Tagged: Dollar

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…)

Yin and Yang in Your Stock

Stocks go up and down. Nothing new there.

The dollar dropped for a second straight day today. Stocks are again up, like they were yesterday. The dollar gained ground last Wed-Fri, and stocks fell.

This week marks the end of the month and quarter. We recommend in our IR Calendar that you consider some tactical timing as part of your overall IR strategy. Generally, the last few trading days of a quarter or month aren’t best for releasing good news. But they may be perfect for bad news.

Why? Institutions will be shoring up portfolio returns or managing exposure to market risk. They address risk by offsetting it with something that is inversely correlated. Notice that stocks and the dollar are inversely correlated. Notice that the dollar and other currencies, such as the Euro, are often inversely correlated. (more…)

The derivative we need is a weather swap. The Winter Olympics would pay a premium for that spare snow lying around unused on the east coast.

Speaking of derivatives, the dollar retreated today, and US equities rebounded. We all want it to be about investing. Commentary everywhere today polished bullishness to an economic sheen. But that won’t make it reflect reality. Money keeps buying short-term love because the direction of the dollar is like a blacksmith’s bellows on equities. (more…)