The 5.5 Market

The capital markets are riven with acronyms.

One of the first you learn in IR (acronym for investor relations) is “GARP.” Growth at a Reasonable Price.  As 2018 begins, GARP is a great way to describe the stock market, just as it was in 2017. Will it continue?

Let’s set ground rules. What “reasonable” means varies with circumstances but the idea is you’re paying a fair price for appreciation, what investors want and companies hope to deliver.

If arguments were colors, you could hear every hue of the rainbow on whether stocks are overpriced or not. Here at ModernIR, we’re statisticians studying how money behaves. We measure what it’s doing rather than whether it should be doing what it’s doing.

What I’ve learned from observing data is that there is an elegant and uniform explanation for why we have a GARP market. I’ll come to it in a moment.

But to ModernIR GARP is a number: 5.5/10.0 on the ModernIR Behavioral Sentiment Index.  Take the FAANGGs – Facebook, Amazon, Apple, Netflix, the two Alphabets. For 2017, the ModernIR BSI is 5.44 for them. The Russell 1000 is 5.48.  The BSI comprised of our client base with more energy and telecom is 5.39 for 2017.

As 2018 begins, it’s 5.6. All these numbers are within two-tenths of a point. It’s a GARP market.

It means it’s a little better than neutral, which is GARP investment.  For instance, if an economy’s population grew, and the ratio of people employed remained constant, and purchasing power outpaced inflation, you’d have a GARP economy.  Buying and holding it would mean appreciation.

Don’t think too long about that one. You’ll become disturbed by incongruity – but that’s a separate story. We’re after an elegant and uniform explanation to why our market runs according to GARP.

CNBC’s Jim Cramer believes it’s this: “There aren’t enough shares!!!”

It’s a point we’ve made too.  Both the number of companies in the US stock market and the total number of outstanding shares has been in steady decline while the amount of money chasing the shrinking product pool continues to rise.

Is inflation the elegant explanation? More money chasing fewer goods? Discounting fundamentals entirely seems incorrect.

But money chases the goods, and what form is money taking? A passive form. Statistically, 100% of the net inflows to stocks the past decade have gone to index and exchange-traded funds. Over that time, stock pickers have lost trillions.

Therefore, the money chasing the goods is pegging a benchmark, not picking outperformers. And by far the big winner is ETFs. What can ETFs do that no other investment vehicle can? They can substitute shares representing stocks, so they don’t have to buy or sell them like other investors do.

More ETF shares are created to accommodate inflows, and then destroyed during outflows, so ETFs bob on the surface of the market, which otherwise fluctuates with supply and demand.

And since all the new money is using ETFs, the entire market has become the bobber.  ETFs create the capacity for ever more money to have access to the same underlying goods. And that is why the market is up, all other things being equal.

It struck me over the holidays that the structure of ETFs, which depends on arbitrage – profiting on price-differences – would inevitably produce a declining market IF the number of shares or public companies or both were expanding. Arbitrage would consume appreciation, leading to an investor exodus from ETFs.

Thus, the elegant explanation for our GARP market is that ETFs arbitrage stocks back to the mean, which is 5.0, and rising flows of capital and shrinking numbers of public companies combine to breed a 5.5 market. GARP.

Why? Because there are ever more ETF shares to accommodate flows to ETFs. For stocks it means multiple-expansion, since ETFs, unlike IPOs, do not create shares of more value-creating enterprises. They only give more money access to the same stocks.

What stops it? The same thing that haunts the global currency system. If at any point, global currencies stop expanding, the prices of all assets could plummet. Why? Because expanding currency supplies drive up prices and create credit, so people keep borrowing more money to buy things. If that process freezes up, prices will implode. Witness 2008.

For ETFs, the danger is as simple as a market in which inflows stop.  What would cause that?  I don’t know right now!  But for the moment it’s not something to fear. We’re in a GARP world.