Albert Einstein reputedly quipped that compounding was the 8th wonder of the world. What would he think of negative interest rates?
The 10-year German government bond yield is -0.61%. The Rule of 72, which nobody mentions now, says dividing 72 by the expected rate of investment return tells you when it’ll double. At 6%, that’s 12 years. At 2%, 36 years. Try compounding negative rates.
Believe it or not, the stock market is weirder still.
Volatility in US stocks averaged 3.4% daily the past week, 55% higher than the risk-free return of 2.2% for 30-year US Treasurys.
Plug those figures into an equity cost of capital calculation where the expected return is 8%. You with me? It’s 22%! So, the interest you earn on cash has vanished while the cost of raising it in public markets has exploded.
You may say, investor-relations professionals, there’s no way my equity costs 22%. The truth is, volatility introduces value-uncertainty, which both increases what you pay for money, and on the other side, decreases returns on it.
University of Chicago professors Eugene Fama, who won a Nobel Prize in 2013, and Kenneth French, who also serves as head of investment policy for quant investor Dimensional Fund Advisors, co-authored a paper describing how equity-market volatility diminishes the apparent superiority of equities over bonds.
To wit, three-month Treasury Bills are returning 2% annualized. The S&P 500 since Sep 20, 2018 is down 0.4% even after yesterday’s gains. What if you’d sold Monday when the Dow Industrials dropped 391 points and bought yesterday when they rose 372? One day can make or break returns for investors.
Same for public companies. Say you issued stock in Dec 2018 and implemented an aggressive buyback in Jan 2019. On the wrong side of the market, cost of capital skyrockets.
Rather than rationalizing market behavior, we should be asking why it’s become so volatile. And yes, it’s vastly more so now than during earlier epochs.
The answers? Rules. Stocks must trade between the best bid to buy and offer to sell, which cannot be the same. Thus, machines change prices. They’re 45% of volume.
On top of that, stock exchanges give firms economic incentives to trade stocks and derivatives simultaneously, accelerating the rate of change for prices.
For instance, the Nasdaq pays traders with more than 0.6% of sell volume (they call it adding liquidity but it’s paying traders to set the offer, the highest price for a stock) $0.29 per hundred shares.
Sell 1.75% of Nasdaq volume, with 0.6% in derivatives like options and futures, and if that amount is 0.1% of total Nasdaq derivatives volume, the exchanges pays $0.32 per hundred shares. That’s a 10% kicker for more prices.
Now add Exchange Traded Funds, which have no intrinsic value and depend for prices on the stocks that collateralize them. The two – stocks, and ETFs – are always a bit out of step.
Take Energy stocks last week. XLE, a big Energy ETF, was down 2.2%. But composite Energy stocks were down 5.5% – a spread of 150%!
Capture half that by buying the ETF and selling the stocks, and it’s a 75% return. No wonder traders trade.
ETFs drive what we estimate is 60% of total market volume now. ETFs exist via a regulatory exemption from the Investment Company Act of 1940 permitting them to trade as stock substitutes around an “arbitrage mechanism.”
That is, they depend on changing prices. There are thousands of ETFs, worth trillions of dollars. It’s a mania.
I’ll summarize: Market rules and investment behavior built on continually changing prices have transformed the market from a place where long-range horizons are the objective, to one where continuously changing prices are the objective.
Changing prices is the definition of volatility. Traders trade to profit on it. They rule.
What we expect from the stock market should derive from these facts. Public companies and investors alike should adapt. How? Understand the ebbs and flows and surf them like waves (we have that data). Modulate your buybacks, your stock issuances, your tactical investor-outreach, your investment decisions, to reflect behavioral facts.
Investors and public companies could also band together to petition the SEC to stop giving arbitrage a leg up. The first step toward that goal is understanding how and why the market’s focus is now today’s spread, not tomorrow’s capital appreciation. I’ve explained it.
Mark Twain would say: Is the market run by smart people who are putting us on or imbeciles who really mean it?