Tagged: Dollar

Yet Arrived

Bula!

That’s Fijian for “greetings!” You say it “boo-lah.” Fiji is among the friendliest places on the planet. Karen and I are just back from the South Pacific, as this compilation illustrates.  Do you know it’s traditional in Fiji to invite anyone passing by to breakfast?

Maybe that’s the answer to the world’s woes.

And maybe we should have stayed out to sea!  Our first day back the market tumbled.

We left you July 18 with our concern that the market had become a runaway train. In a private client note Jul 19 as options expired we said, “Right now, the data say the market will next tick up. If it’s a weak top – check page 3 of your Market Structure Reports – we could have trouble. At this moment, I don’t think that’s set to occur. Yet.

Well, “yet” arrived.

Is it possible to know when yet is coming?

Yes. At least the way one knows a storm front is forming. It’s not mystical knowledge. It’s math. Weather forecasters track patterns because, as it turns out, weather is mathematical.  It follows rules that can be modeled.

We put a man on the moon 50 years ago because escaping gravity and traveling four days at predictable velocity will get you there. It’s math – which smart people computed on devices less powerful than your smart phone.

Even human behavior, which isn’t mathematical, can often be predicted (somebody needs to develop a model for mass-shooting nutcases). For instance, in the stock market rational people predictably buy weakness and sell strength.

What kind of money sells weakness and buys strength? We’ll come to that.

Conventional wisdom says stocks imploded because a) people wanted the Federal Reserve to cut rates Jul 31 more than it did, b) President Trump tweeted about Chinese tariffs, c) and the Chinese retaliated by letting the yuan slide.

Relative currency values matter. We’ve written often about it. The pandemonium routing equities Aug 24, 2015 followed a yuan devaluation too. Stocks inversely correlate with the dollar because currencies have no inherent value today.

So if the supply of dollars rises, the value of the dollar falls, and the prices of assets denominated in dollars that serve as stores of value, such as stocks, rise. Value investor Ron Baron said he puts depreciating assets, dollars, into appreciating assets, stocks.

With dollars increasing, the relative value of other currencies like the euro and the yen rises, so prices of goods denominated in them fall – which governments and central banks interpret as “a recession,” leading to interest-rate cuts, negative bond yields, banks buying stuff to create money, and other weirdness.

Makes you wonder if these central planners actually understand economics.

I digress. That’s not the root reason why stocks rolled over. Headlines, Fed actions and currencies don’t buy or sell stocks. People and machines do.

The majority of the money in the market pegs a benchmark now – machine-like behavior. Market Structure Sentiment, our index for short-term market-direction, has been above 5.0 for an extended period without mean-reversion.

That matters because money tracking a measure must rebalance – mean-revert. If it goes an unusual stretch without doing so, risk of a sudden mean-reversion rises.

We saw the same condition before stock-corrections in Jan 2016, June 2016 around Brexit, ahead of the US election in late Oct 2016, in Jan 2018, and in Sep 2018. Each featured an extended positive Sentiment run with a weak top, as now.

The week ended Aug 2 also had another mathematical doozy: Exchange Traded Fund flows as measured not by purchases or sales of ETFs but market-making by brokers plunged 20%.  In some mega capitalization stocks it was the largest decline in ETF flows since early Dec 2018.

Passive money buys strength, until it stops. When it stops, weakness often follows. And if it has not rebalanced, it sells weakness because weakness means deteriorating returns.

The last day of trading every month is the most important one for money tracking benchmarks. That was July 31. Stocks deteriorated in the afternoon. Pundits blamed Jay Powell’s comments. What if it was long overdue rebalancing on the last trading day?

That selling coupled with a big overall decline in ETF flows converged with a currency depreciation Monday, and whoosh! What yet we feared arrived.

And yet. It’s not fundamental. Why does that matter? Monetary policy, portfolio positioning, and economic predictions may be predicated on a false premise that rational people had unmet expectations.

I think that’s a big deal.

So. Since yet has arrived, is yet over?  Data say no. It’s a model with predictiveness that may be a step ahead or behind. But a swoon like this should produce a mean-reversion. That’s not – yet – happened.

With that, I say Bula! And if you’re in the neighborhood, drop by for breakfast on us.

Bucking the Mighty

Federal Reserve Chairman Jerome Powell, keeper of the buck, speaks today. Should we care, investors and investor-relations folks?

There’s been less worshipfulness in the Powell Fed era than during the Yellen and Bernanke regimes. Out of sight, out of mind.  We tend in the absence of devotion to monetarists to forget that the mighty buck is the world’s only reserve currency.

Yet the buck remains the most predictive – besides ModernIR Market Structure Sentiment™ – signal for market-direction. So we have to know what it’s signaling.

When we say the dollar is the reserve currency, we mean it’s proportionate underpinning for other currencies. Effectively, collateral. The European Central Bank owns bucks and will sell them to weaken the dollar and strengthen the euro, and vice versa.

The USA alone holds no foreign currency reserves as ballast to balance out the buck. Instead, if the Fed wants to hike rates, dollars have to become a little rarer, harder to find.

The Federal Reserve as we noted when oil dove has been selling securities off its balance sheet.  It receives Federal Reserve Notes, bucks, in return, and that money comes out of circulation, and dollars nudge higher (forcing other central banks to sell dollars).

Combine what the Fed has sold and what banks are no longer leaving idle at the Fed as excess reserves (at the height $2.6 trillion but now below $1.8 trillion) and the supply of bucks has shrunk $1 trillion, and since banks can loan out about nine dollars for every one held in reserve, that’s a big decline out there – effectively, trillions.

So the dollar rises, and markets falter, and oil plunges.  We wrote about this back in January and said to watch for a rising dollar (even as others were predicting $100 oil).

Now why do stocks and oil react to relative dollar-value?  Because they are substitutes for each other.  As famous value investor Ron Baron says, investors trade depreciating assets called dollars for appreciating ones called stocks.

If the dollar becomes stronger, you trade fewer of them for stocks. Or oil. That means lower prices for both. Conversely, when interest rates are as low as a doormat, credit creates surging quantities of dollars, and the prices of substitutes like stocks and oil rise.

It raises a point I hope future economics textbooks will recognize: The definition of inflation should be “low interest rates,” not higher prices. Low rates surge the supply of dollars via credit, so even if prices don’t rise everywhere, inflation exists, which we find out when rates rise and prices of things used as substitutes for dollars fall.

Those people saying “see, there’s no inflation” do not understand inflation. By the way, Exchange Traded Funds have exactly the same condition, and risk. They are substitutes for stocks that expand and contract to equalize supply and demand.

Presuming Chairman Powell wants interest rates higher so we can lower them furiously – and wrongly – in the next crisis, we can expect more deflation for things that substitute for dollars.

It won’t be linear.  ModernIR Market Structure Sentiment™ signals a short-term bottom is near. There may be a rush to the upside for a bit. Credit will go to “strong sales expectations for the holiday season” when it’s likely market-makers for ETFs trading depreciated stocks for the right to create ETF shares.  Like the buck, the stocks come out of circulation – causing stocks to rise – which in turn boosts ETF shares tracking those prices.

The problem as with currencies is that we can’t get a good view of supply or demand when the medium of exchange – money, ETF shares – keeps expanding and contracting to balance out supply and demand.

The market loses its capacity to serve as an economic or valuation barometer, just as money loses its capacity to store value.

I’ve said before to picture a teeter-totter. One side is supply, the other, demand. When currencies have fixed value, we know which thing is out of balance. When the fulcrum moves, we have no idea.

That distortion exists in stocks via ETFs and economies via the mighty buck, which both must buck mightily to equalize supply and demand. Who thought it was a good idea to equalize supply and demand?  I hope Jerome Powell bucks the mighty.

When Oil Swoons

How is it that stocks and oil fall if no one is selling them? There’s an answer. Tim Tebow once famously sent a one-word tweet: “Motivation.”

For Tebow (Karen and I were downtown years ago when Tim was a Denver Broncos quarterback, and we passed a handsome youngster who offered a friendly hello and seemed familiar and had shoulders so wide they covered most of the sidewalk…and we realized seconds later we’d passed Tim Tebow.), the word meant a reason to try.

Motivation in markets is money.

Whatever your ticker, investor-relations professionals (or investors, whatever the composition of your portfolios), your price is often set by trading firms.

How do we know? Floor rules at the exchange prohibit using customer orders to price NYSE-listed stocks at the open. Designated Market Makers (DMMs) must trade their own capital to set a bid and offer for your shares. Now all DMMs are proprietary traders.

Investors:  If you don’t know how stock prices are set, you deserve to be outperformed by Exchange Traded Funds (ETFs). ETFs don’t even buy and sell stocks!  They are collateralized stock derivatives (let’s call them CSDs).

Don’t know what I mean? Stop, and listen:

If you’re in Dallas Fri Nov 16, hear my presentation on ETFs at The Clubs at Prestonwood.  Clients in Dallas: Ask your CFO and Treasurer and VP of Finance and Controller to learn what the money is doing behind price and volume, and why.

What if you’re Nasdaq-listed?  The first and fastest machines set all offers to sell (the primary price) and bids to buy (the secondary price) when stocks open for trading, and chances are traders (not IEX, the only exception) have been paid to set bids and offers.

It’s not your fundamentals. Machines set prices all day long.

And the price of oil most days is not determined by fundamentals either. It’s set by a currency. The US dollar.  Oil is denominated in dollars. Big dollar, smaller oil price. Small dollar – say 2007, or much of 2017 – big oil price.

Back to stocks. Under Regulation National Market System, there is a spread between the best bid to buy and offer to sell for your shares.  They can’t be the same ($15.01 buy, $15.01 to sell). That’s a locked market. Against the law.

The Bid cannot be higher than the Offer (e.g. Bid, $15.02, Offer $15.01). That’s a crossed market. Can’t happen. Why? So there’s an audit trail, a way to trace which firms set every bid, every offer, in the market. And a crossed market cannot be controlled by limit-up/limit-down girders that govern stocks now. (You can bid more than what’s asked for art, houses, cars, companies, etc. But not stocks.)

If demand from money wanting to buy shares exactly matched supply, stocks would decline. Brokers, required by rule to set every bid and offer, have to be paid.

That means stocks can rise only if demand exceeds supply, a condition we measure every day for you, and the market. Do you think your board and executive team might like to know?  (Note: If you want to know if supply exceeds demand in your stock, or your sector, ask us. We’ll give you a look gratis.)

Knowing if or when supply exceeds demand is not determined by whether your stock goes up or down. Were it so, 100% of trades would be front-run by Fast Traders. So how can it be that no money leaves stocks and they fall, and no money sells oil and it falls?

Do you own a house? Suppose you put it up as collateral for a loan to start a business you believed would be more valuable than your house. This is the bet ETF traders make daily. Put up collateral, create ETF shares, bet that ETF shares can be sold for more ($12.1 million) than the cost of the collateral offered for the right to create them ($12.0 million).

Then suppose you can sit between buyers and sellers and make 10 basis points on every trade in the ETF, the index futures the ETF tracks, and the stocks comprising the index.  Another $120,000 (a 20% margin over collateral). Do that every day and it’s meaningful even to Goldman Sachs for whom this business is now 90% of equity trading.

Reverse it. When stock-supply exceeds demand, ETF creators and market-makers lose money. So they sell and short, and the whole market convulses.  Spreads jump. Nobody can make heads or tails of it – until you consider the motivation. Price-spreads.

Oil? Remember our time-tested theme (you veteran readers). If the dollar rises, oil falls. It happened in Sep 2014 when the Federal Reserve stopped expanding its balance sheet.

Now it’s worse. The Fed is shrinking its balance sheet. Oil is denominated in dollars no matter what Saudi Arabia does. If the dollar gets bigger – stronger – oil prices shrink. Look at the chart here for the Energy sector. ETFs? Devalued collateral?

ETFs, the greatest investment phenomenon of the modern era, behave like currencies. We’ve not yet had a BIG imbalance. It’s coming. We’ll see it.  Subscribe. It’s motivating.

August Currents

“Treasury yields rise as Turkey worries fade,” declaimed a headline at Dow Jones Marketwatch yesterday.

This one day after the New York Times bleated, “Plunge in Lira, Turkey’s Currency, Fuels Fears of Financial Contagion.”

Why are stocks, ostensibly propelled by fundamentals (earnings and revenue growth this reporting cycle were strong), instead wracked by the machinations of a minor monetary unit for an economy that ranks 19th, behind the Netherlands and Indonesia and just ahead of Saudi Arabia?

They’re not.  It’s the dollar. Every investor and investor-relations professional should understand currency valuation, just as we all must grasp how the market works and what the money is doing (we wrote about that last week).

(To Turkey, for a prescient economic perspective, read this piece by Jim Rickards – whose gold views fuel skepticism but who always writes thoughtfully.)

The dollar is the world’s reserve currency. Simplistically, instead of holding gold, countries own dollars, and sell or buy them to adjust the value of their own currencies.

The USA by contrast only mints the buck and the Federal Reserve uses interest rates to regulate its value. In effect, higher interest rates mean a stronger dollar, lower interest rates a weaker buck, all other things being equal. (In fact, some economics ingenue somewhere should write a thesis establishing that the definition of inflation is low rates.)

Anyway, stocks are risk assets that reflect fluctuations in currencies every bit as much as they are supposed to offer a barometer of economic activity.

Take Turkish stocks.  The lira has been falling in value for years while Istanbul’s stocks shined, especially last year. Yet the economy has slipped a couple notches in global rankings.

The US economy is booming, and yet markets have stalled in 2018. The dollar is at a 52-wk high, spiking lately. In 2017, the dollar devalued 12% and stocks soared. There’s consistent inverse correlation between broad US equity measures and the dollar’s value.

We’ve described Teeter Totter Monetary Theory before. The nexus of the Teeter of supply meeting the Totter of demand should determine prices.

But under the modern floating-rate currency construct, central bankers move the fulcrum, which is money, to balance out the teeter totter. To encourage investment (supply) increase the value of the dollar (also lifting productivity, something few in orthodox economics recognize). To fuel consumption, depress interest rates so people borrow more and save less.

The problem is these policies over time erode the veracity of stock prices – and the value of everything from debt to art to homes to money.

Yes, many economists will disagree. But the evidence is stark, as is the math. Goods are the numerator, dollars, the denominator. If the dollar depreciates, things like stocks and beer cost more. Increase its value – more purchasing power – and prices fall.

August has had a recent history of currency volatility.  August 2010 and August 2011 were rocked by the euro, which nearly failed. August 2015 brought a sudden Chinese currency devaluation and on the 24th a thousand Exchange Traded Funds were volatility halted. Stocks didn’t recover until October.

As August 2018 fades like summer grass, there are currents.  The dollar is strong and market-structure Sentiment is sluggish, positive now but without a vital mean-reversion. Options expire the 16th-17th and 22nd, a split cycle for derivatives. (NOTE: Speaking of August, don’t miss NIRI SWRC next week — I’ll be there.)

If stocks top into expirations with a rising dollar, we could have a hard mean-reversion to finish the summer. It’s no prediction, just a higher probability. And it’s not fundamental – yet another reminder that the stock market cannot be seen merely as an economic gauge.

 

The GRAR

Power changed hands in the USA today.

I don’t know in what way yet because I’m writing before election outcomes are known, and about something for the market that will be bigger than which person sits in the oval office or what party holds congressional sway.

The GRAR is a lousy acronym, I admit. If somebody has got a better name, holler.  We started talking about it in latter 2014.  It’s the Great Risk Asset Revaluation. We had the Great Recession. Then followed the Great Intervention. What awaits the new Congress and President is the GRAR.

I’ll give you three signs of the GRAR’s presence.  Number one, the current quarter is the first since March 2015 for a rise in earnings among the S&P 500, and the first for higher revenues since October 2014. Until now, companies have been generating lower revenues and earning less money as stocks treaded water, and the uptick still leaves us well short of previous levels.

Since 1948, these recessions in corporate financials of two or more quarters have always accompanied actual recessions and stock-retreats. The GRAR has delayed both.

Second, gains off lows this year for the Dow Jones Industrial Average have come on five stocks primarily. One could use various similar examples to make this point, but it’s advances dependent on a concentrated set of stocks.  This five – which isn’t important but you can find them – include four with falling revenues and earnings. Counterintuitive.

Finally, the market is not statistically higher (adding or subtracting marketwide intraday volatility for all prices of nearly 2% daily) than it was in December 2014.

That’s remarkable data.  It says prices are not set by fundamentals but intervention.

We might think that if earnings growth resumes, markets will likewise step off this 2014 treadmill and march upward. And that’s independent of whatever may be occurring today – soaring stocks or falling ones, reflecting electoral expectations versus outcomes.

In that regard, our data showed money before the election positioned much as it was ahead of the Brexit vote:  Active buying, market sentiment bottomed, short volume down – bullish signals.

You’ve heard the term “delayed gratification?” It means exercising self-discipline until you’re able to afford desired indulgences.  Its doppelganger is delayed consequences, which is the mistaken idea that because nothing bad arises from bad decisions that one has escaped them.

The bad decision is the middle one – The Great Intervention.  The Great Recession was a consequence arising from a failure to live within our means. When we all – governments, companies, individuals – spend less than we make, nobody ever needs a bailout.

But you don’t solve a profligacy problem by providing more access to credit.  The breathtaking expansion of global central-bank balance sheets coupled with interest rates near zero is credit-expansion. To save us from our overspending, let’s spend more.

If I held in my palms a gold coin and a paper dollar and I said to you, “Pick one,” which would you take?

If you said “the dollar bill,” I can’t help you and neither can Copernicus, who first described this phenomenon that explains the GRAR 500 years ago. Nearly everybody takes the gold, right? We inherently know it’s more valuable than the paper, even if I tell you they have the exact same value.  This principle is called Gresham’s Law today.

Credit does not have the same value as cash.  But assets in the world today have been driven to heights by credit, the expansion of which diminishes the value of cash.

What happens when the people owning high-priced assets such as stocks, bonds, apartments in New York, farmland in Nebraska and so on want to sell them?  All the cash and credit has already been consumed driving prices up in the first place.

What will follow without fail is the GRAR. Depending on who got elected, it might come sooner or later.  But without respect to the winner, it’s coming.  The correct solution for those now in power is to avoid the temptation to meet it with credit again, and to let prices become valuable and attractive. Painful yes, but healthy long-term.

That’s the path out of the GRAR. I hope our winner has the discipline to delay gratification.

Ring of Fire

Yesterday China’s stock-futures market Flash-Crashed 10% and recovered in the same single minute.

For those new to market structure, the term “Flash Crash” references a hyperbolic rout and recovery in US equities May 6, 2010 in which the Dow 30 erased a thousand points and gained most of that back, all in 20 minutes. It’s vital to understand the cause, whether you’re the investor-relations officer for a public company or an investor.

China blamed a futures trade for prompting Tuesday’s fleeting plunge. A year ago, China’s stock-futures market had exploded into the planet’s busiest. Then as its equity market was imploding last summer, the government cracked down on futures trading. China also moved to devalue its currency in August last year, ahead of a dizzying Aug 24 plunge in US equities that saw trading in hundreds of Exchange Traded Funds (ETFs) halted as share-prices and fund asset-values veered sharply apart.

Trading in 2016 Chinese stock futures is a shadow of its 2015 glory but yet again sharp volatility in derivatives followed a currency move. Monday as the USA marked Memorial Day the People’s Bank of China pegged the yuan, China’s currency, at the lowest relative level versus the dollar since the Euro crisis of 2011, which also brought rocking volatility to US stocks.  A similar move Aug 12 preceded last summer’s global stock-market stammer.

Every time there’s an earthquake in Japan or Indonesia, it seems like another follows in Chile or New Zealand.  What geologists call the “Ring of Fire” runs from Chile and Peru up along the west coast of the United States and out through the Aleutian Islands of Alaska and down past Japan and Southeast Asia to the South Pacific and New Zealand.

The more things interconnect, the greater the risk. Tectonic connections are a fact of life on this planet, and we adapt.  But we’ve turned global securities markets into a sort of ring of fire as well. In geology, we link tectonic events and observable consequences. In global securities markets, we don’t yet give the magma of money its due.

Globalization helped to intertwine the planet, sure. But it’s not the fault line. All the money denominating everything from your house to Chinese futures is linked via the dollar, the globe’s “reserve currency,” meaning it’s the House Money, the one every country’s central bank must have. If for instance a country’s currency is falling, it can sell dollars and other currencies and buy its own to improve the ratio and thus the value.

Two consequences arise that feed directly back to US public companies and investors.  Suppose the world’s markets were all tied together with a single string and each market had a little coil to play out. That’s currency. Money.  If one market is doing well, the others may be tempted to tug on the string in order to be pulled along, or to let out some string to change the balance of investment flows.

The process becomes an end unto itself.  The connecting currency string is tugged and played in an effort to promote global equilibrium in prices of assets and performance of economies. So arbitrage develops, which is investing in the expectations of outcomes rather than the outcomes themselves. Focus shifts from long-term returns to how things may change based on this economic data point or that central-bank policy shift.

The fissures that develop can be minute monetary arbitrage imbalances like China’s futures flash crash yesterday.  Or much larger and harder to see, like trillions of dollars in ETFs focused on a stock market trading 15% over long-term valuations that rest on economic growth half that of historical averages.

Before the May 2010 Flash Crash, the Euro was falling sharply as Greece neared collapse.  Before 2011 market turmoil globally, the Euro was again shuddering and some thought it was in danger of failing as a currency (that risk remains).  In Japan, the stock market is up 80% since the government there embarked in 2012 on a massive currency expansion. Now this year, the government having paused that expansion, it’s down 10%.  Has the market corrected or is it inflated?  Is the problem the economy or the money?

On the globe’s geological Ring of Fire, unless we achieve some monumental technological advance, living on it comes with risk and no amount of adjustment in human behavior will have an iota of impact. It’s tectonic.

In the stock market, fundamentals matter. But beneath lies a larger consideration. Markets are linked by currencies and central banks toying with strings.  The lesson for public companies and investors alike is that a grand unifying theme exists, like the physical fact of a Ring of Fire: Watch the string.

And there was a tremor in China again.

Dollar Ratios

My friend’s dad joked that kids are the most destructive force in the universe.

For stocks, the most powerful (and sometimes destructive) force is the movement of the dollar. The Federal Reserve and the Bank of Japan both meet today so it could soar or swoon. Since the buck holds sway, we should all of us in the capital markets from investors to issuers understand how and why.

Stocks react to the dollar because they’re opposite sides of the ledger. Debits and credits.  If money buys less, a debit, then what preserves value (stocks) increases in price, a credit.  So a “strong dollar” means more value resides in the currency and less in stocks.  A weak dollar is the opposite, and value transfers at higher risk into stocks to offset diminishing purchasing power – the quantity of things money buys.

It’s about ratios.  In the past, countries would scrounge around for a gob of gold. Then they could issue paper currency at a ratio. Played poker?  Chips are an asset-backed currency. Pay money, get chips.  Want more chips? Pay more money. The ratio is always the same so chips have fixed value and supply varies with the number of players.

Not so with money.  If Europe has spent more than it makes, its debts depressing the economy (like credit card debt constrains discretionary income), the European Central Bank can manufacture more money – bump up the chip stack without paying.  Remember our ratios?  Increase the supply of euros and prices of risk assets that preserve value, like stocks and bonds, rise to compensate.

Follow that reasoning. When money declines in value, stuff costs more. When stuff costs more, the revenues of the businesses supplying the stuff increase.  And since consumption – buying stuff – is the core way we count “economic growth” today, economies grow when prices rise.

Get it?  Yeah, it’s balderdash that selling the same unit at a higher price is growth. But that’s how governments now measure it. All central banks including the Federal Reserve thus have inflation targets. They are trying to create growth, without which most governments go broke.

Think I’m making this up?  Follow the math. You can’t print a batch of Benjamins. That’s counterfeiting. So how do central banks create money?  They issue money against the most widely available commodity in the world today:  Debt.

When you buy dinner on a credit card, the bank doesn’t reach into somebody’s savings account to pay the restaurant. It creates money. Pay the balance and that money vanishes.

Remember the ratios? Burn money and there are fewer dollars, which means the dollar rises in value, and prices fall, and economies contract (not really but that’s how we count now), and stocks swoon. Create money and the opposite occurs – everything rises.

Investor-relations people, you know the term “multiple-expansion?” It describes stocks that cost more without any change to underlying fundamentals.  This is a product of money-creation. In effect, central banks are trying to induce us all to pay more for things than they’re worth.  Value investment is the opposite: buying at a discount.

For perspective, JP Morgan is leveraged about 8 to 1.  Citigroup, about 7 to 1.  The Fed? With capital of $40 billion and liabilities of $4.54 trillion, its leverage ratio is 113 to 1.  Where money before depended on assets, like gold, now it’s backed by liabilities – debt.

The European Central Bank is buying eighty billion euros of debt a month to create money. What happens to debt? Its value skyrockets and interest rates plunge. It’s the opposite in the real world. You’re in hock, you pay the vig.  Bigger debts, more cost.

Japan is way beyond that, financing the government by directly trading yen for government debt, and now it’s buying exchange-traded funds, shifting to equities with infinite supply (ETFs can theoretically create as many shares as demand requires – but inevitably leverage increases). Japan is even contemplating paying banks and businesses to borrow. Why? Because debt creates money and more money keeps prices from falling.

The effort fails because consumers buy more when prices fall and less when they rise. So the very attempt to drive economic growth is in fact undermining it. Plus, the soundness of our currencies today depends on the capacity of governments to pay on their debts.

Summarizing, the world is indebted so it needs money. Central banks supply money by exchanging it for debt.  Creating money paradoxically reduces the capacity of consumers to buy things because prices rise. So they have to go into debt.  The cycle repeats like two parties munching opposite ends of a strand of spaghetti.

Back to stocks. When they vary inversely with the dollar it’s contraction or expansion of multiples, not real growth.  And that means consumers are losing purchasing power.  Since consumption drives economies now, it inevitably leads to slower growth.

And that’s what the planet’s got. Circular reasoning obfuscates facts.  The solution is a stable currency so all of us can understand fair value for stocks and everything else. But we’ll start with identifying the destructive force – and it’s not the kids.

The Flood

The word of the week was “flood.”

Here in Colorado, Denver had a coup d’état by weather patterns from Portland, Oregon for a week but our streets never ran in torrents. Where the Rocky Mountain watershed empties to the flood plain from the Mesozoic Era, occupied by present-day Boulder, Loveland and Greeley and small towns like Evans and Lyons hugging the banks of normally docile tributaries, the week past reshaped history and landscape. It will take months to recover.

In the markets too there was and remains a flood that surfaces with rising intensity from its subterranean aquifers to toss debris into market machinery. It’s the spreading vastness of complex market data.

SIDEBAR: If you’re in St. Louis Friday, join us at the NIRI luncheon Sept 20 for a rollicking session on the equity market – how it works and why it fails at times.

Data is the fuel powering market activity. Globally, trading in multiple asset classes turns on computerized models that depend on uninterrupted streams of reliable data. This gargantuan global data cross-pollination affects trading in your shares. After all, there are two million global indexes, as the WSJ’s Jason Zweig noted in a poignant view last weekend on modern equities. (more…)

The Theory of Value Relativity

There’s an old stock market joke. Every time one person sells, another buys, and they both think they’re smart.

Value is relative. And yet. Anybody in the IR chair pencils valuations for his or her shares. Isn’t this the battle – measuring value? Karen and I on a recent trip sat with a sharp IR pro who explained how the team had an internal valuation model for company stock.

Many consider historical price-to-earnings ratios of the S&P 500 (about 16 over 130 years but ranging from below 9 in 1933 and 1983, to 40-plus in 2000, the record). Some like the S&P earnings yield versus 10-year Treasurys (7% to 2%). On that basis, markets would seem to be a whopping good buy.

And yet the Dow was down 500 points in five days through Tuesday.

There are three immutable valuation meters. You’ve got future value of cash flows. For instance, somebody at Facebook determined that Instagram’s future cash flows discounted to present value are worth $1 billion rather than the current figure of zero.

There’s net worth. When Microsoft bought AOL patents this week for $1 billion, the market added the cash to AOL’s net worth and shares shot up about 20%. (more…)

Arbitragers Love Monetary Intervention

Say you were playing poker.

I don’t mean gambling, but real cards. You’re engaged with some seriousness. You’re watching how you bet and when, reading the players ahead and after you.

Then The House starts doling out stacks of chips. Would you play more or less cautiously if you had free chips?

Apply this thinking to equity markets, IR folks. In trading data, we saw European money sweeping into US equities Nov 28. Why did markets trembling Nov 25 decide by the following Monday to up the ante in risk-taking? Primary dealers implementing policy for global central banks also drive most program-trading strategies.

Thus, European money surmised that central banks would intervene, and their behavior reflected it. The rest caught on, and markets soared Nov 30 on free chips from central banks. It was short-lived. By Dec 2, we saw institutions market-wide assaying portfolio risk and locking in higher derivatives insurance. The chips were gone.

Money sat back expectantly. On Dec 8, The House delivered chips as the European Central Bank lowered interest rates. That’s devaluing the euro. At first, cheapening the euro increases the value of the dollar – which lowers US stocks (a la Dec 8). But if you’d hedged with derivatives as most of the globe did, you bluffed The House. Plus, the Fed will likely have to follow Europe’s bet up with a see-and-raise to devalue the dollar back into line with the euro (expect it next week, but before options expirations).

In poker, having “the nuts” is holding the best cards, and knowing it. Central banks have given arbitragers the nuts. (more…)