Why is the Stock Market Up Amid a Shrinking Economy?
Whole sectors of the global economy remain shuttered, commerce is hostage to infection outbreaks, businesses face unprecedented solvency problems, while unemployment is set to explode. Global supply chains remain fractured. Consumption could plummet. Government deficits are expanding at a record pace to finance bailouts, support, furloughs and rescues. The outlook has never looked so dire, yet stock markets have risen to record levels, apparently ignoring the single most sudden, profound and destabilising shock in economic history.
It seems an absolute denial of common sense – how can markets thrive in a time of economic mayhem? Conventional wisdom – as I recently read in a US Investment Bank’s equity strategy note – tries to explain the gains in terms of: “Markets anticipate better days ahead. Although the timing is uncertain, the stock market is expressing confidence the pandemic will end with a vaccine and better treatments in the interim.”
Really? Markets are supposed to be rational. A vaccine tomorrow will not undo the damage already done and at best could only accelerate a recovery back to where we were. Corporate earnings may take years to recover. Betting big on the hope of a vaccine sounds like an irrational toss of the dice. And…hope is never a good investment strategy.
To understand why markets are so strong you need to follow the implications and consequences of government, and particularly, Central Bank action. Markets follow the money – and that requires you forget everything you thought you knew about stocks, bonds, prices and future valuations. Concepts such as the ability of a firm to generate future growth, or earnings before tax and interest, or even its likely ability to repay its borrowings, are no longer relevant in today’s markets. Put away that copy of Benjamin Graham’s ‘The Intelligent Investor’, it will not be needed these next 30 years, and dispense with notions like fundamentals or value.
Today there are new themes to consider.
Markets are no longer setting prices. The “invisible hand” of markets efficiently allocates capital based on demand and supply representing the summation of what every market participant believes. It ensured companies were disciplined to perform strongly. Failing companies were punished by stock price falls and wider bond spreads.
But that price-setting function has been replaced by an implicit understanding that Central Banks will do “whatever it takes” to avoid a market meltdown. It no longer matters what investors really think about the economy – if they are certain Central Banks will bail them out, then that dictates their investment behaviour.
What matters most in today’s hyperbolic market are the consequences of Zero Interest Rate Policy (“ZIRP”) and QE Infinity. ZIRP absolutely distorts the assessment of risks vs returns. QE is the process by which Central banks have flooded markets with liquidity since the Pandemic erupted to stave off an immediate recession, corporate insolvencies, and a catastrophic market crash. They have succeeded but at an enormous cost.
It’s been the limitless Central Bank liquidity and the promise they will do, even more, that has caused Financial Assets (Bonds and Equity) to soar. The investors who understand the process are simply following the money – arbitraging the implied Central Bank “put”. They know the economic damage that’s been done, how corporates are closer to bankruptcy than ever, and that global demand and supply remains absolutely stressed. They aren’t investing on the basis of recovery – they are simply investing on the basis that Central Banks have no option but to continue bailing them out.
Markets follow the money – and that requires you forget everything you thought you knew about stocks, bonds, prices and future valuations.
It’s been a wild and improbable ride. At times it felt like markets were out of control. Although there are stories like a hybrid truck-maker being worth more than Ford despite not having delivered a single vehicle, this rally started with less of the “Irrational Exuberance” that has characterised other historical stock market price bubbles. What we have this time is a bubble and price distortion deliberately created by Central Banks.
The smart money knows the Central Bankers have little choice but to sustain it. Not everyone is smart money. Most investors are followers and are all too easily persuaded of the merits of a snake oil that promises enormous returns. Who wants to listen to sage market professionals warning of the dangers of Central Bankers setting market prices when stocks are going ever higher?
Most investors aren’t particularly aware of the Central Banking shenanigans going on under the surface – what they see is a market going up and up. FOMO (the fear of missing out) is one of the most powerful forces in finance. That’s particularly relevant in terms of the funds management industry – where complacent investment managers are far more concerned about career-risk rather than market-risk. Missing a rally like the one we’ve seen since March would be a career-limiting mistake. Career risk explains why most investment managers do a little more than benchmark themselves to indices.
The rally has developed a momentum all of its own – sucking in buyers who fail to see the dangers implicit in herd mentality and the triumph (in many cases) of hope over common sense. The rise of “Robin Hood” retail day-traders unburdened by conventional market wisdom says it all – they genuinely believe the most dangerous four words in the market lexicon: “this time it’s different”.
The rally has developed a momentum all of its own – sucking in buyers who fail to see the dangers implicit in herd mentality and the triumph (in many cases) of hope over common sense.
Long-term… It’s never different.
In the short-term, QE Infinity is working. Cash-strapped corporates have been able to borrow the money they need to see them through lockdown at ultralow interest rates. Widespread insolvency and default has been avoided. Investment banks are all advising their clients to buy corporate debt and finding reasons to promote stocks. That’s their business model – to sell financial assets.
But there will be consequences.
As prices head stratospheric, it’s caused returns to plummet. The result is Financial Asset Stagnation – bonds and stocks cost more but are worth less. That’s triggered a desperate search for meaningful returns in an increasingly repressed market where yields are trending towards zero. Pension funds are dipping into their capital to meet their liabilities. The only way to improve returns is to take more risk – hence normally staid bond investors find themselves sucked into equity markets as “yield tourists” in order to squeeze some returns from their portfolios.
This is going to prove a massive long-term problem. Ultra-low interest rates and unlimited liquidity are boosting markets but make long-term investment planning impossible. The value of a typical pension fund has increased, but the size of pension it can fund has dramatically lessened.
It’s hard to see how Central Banks can now exit their role of handing out free cash to markets. More and more companies are now dependent on cheap debt. Sovereign nations are running up borrowing to pay for it all. At some point, can the money that’s bailing out markets run out? Not necessarily – interest rates are effectively zero, and the money creation by Central Banks costs nothing. (Unless it causes a crisis of confidence in the underlying currency, which cause devaluation and inflation – but if every country is doing the same thing… why would that matter.)
The devil is in the detail. The market is no longer disciplining bad companies or forcing them to invest, plan and develop sensibly. Terminally stupid and financial challenged companies, like Boeing, have been able to borrow billions at record low-interest rates despite manifest corporate failings. If the market doesn’t discipline companies – who does? Hence the rise of the dangerous ESG (Environment, Social and Governance) approach to investment – only buy companies that pass unquantified tests on what is good and bad. It’s a form of financial woke – and makes even less sense. A company that is well managed and led (Governance) will always do better.
And what do companies do with all that money they’ve borrowed? Up until the coronavirus, a significant amount of debt was raised to finance stock buybacks – doing nothing in terms of financing value-added productive assets, but simply pushing up the firm’s stock price and inflating executive bonuses! The first half of 2020 has seen record volumes of new corporate debt issued on the markets, mainly to finance the costs of the virus shutdown. None of the debt is creating new jobs or new factories – it’s increased leverage simply to stay still.
There is no doubt Central Bank action has created an enormous financial asset price bubble. The question is – will it pop? Can Central Banks risk it? It is probably worth reminding readers of my number one market mantra: “The market has but one objective: to inflict the maximum amount of pain on the maximum number of participants”.