Mark Potter

This is a long and quite complicated post but I suggest it offers an insight into market pricing that is both a permanent change and relevant to all investors.

The conundrum

As I have suggested in earlier posts, the pricing of global stock markets in the near term will react to news flow about the Covid-19 pandemic, but the medical news flow, not the economics. That follows the fairly unremarkable idea that the economic news probably depends on the medical news.

However, some apparently inconsistent things are happening. For example, when it was suggested that a certain anti-viral drug might be useful, markets shot up on the news but when it was reported that testing was a failure, markets did not fall back.

Furthermore, as the Financial Times noted last week, experienced investors are rather surprised that as time passes and the already known consequences of lock downs are understood, and they are indeed awful for global economies and fatal for some businesses, markets are moving up as if they were pricing for a recovery.

Free money (for now)

Worldwide, governments are inverting the old idea of ‘jam tomorrow’, and instead seeking to keep economic growth going with barrowloads of money, which they are borrowing with no idea of when they will pay it back.

This perhaps harks back to the success of Roosevelt’s New Deal (much hated by corporate American initially, because it was vaguely like communism in their view) but this time the corporates are tuned in and know how to get their grubby mitts on the money before it filters down to all those annoying little small businesses and heaven forbid, actual citizens!

As I will propose later, the price of many large capitalisation shares in the markets is now driven not by value measures but by the trading manipulations of a small number of private individuals, private equity funds and venture capitalists. They learned a while ago how to use the borrowing capacity of major governments to pump the valuations of loss making companies, so when they see the taps of state funding fully open, they see opportunity.

Money like water, finds a level. With more money, the level will be higher.

Now I guess readers may be either feeling lost at this stage, or thinking I am an idiot with a personal political agenda. How does money paid to keep companies and small businesses afloat end up benefiting private equity funds, you may ask.

I will answer that in two stages. Stage one offers a simple explanation of monetary theory, stage two seeks to explain where we are now.

Money supply and inflation

It is necessary to think about the economic theory of the money supply a little – not too deeply, have no fear!

When the economy is working normally, money is its lubricant. A company raises money from those that already have some (capitalists) and borrows from banks. The money gets used to buy land and premises, investment capital equipment (machines, stock, media content and so on) and to pay people.

All the people who get money from selling things to the company, or working for it, then spend the money on the products and services on offer from all companies. They also pay taxes, in return for which the government delivers services, re-spending the money. They might save some money, but that is not good for most capitalists (some banks excepted), so a massive services industry (marketing and advertising) exists to drive people to consume, based on behavioural psychology.

As long as people and governments spend enough, companies make profits from selling them stuff and they reward the owners of the shares (who may or may not now be the original capitalists) with dividends. If dividends are good, share prices go up because people want to get hold of them.

That is the traditional model and it is suggested that it gets rather messed up when governments and consumers borrow money over and above what is generated as explained. A strong view was put forward in the Reagan/Thatcher years that increasing the supply of money by government borrowing would cause inflation. In fact, it might be the main cause of inflation, so they said.

So, if that is the case, we ought to expect inflation in bucket loads in the near future, governments have started borrowing money like the novelist’s miscreant heir to a Victorian fortune.

What gets inflated

When Milton Friedman and his fellow monetarists were advising Mrs Thatcher and Mr Reagan, they were talking about consumer price inflation and wage inflation. It is assumed that workers demand more wages to cover higher prices in the shops. To the capitalists of the USA in particular, wage inflation has been something to control at all costs for well over a century. Even with increased productivity, the biggest risk to profits has always been an increasing wage bill.

But if governments were going to be foolish enough to allow trade unions to operate legally, increases in productivity were likely going to be offset by higher wages. More mechanisation and the use of immigrant labour would help, but in the meantime the easy answer was to keep up the marketing pressure and put prices up. In that way businesses could cope with wage inflation as long as they could put prices up. That was how it was in the 1980’s – you may remember it! Even a left wing Labour government decided the answer was to cap wages.

The monetarists suggested that cutting government activity in the economy would slow down the rate at which money got cycled around (cutting corporate activity could never be on the agenda in the USA). That was taken very seriously as a proposition. Hindsight suggests that it is likely that various other political actions and the rise of technology did more to bring inflation under control, with harsh impacts on traditional industries.

Furthermore, in Japan, where the government has for many years been shovelling money at the economy to generate inflation, it has failed.

So if large increases in the money supply do not seem to result in wage or consumer price inflation, where des the money go? The evidence I think is overwhelming that it goes into financial assets. I think I am late coming to this conclusion and markets are behaving in full expectation of that consequence.

But hang on Harry…

I know, I am always droning on about the value of a share being the discounted value of all future cash flows, being dividends in the main. In other words shares are worth money based on company profits, right? So how can the money coming from government borrowing end up in companies? What’s the link?

Firstly, the extra money in the system will be stored in large part in banks, so they want to lend it. With more supply, interest rates will be lower. The governments also want interest rates to be lower, so they can afford the interest on all those extra Treasuries and Gilts. Lower borrowing costs mean better profits, so potentially higher dividends.

Secondly, if companies can borrow this government dosh very cheaply (even if they don’t need it, as we have just seen in the USA), they can use it to buy back shares.

Thirdly, if private equity firms (and there are many of them controlling trillions in assets), operating through their investments in trading companies that can access this money can get hold of lots of it, and there is evidence that they will, then they can use it for investment activities of all sorts.

Which brings us neatly to the relatively new phenomenon of ‘imaginary’ share valuations.

How to make the value of shares you own go up

The value of ‘quality’ shares is easy to explain. The company has a strong position in various markets, good governance, is technologically advanced, develops new product lines, controls costs etc etc. Investing in such companies will make you money, even it is only decent dividends. But slowly. You may admire Warren Buffet if you think that is the right way to invest.

That is not the way most 21st Century investors like to play the game. As students, they read about the asset strippers of the late 20th Century, the rise and fall of the dot.com businesses, bank rescues in 2008 and the fortunes made (and lost) in mergers and acquisitions.

This is not really a new idea but they think that the way to make money fast is not to do with investing in great companies – that is for simpletons – it is about knowing how to play the market game, Monopoly on steroids, if you like.

These gamers are now significant influencers of share prices (to include two modern words in one sentence!)

This newest trick is based on funding the ‘next great idea’. That is facilitated by the reality of our living in an age of great change.

It works like this: a company is developed with a workable leading edge technology or new way of meeting a consumer need that can be expanded. I can think of these recent examples: cheap ways of sharing rides (Uber/Lyft), take-away food from your favourite restaurant (Deliveroo), new video content to watch with your slowly congealing nouvelle cuisine (Netflix), an electronic only multi currency bank account (Resolut) to pay for the apartment in Cannes where you going (hopefully) to get real food (AirBNB), wearing the clothes you bought from a new version of John Moores/Littlewoods (Asos/Boohoo) and so on.

The ‘great new idea’ company needs to scale up, so it gets some private equity firms to take up new shares (a placing) at a modest price – they can see the potential, not just in the business, but in the game of raising money.

The company quickly burns through the capital raised acquiring customers and developing products and services. It makes gigantic losses in accounting terms. Everyone seems strangely happy. Especially marketing services companies.

When it needs new capital, it offers more new shares – the ‘funding round’. By agreeing to buy these at a much higher price, the original club of investors automatically gets their initial investment revalued up and it also puts momentum behind the share price as other investors want to jump on the bandwagon – they know how this game works. Pump, pump.

In some cases the company becomes hugely profitable, but that is not important to the financiers who propelled its share price along – they will sell out quietly at a good profit and if all goes wrong and losses become unmanageable and the company becomes insolvent, they will buy it back again at a gigantic discount.

Does that sound fanciful or immoral? Sorry, dear reader it happens all the time.

• Potter, you are moralising and still not getting to the point, I fear you are thinking.

The point is this: the money that private equity firms use to fund these transactions is very often borrowed, often in very complex ways.

The more money in the market there is to borrow (see above), the easier it is to drive share prices along like this.

Good value companies may well remain out of fashion and see little share price growth, but shares in ‘next best thing’ companies that offer low or no dividends will mysteriously fly along as each ‘funding round’ goes through.

In effect, capital raising that looks like the issue of equity shares is more like the issue of bonds, in the form of borrowing from banks (and at the moment governments). It is just that a shape shifter, the private equity operator, has come in the middle.

The buyers of the newly issued shares shares have borrowed the money very cheaply and intend to use that money not to bet on the company, but to bet on the market mechanism. If you look through it all, you see that the likes of Tesla are not generally burning through the private wealth of the world’s super rich, but through borrowed money (and some money supplied by retail investors!). That means that people who own Tesla shares are in reality owning junk bonds but with no yield and no maturity date.

But that’s like a Ponzi scheme, surely?

In my view it works much the same, yes. Just like a Ponzi scheme, it works for a while. If you know it’s a sort of Ponzi scheme because you are a relative or a mate of the operator, it’s brilliant! You watch your investment fly and then you exit at a great price.

Of course, eventually the fiction unravels and a lot of less well informed people will lose their shirts.

Summary and conclusion

• I have proposed that markets are doing much better than economic fundamentals suggest they ought to because experienced operators with billions to invest anticipate that huge flows of cheap to borrow money will allow share prices to get pumped up.

They accept that many companies will reduce dividends, sell up, even go bust, but they see plenty of money to be made just betting on the money levelling up, mainly in the asset valuation ‘slice’ of global wealth.

• I have further proposed that for some time some asset prices are in fact invented, but sustained as long as new capital can be raised by what appears to be share issues but is actually more akin to junk bonds.

How do we deal with this?

Some investment managers either don’t agree with my expectation that we are heading for trouble with a whole bunch of share values, or they think they can play the momentum for now. This is a reflection of the trend towards ‘factor’ investing.

I personally prefer to avoid those fund managers, so don’t buy funds that are keen on IPOs (new share issues) and loss making businesses. I prefer funds that look at global themes and select profitable companies with cash flow and dividends that can benefit from the way those themes play out.

But have no doubt, the speculators are in charge at the moment. When their fictions blow up, we may have a market crisis bigger than the one we have just seen and even well run funds will carry the systemic market risk. But quality companies are only out of fashion for a while.

I remain of the opinion that overall market levels being so far detached from the returns on traditional good value shares means we have trouble ahead and am thinking very carefully about what to buy to make money long term and control risk short term.

Those of you who prefer index tracking funds need to make sure you are getting an asset mix that does not leave you too exposed to the eventual demise of the ‘momentum’ factor in the market.