Tagged: valuation

Unknowable

The question vexing Uber and Grubhub as they wrestle over a merger is which firm’s losses are worth more?

And for investors considering opportunities among stocks, a larger question: What companies or industries deserve better multiples on the Federal Reserve’s backstopping balance sheet and Congress’s operating loans?

Sure, I’m being cheeky, as the Brits would say.  The point is the market isn’t trading on fundamentals. Undeniable now to even the most ardent skeptics is that something is going on with stocks that wears an air of unreality.

And there is no higher impertinence than the somber assertion of the absurd. It deserves a smart retort.

We’ve been writing on market structure for over a decade. Market structure is to the stock market what the Periodic Table is to chemistry. Building blocks.

We’ve argued that the building blocks of the market, the rules governing how stock prices are set, have triumphed over the conventions of stock-valuation.

SPY, the S&P 500 Exchange Traded Fund (ETF), yesterday closed above $308. It last traded near these levels Mar 2.

What’s happened since? Well, we had a global pandemic that shut down the entire planetary economic machinery save what’s in Sweden, North Dakota and Africa. Over 40 million people in the United States alone took unemployment. Perhaps another 50 million got a paycheck courtesy of the US Congress’s Paycheck Protection Program.

Which means more than half the 160 million Americans working on Mar 2 when stocks last traded at current levels have been idled (though yes, some are returning).

At Feb 27, the Federal Reserve’s balance sheet was $4.2 trillion, of which $2.6 trillion sat in excess-reserve accounts earning interest of about 1.6% (why banks could pay some basis points on your savings account – arbitrage, really, that you, the taxpayer, footed).

By May 28 the Fed’s obligations on your behalf (all that money the Fed doles out has your name on it – “full faith and credit of the United States”) were $7.1 trillion, with $3.3 trillion in excess reserves now earning ten cents and wiping out meager savings-account returns but freeing taxpayers of interest expense.

The nearest facsimile I can arrive at for this great workforce idling, casting about in my history-obsessed mind, is the American Indians.  They were told, stop hunting and gathering and go on the government’s payroll.

Cough, cough.

You cannot idle the industrious and value their output the same as you did before.

Yet we are.

While I’m a pessimist about liberal democracy (classical meaning of “freedom”) because it persisted through a pandemic by the barest thread, I’m an inveterate optimist about American business.  I’ve obsessed on it my adult life. It affords a fulsome lifestyle.

The goal of good fiction is suspense of disbelief. That is, do I buy the thesis of the story? (News of the World is by the way brilliant fiction from Paulette Jiles with a high disbelief-suspension quotient).

Well, the stock market is supposed to be a barometer for truth. Not a litmus test for suspension of disbelief.

Sure, the pandemic cut some costs, like business travel. But contending a benefit for bottom lines ignores the long consequential food chain of ramifications rippling through airlines, hotels, restaurants, auto rentals, Uber, Lyft, on it goes.

How about corporate spending on box seats at big arenas?

Marc Benioff is still building his version of Larry Ellison’s Altar to Self in downtown San Francisco (no slight intended, just humor) for salesforce.  Yet he said to CNBC that some meaningful part of the workforce may never return to the office.

An empty edifice?

And nationwide riots now around racial injustice will leave at this point unknown physical and psychological imprints on the nerve cluster of the great American economic noggin.

Should stocks trade where they did before these things?

The answer is unknowable. Despite the claims of so many, from Leuthold’s Jim Paulson to Wharton’s Jeremy Siegel, that stocks reflect the verve of future expectations, it’s not possible to answer something unknowable.

So. The market is up on its structure. Its building blocks. The way it works.

Yes, Active investors have dollar-cost-averaged into stocks since late March. But that was money expecting a bumpy ride through The Unknowable.

Instead the market rocketed up on its other chock-full things.

Quants chased up prices out of whack with trailing data. ETF arbitragers and high-speed traders feasted on spreads between the papery substance of ETF shares and the wobbly movement of underlying stocks.  Counterparties to derivatives were repeatedly forced to cover unexpected moves. The combination lofted valuations.

None of these behaviors considers The Unknowable.  So, as the Unknowable becomes known, will it be better or worse than it was Mar 2?

What’s your bet?

Daily Market Structure Sentiment™ has peaked over 8.0/10.0 for the third time in two months, something we’ve not seen before. The causes are known.  The effects are unknowable save that stocks have always paused at eights but never plunged.

The unknowable is never boring, sometimes rewarding, sometimes harsh. We’ll see.

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.

Best Of: The GRAR

Editorial Note: Happy Thanksgiving!  We hope you reflect gratefully this season, as we will.  And speaking of reflecting, you might think with markets hitting new all-time highs after the election that we’ve beaten a retreat (what the military calls without irony “advancing to the rear”) from our two-year declamation about coming risk-asset revaluation. We’re by no means complaining about gains. We think prospects for the USA merit giving thanks. 

But there will be no escaping the consequences of artificial asset-price inflation. You can’t blow a balloon full of air and suppose it’ll float forever.  Runs here in November will have a profound reversal magnified by the meteoric dollar-rise. Whether it happens in days or weeks, it’s coming. The question for the new administration will be whether it possesses the fortitude to let prices find proper equilibrium so the economy can actually find “escape velocity” finally, in its aftermath.  -TQ

Originally posted Nov 9, 2016:

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.

Stuck Throttle

Imagine you were driving and your throttle stuck.

Our market Sentiment gauge, the ModernIR 10-pt Behavioral Index (MIRBI) has manifested like a jammed accelerator, remaining above neutral (signaling gains) since Feb 19. At Apr 15 it was still 5.4, just over the 5.3 reading at Feb 19, which proceeded to top (Positive is overbought, roughly 7.0) four consecutive times without ever reverting to Neutral (5.0) or Negative (below 5.0). That’s unprecedented.

Speaking of stuck throttles, I first drove a John Deere tractor on the cattle ranch of my youth at age seven.  It was a one-cylinder 1930s model B that sounded like it was always about to blow up or stall. My dad let me drive it solo and I was chortling down our long driveway with the throttle set low and the clutch shoved forward.  I was approaching an irrigation ditch. I yanked at the clutch (on these old tractors, it’s a long lever, not a pedal). Nothing.  I shouted to my dad that I couldn’t budge it, looking wildly at the ditch.

“Turn the wheel!” he yelled.

Disaster averted. I felt sheepish for not thinking of it. But it illustrates the dilemma a stuck throttle (or a stiff clutch) presents.  No matter that sense of stolid progress, something with a mind of its own will run out of road.

Another time decades later I had driven myself from Cancun through the jungle of Quintana Roo west of Belize to a resort called the Explorean Kohunlich (awesome place). After two beautiful days, I hopped in the rental car and headed north.  I became gradually aware that the little Chrysler was bogging down. I mashed the throttle and yet the car wheezed and slogged. Then it died.

Took me two hours to hike back to Kohunlich.  “Mi coche expiró en la selva,” I explained in my ill-fitting Spanish. Your car died in the jungle? Yup. It all worked out to another day in paradise. Nothing lost.

Gained: Two contemporary lessons about the stock market.  Stocks should generally describe fundamentals. If they don’t, we’re all lacking “price discovery,” the jargoned term meaning a good understanding of valuations.  It’s as vital to companies as investors, else how do any of us know if shares are fairly valued?

No matter what some say, global economic fundamentals are like a wheezing car with the throttle mashed flat. In the US right now, economic growth projects below 1% for the current quarter, and inflation is over 2%, so consumers are losing purchasing power. And consumption is our engine (purchasing power is the key to growth).

Across the planet, from Europe to Asia to the emerging markets, debt-to-GDP ratios are up and economic growth is down.  So why has the market been a tromped throttle on an unprecedented positive run? Meaning resides in patterns and correlations. It’s the central lesson of data (which we study for a living).

And there is one.  Emerging-market central banks have sold foreign currency reserves at unprecedented rates (matching our Sentiment), and the US Federal Reserve has pushed hundreds of billions of dollars into bank reserves (by buying debt from them) in recent months.  And the dollar has fallen sharply off December highs. When other central banks sell dollars, it weakens our currency, and when our Fed buys assets from banks, it weakens our currency.  And when the dollar falls, stocks, commodities, and oil rise.

On one hand central banks have mashed the monetary accelerator to the floor and still everything is wheezing and coughing and slowing down.  It’s taken unprecedented effort to create this gaseous cloud.

But it’s on the other hand a two-by-four jammed on the equity market throttle, sticking it in Positive and disconnecting it from reality, and sending it screaming up the road out of control.  It’s entertaining, and good for our portfolio values, all of us, and it makes the pundits breathlessly rave about returns to all-time market highs.

But the throttle is stuck.  I’m reminded of a funny bit from a set of paraprosdokian sentences, witty combinations of unexpected or opposing ideas, sent to me by good friend Darwin:  “I want to die peacefully in my sleep like my grandfather. Not screaming and yelling like the passengers in his car.”

It’s better to have a market with its own throttle controlled by facts and fundamentals than one flattened by a bail of depreciating currency. Because we don’t want it dying in the jungle.