The upshot of last month's webinar, for those of you that missed it, was that the Fed is turning the stock market into a house of cards, but you might as well make yourself comfortable in it. Recently, we've been having a number of conversations that suggest we need to elucidate that point a little further than can be accomplished in a 40-minute Zoom. So here we go:
What is investing?
Are you "investing in companies" when you buy into the stock market?
99% of the time you are not investing in a company. The only ways you can actually invest in a company are: public stock offerings (usually IPOs); public debt offerings; private equity or debt deals. Last year, there were a low-200's number of IPOs that raised around $62B total. Through the first half of 2020, there have been 64 IPOs that raised $22.3B. The total value of the US stock market is right around $30T with a "T". So in any given year, about 0.2% of the stock market is actual "I want to invest in your company" money.
You've seen a record $1.2T in new bond issuance (more on this in a bit) year-to-date in a $40T bond market. Private markets are up to about $6.5T total and have added $370B or so a year (including performance). So recently, in any given year, you could reasonably expect about $1.6T in real "give this company my money" investment. In a combined stock/bond/private marketplace in the US of $77T or so. That's 2%.
Okay, sorry, we were wrong: 98% of the time you are not investing in a company (though really, most of that 2% is limited to a very select few, so in our defense it is likely closer to 99%).
So what are you investing in? When you buy your shares of Apple or Tesla or Aurora Cannabis, you aren't giving your money to the company for them to do amazing world-changing things with. You're not giving your money to the company at all. That's why the stock market is a "secondary" market - you're giving it to the person you bought the shares from.
Instead of investing in companies, we want you to think about investing in assets that are expected to grow in value over time. In the case of the stock market, those assets are fractional ownership shares in a company. For some companies, the share assets you are buying are backed by something tangible like earnings or dividends. Let's call these "investment-worthy" companies (which, yes, is a confusing reuse of the word 'investment' but oh well).
For other companies, there aren't earnings or dividends; at best you have some hype around an intangible like "future growth" that may or may not materialize. The only justification for a future increase in value in these cases comes from an implicit expectation that someone else will be willing to pay a higher price down the road. Let's call these "speculative" companies.
The problem with speculation is that it is entirely psychological. If people are feeling good about risk, those stocks can rip. (See: Kodak, Hertz, Chesapeake, Tesla, Inovio, Nikola, Growth vs. Value, US vs International...the entire stock market since March, etc.). When something causes that psychology to change, it can turn on a dime with fairly disastrous results for those caught up in the initial euphoria, aka "bagholders". (See: Kodak, Hertz, Chesapeake, Tesla, Inovio, Nikola, etc.). And that is a problem because the madness of crowds is fickle at best and tends to defy any kind of explicative or predictive methodologies. It's not our preferred kind of market to invest in, but that's the direction this market is headed.
Why, you may ask?
The Federal Reserve, for the last 10+ years, has tacitly encouraged what we're calling "speculation" over "investment", both by keeping rates right around 0% and pumping $6T or so of liquidity into the market. We need to get a little academic for a minute, because that phrase "into the market" is somewhat controversial. There isn't a real clear transmission mechanism between QE and stock market, but we'll propose a three likely candidates that link the Fed's easy money policies to a rising stock market:
1) 0% interest rates encourage a higher amount of leverage (debt) in the system.
It's sound corporate policy to raise cash when you can, not when you have to. So if the Fed is going to drop interest rates to 0%, that means that you, as a company, can raise massive piles of cash by selling debt at relatively low interest rates. It just keeps getting cheaper and cheaper for companies to issue debt. And so they keep issuing it!
But here's where things go sideways. In a lot of cases, rather than being used for productive investments in capital expenditures (think: plants, equipment...things that support long-term growth), that debt is being used to fund stock buybacks. We detailed some of the more obvious offenders earlier this year when looking at the airlines and Boeing requesting government bailouts when they had spent (in some cases) more than 100% of their earnings on stock buybacks. Here's a fun chart - total debt minus total capital expenditures divided by total debt. Same time period as the charts above. Essentially, this is the percentage of debt that is not being used in capex spending and is free to go into the market via stock buybacks:
It's pushing 20% these days, or about $250B based on that $1.2T of debt issued YTD. Now, this is a rather simplistic view, as there is more than one input to available cash and more than one output to spending. But let's zoom out a little bit and see what happens. Same chart as above, excess debt over capex spending, since 1950:
Interesting. That data series was never ever ever positive until the first quarter of 2009. In other words, going back to WWII, companies had regularly spent more on capex than they raised in new debt. Starting Q1 2009, capex spending declined and/or debt increased resulting in excess cash that was available to go into the market via stock buybacks. First quarter 2009...huh, it's probably just a coincidence that March 2009 was when the Fed first started pumping money into the system via unsterilized QE purchases, right?
Note that while overall performance has been "better" (more accurately: "better over the time period analyzed"), it has also been way more volatile. That is, the highs have been higher and steeper, but so have the lows (late 2011, 2015-2016, early 2018, early 2019) been sharper and deeper. That's a pretty classic characteristic of speculation.
So. QE happens to coincide with the first time ever debt has exceeded capex spending which happens to coincide with a significant jump in stock buybacks which happens to coincide with more speculative-like stock performance.
2) The cash "hot potato".
There is a psychological component we'll call the "cash hot potato" that unfortunately doesn't have a whole lot of fun explicative graphs to look at. Through QE policies, the Fed buys Treasury bonds. That is, the Fed removes low-yielding Treasury bonds from the system and replaces them with zero-yielding cash. That zero-yielding cash then ends up flowing into risk assets, driving asset prices higher across the board.
Importantly, there is no such thing as "cash on the sidelines", as the amount of cash in the system stays there until retired by the Federal Reserve. If someone is "sitting on cash" and decides to "put it to work" in the stock market, then whoever they bought the stocks from now has the cash. The same amount of cash is in the system, the only thing that changed was who holds it.
Thus, in times of speculation, the zero-yielding cash becomes very uncomfortable to hold and gets "passed around" like a hot potato, driving up risk assets. The times when this isn't the case are when the prevailing psychology is "risk aversion" and all of a sudden there's a preference for holding cash, à la what we saw in March.
3) The Fed just buys stuff outright
As of March 23, there is now a quite literal direct transmission mechanism, as the Fed has started buying both investment grade and junk(!) bonds on the secondary market. As of August 10th, they have bought just over $12B in bonds on the secondary market - $7.6B of investment grade ETFs, $1.1B of junk bond ETFs, and about $3.5B in individual bonds.
It's probably coincidental that bond ETFs are at all-time highs. And that the first 8 months of this year have already seen more corporate debt issuance than in any other full year on record. (See point 1 above for where that debt issuance ultimately ends up).
As an aside, let us just point out that it might be a bit of a questionable policy decision in the current climate to backstop the bonds of and give money to your largest companies while your small business are going bankrupt because nobody will lend to them. Also, there's a decent chance that those secondary purchases are actually illegal based on the law that prohibits the Fed from engaging in fiscal policy, but we'll save that for now.
So. That's the "how" of QE ending up in the markets, but the "so what" is the more important question.
One way stocks are commonly valued is the PE ratio - price divided by earnings. We wrote about this previously, so we won't recreate it here. It leads to lots of charts in this vein, making the case that stocks are "expensive" or "overvalued":
The idea is that P = E*r , where r is some multiple that has a tendency to mean-revert over time.
Thought experiment: we just outlined three transmission mechanisms that enable newly-created cash from the Fed to flow into the stock market. Assume constant earnings (E). If you have more money chasing the same amount of earnings, what do you call that? Inflation. And what does that mean for price? It goes up. And if P goes up while E remains constant, what happens to r? It also goes up. So we don't see anything at all unusual about higher-than-average PE ratios given all the excess liquidity sloshing around.
Really, we would suggest the need for a liquidity component to the above equation, something like P = E*L*r .
This is more useful for comparison purposes rather than absolute valuations. From a comparison standpoint, let's say earnings get back to pre-COVID levels by 2022. So E constant. Let's also hold r constant. L (as proxied by Fed balance sheet) has gone up roughly 50% since the start of the year, and let's say it stays at this level for the next two years. Put that all together (L up 50%, E and r constant) and you get P up by 50%...or a 2022 price target of close to 5,000 on the S&P 500. Yowza.
On the flip side, Q2 earnings are expected to be down ~35%. So for constant r, if E drops 35% but L goes up 50% (current scenario), then price should be...down just 2.5%. We've overshot that here, but not by much. We'd be inclined to say, then, that markets are pretty fairly valued at the moment.
If you buy the premise that QE is market-supportive through various plausible transmission mechanisms, then historical PEs aren't particularly informative, as they neglect the entire thrust of the last decade of "extraordinary" (to quote then-Chairman Bernanke) monetary policy measures. On a relative basis, the market looks fairly valued right now...and would look fairly valued up 50% in two years as well.
However, acceptance of this fair valuation measure necessitates an acceptance as well of the increasingly speculative nature of the market as a whole, meaning it is increasingly going to be whipped around by changes in investor psychology and the "madness of crowds". So go ahead and get cozy in the house of cards...but maybe get yourself a storm shelter, just in case.
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