would keep pace with higher inflation.
 

To be clear, inflation by definition increases total income. Someone ends up holding the new money. The question is about distribution: Are workers able to secure the raises necessary to keep pace with inflation, or does the extra money simply pad profits?

(Also, Dean Baker wrote a response to the Appelbaum article here.)




The chart above shows the history of the net operating surplus (as a share of Gross Domestic Income) versus CPI inflation. (The net operating surplus is the complement of the wage share of national income; roughly speaking it is business revenue less wages. You need to subtract things like taxes to arrive at profits.) The surplus rises and falls with economic cycles (investment is a major driver of corporate profits), but this cyclical movement overlays multi-decade trends. What we see is that the trend in the net operating surplus share moved in the opposite manner of the trend in CPI inflation; inflation peaked in the early 1980’s, when the net operating surplus bottomed. (Note that the experience in many other developed countries was similar to that of the United States.)

The question is: were these inverse trend movements a coincidence, or have the developed economies only been able to achieve low inflation by suppressing wages and squeezing labour’s share of national income? The political implications of this question will cause discomfort amongst central bankers, who argue that disinflation should be neutral for the distribution of income. They would presumably argue that this was a coincidence. However, my guess is that this was not a coincidence, and this provides a roadmap for possible ways in which the structure economy will evolve.

The current situation is self-reinforcing. High corporate profits mean that income is being increasingly distributed towards those who have a low propensity to consume, helping create the undertow of weak demand that plagues the developed economies. The weak demand in turn keeps inflation and wage pressures at bay, locking the economy into structural sluggishness. It seems likely that it will take a powerful force to break this cycle.

However, to return to Binyamin Appelbaum’s question, the historical relationship would indicate that wages will outpace inflation if the future rate of inflation is high. However, a mild inflation (returning to 3%, say) may not be enough for labour to recapture a larger share of national income.

For further reading on this and similar subjects, I recommend the web site of Bill Mitchell, an Australian academic with an expertise in labour market economics.

An Aside On Equities As An Inflation Hedge

As a final note, the relationship above between inflation and profits casts some doubt over the view that equities provide an effective hedge against inflation. If the correlation holds, a significant rise in inflation would coincide with a falling profit share of GDP. The fact that the corporate piece of the pie is shrinking could swamp the effect of a growing pie, and so profits could be stagnant or even fall. Given the sensitivity of equity investors to earnings growth, falling profits plus higher discount rates could prove toxic for equity returns.

(c) Brian Romanchuk 2013

Equities Catch-22

The U.S. fiscal deadlock appears not to have been resolved at the time of writing. This is an interesting Catch-22 situation for equity markets.

I think the most likely outcome for the budget and debt ceiling talks is that the U.S. will continue to muddle through without any major concessions by President Obama, after a "short" shutdown of 1-2 weeks. This should mean that the shutdown should largely be a non-event for the economy from a very macro level; growth is slow, and should just get marginally slower. (I do not think the shutdown by itself will be enough to trigger the inventory correction which appears to be the likely cause of the next U.S. recession. That said, the news flow from outside the U.S. poses greater risks.)

However, to get there, strong pressure will have to be put on the Republicans to compromise. It may be that the equity markets need to start falling with enough vigour to catch the attention of the party's financial backers.  But if you take a longer view, there is no reason for the equity markets to fall, since the impasse will be a non-event economically.

For a longer-term investor, it seems the only sensible policy is to do nothing special, and hope that the other investors panic. With the average holding period for equities now measured in milliseconds, it may be that there will be enough news-driven volatility to provide the short-term panic so that equities will end up OK in the longer-term.

My guess is the bond market will be watching this from the sidelines. The level of bond yields we are looking at do not pose enough interest to the public to put pressure on lawmakers one way or another. (For example, let's say the 10-year Treasury Note sold off to 3.5% on fears over potential default. That would be a very impressive move from the point of view of a fixed income analyst, but the broad public would rightly say, "So what? 3.5% is a very low interest rate.")
 
Turning to other legislative failures, the situation in Italy could be very important, but it appears that a crisis should be averted for now.

(c) Brian Romanchuk 2013