Can It Last?

It’s the number one question.  Tack “how long” on the front.

I’m asked all the time: “Tim, do you think the stock market is sustainable? Are fundamentals driving it or is this a bubble? Stock buybacks?  The Fed is behind it, right? Isn’t bitcoin proof of irrational exuberance?”

And everybody with an opinion is asked, and answers. I’ve offered mine (read The 5.5 Market from last week) and I’ll add today what we’ve further learned about the behavior of money.

Speaking of money, Karen and I joke that we miss the recession. Hotels were a bargain.  They gave you free tickets to shows if you just came to Las Vegas. Vacations were affordable (I’m not making light of great stock returns but if we give it all back, how is that helpful?).

Now suppose at the same time interest rates would rise. People and companies with too much debt would suffer, sure. But society would save money and take on less debt. That’s what higher interest rates encourage. From Hammurabi in Babylon until fairly recently we understood this to be the formula for prosperity.

“Quast, do you know nothing about contemporary behavioral economics? What kind of idiot would think it’s better to save money and avoid debt?  Economists agree that debt and spending drive the global consumption economy.”

Ask your financial advisor if you should borrow money and spend more, or save money and invest it.  So how come the Federal Reserve encourages borrowing and spending?

Recessions have purpose – and they’re packed with opportunity!  Seriously. They reset the economic calculus.

I’ll give you an example from the Wall Street Journal yesterday, which reported that here in Denver we have 16,000 vacant metro apartments, most in the luxury category. And 22,000 more are being built. Since they’re unaffordable, the city has launched a program to subsidize rents.

This is the kind of warped outcome one gets from promoting debt and spending, and it’s influencing our stock market too. I’m not the least worried because I know boundless opportunity awaits when prices reset, and that’s the right way to see it.  Warren Buffett said it’s unwise to pay more for a thing than it’s worth.  All right, I look forward to attractive prices ahead.

And prices are products of the behavior of money.  Last week we described how the market could not correctly be credited with rational valuation because stock-picking was not the principal behavior. Over the past ten years, all the NET new inflows into US equities have gone to index and exchange-traded funds. They follow a benchmark. They don’t pick stocks.

They also rarely sell them. If things are bought and not sold, prices rise.  There is a paucity of stocks for sale. In its 2016 prospectus for the S&P 500 ETF SPY, State Street said its turnover – proportion of holdings bought and sold – was 4%.  The fund that year, the latest available, had $197 billion in net asset value. Four percent is about $8 billion.

Yet SPY traded $25 billion daily in 2016 (still does!), about three times the entire annual fund turnover. Explanation? Right there on page 2 of the prospectus: The Trust’s portfolio turnover rate does not include securities received or delivered from processing creations or redemptions of Units.

On page 30 we learn this:  For the year ended September 30, 2016, the Trust had in-kind contributions, in-kind redemptions, purchases and sales of investment securities of $177,227,631,568, $167,729,988,725, $7,783,624,798, and $6,444,954,759, respectively.

Translating to English, it means brokers called Authorized Participants created $177 billion worth of new ETF shares by exchanging assemblages of stocks for them that were not counted as sales by SPY. It counted sales of only about $8 billion – as I said above.

The functional turnover rate for SPY is closer to 100%. If it really was, the market would be volatile. Prices would fall as shares hit the market. SPY drives 10% of the entire stock market’s dollar volume.

But what trades is ETF shares. The creation and redemption process occurs away from the market in some secretive block-transaction fashion that means the natural buying or selling that would otherwise be done is not happening.

Selling lowers prices. The absence of selling, the replacement of selling with trading in ETF shares predicated primarily on price-differences – arbitrage – produces a market that relentlessly rises with very little volatility.

And which notably means investors don’t actually own anything when they buy ETF shares. If they did, that $177 billion SPY exchanged for ETF shares would carry a taxable ownership interest, and transaction costs. It doesn’t.

Think about that.

When the recession comes because of this bizarre displacement of actual buying and selling by derivatives, I look greatly forward to all the bargains, the affordable vacation homes in desirable places, the cheap stocks, and the free show tickets in Las Vegas.

I just can’t tell you when. The wise are always prepared.