Economics

Monday mashup – a riddle solved?

27th April 2020 by Mark Potter Leave a Comment

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.

Are you a long term investor who relaxes and waits for everything to be ok?

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.

Not all great new ideas are that great or that new.

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.

Monday mashup – brave new world?

23rd March 2020 by Mark Potter Leave a Comment

As I have been posting much more frequently recently to offer readers some insights during difficult times, this week’s meandering heads off into the future and attempts, Beethoven like, to find leisurely pastoral scenes after a frightening storm. But only finds something less attractive.

So this is an opinion piece and you can stop reading now if you were only expecting market commentary.

A potted history

I have read some serious commentators (Andrew Rawnsley in The Observer, for example) pointing out that the reaction of the UK government to the coronavirus threat effectively makes a bonfire of everything Conservatives in the UK claimed they believed in. For very good reasons, the UK will have a public spending budget not seen since WW2, life dictated at a microscopic level by the state (not nanny state, more like Big Brother), nationalised railways (just to start, wait for more), enhanced State benefits and so on.

My thinking has for a few weeks been that whatever the economic consequences of the virus, there will in time be a seismic change in the relationships and rewards in the capitalist system.

The world will be different for investors from now on, I think

When I was training to be a Chartered Secretary, just pre-Thatcher in the 1980’s, we were taught that big companies were ideally governed in the interest of stakeholders, not just shareholders. Other interests might include employees, pensioners of the business, consumers, the environment and even the public purse. In those times there was much talk of putting representatives of these other interest groups, especially employees, on company boards.

That seemed civilised to me. The large corporates have been identified as self perpetuating entities that in some cases are larger and more powerful than governments right back to the days of the Dutch East India Company, who had the largest military in the world. We have had the American ‘corporate robber barons’ like Carnegie, Rockefeller, van der Bilt and maybe now Zuckerberg and Bezos effectively controlling important parts of the largest global economies.

The US writer Thomas Pynchon suggests that the already completed phase of evolution after humanity is the American Corporation. Y N Harari in his best selling book ‘Sapiens’ explores at some length the management of human interests by corporations and collective systems, with the obvious diametric opposite to the corporation being the truly Communist state, like North Korea.

In response to the outrageous use of power by the owners of corporations, the USA developed anti-trust legislation and anti-monopoly law was a big discussion topic when I was studying economics. In those days everyone feared IBM! As a student I felt that checks and balances were at least an objective of the elected representatives in a democracy.

Come the mid 1980s and Reagan and Thatcher and the world changed totally, switching hugely in favour of capitalists (in the economic not political sense) and even more in favour of the managers (directors) of companies. As time went by, even the interest of shareholders seemed to be demoted behind the managers’ remuneration packages and the earnings of corporate lawyers, bankers and anyone powerful enough to get their nose in the trough.

Some global governments held back this rapid rebalancing of economic interests but in general the economies of those countries (say France, for example) did less well. The use and abuse of the unfettered financial system, especially in the selling of vast amounts of debt, boosted the economies of the marauding members of the even freer free market.

Problem with juggling too many balls is that if you drop one, you will usually drop the lot

The financial crisis brought that to an abrupt halt but the sinners were not just forgiven but bailed out with public money and made ready to rush off again in pursuit of directors’ remuneration and spending profit or even borrowing to buy back shares (which makes the business more of a stand alone entity, not answerable to anyone).

Of course, to keep governments sweet, it was necessary for the very biggest and often shadowy beneficiaries to spend their small change on lobbying, funding election campaigns and buying up the mass media to keep the message right. At least that has been true in the USA, the stock market capitalisation of whose businesses is more than all the rest put together (never mind the wealth not in listed shares).

A body blow, from an unexpected quarter

That potted history brings us to Covid-19. Now – The ” ” Strikes Back. Fill in the space according to your personal view of the world.

It is well known that modern capitalism only works because of insatiable consumption. Insatiable consumption will destroy the environment without major changes to the mix of goods and services consumed. If I was ‘the environment’, I would work out that my best defence strategy would be to attack the consumers and directly reduce consumption. It works really fast!

I like to look at history for lessons about cyclical changes – things like changes in world domination, plagues, technological step changes, societal evolution. Nothing is new under the sun, a wise man once wrote.

Now I am not a sci-fi writer even if my readers think I am prone to flights of fancy, and I have developed a sceptical opinion of both religion and philosophy (I am too prosaic), so will stick to observing what is happening and what might follow.

What is happening right now is that all over the world nation states are dictating what people and businesses do. Like they usually do in China.

Everyone in the UK who wanted to privatise the NHS now loves it to bits, especially those with a fever and a cough (they say there are no atheists on a sinking ship).

Decent business owners are directing their facilities to help out and the way companies react now will have long term impacts on their future prospects with consumers.

Politicians who pursued austerity to the point of (probably) killing citizens are now endorsing huge amounts of government spending and libertarians who usually want to inhibit the government’s ability to keep an eye on what we all do are not batting an eyelid at the passing of unreviewed legislation to grant powers even Mr Putin would be happy with!

‘Safe’ investments in high quality bonds or fixed interested securities and even gold are being sold in huge amounts, with the only asset in demand being hard currency (probably US dollars). Portfolios whose diversity depended on the classic equity/bond mix are losing less money than the equity markets, but still losing money rapidly. Cash is king.

Unprecedented is an over-used word, but in this case it is the right one. The financial aspects are not a surprise but the political and social aspects are new to everyone who has not lived through a war.

What will that mean for the future?

History does not repeat itself, but it often rhymes, attributed to Mark Twain but probably a contraction of a more complicated analysis he made. It’s a good point nonetheless.

Of course until we see a slowdown in the rate of infections, we can’t realistically assess the future, because we have no sensible timescale nor can we measure the damage.

But we can expect the relative status of the state to move back towards the level we saw after the second world war.

Well governed businesses will more likely survive than the ‘share buyback/fat directors’ bonuses’ businesses that may have been stock market darlings until now. So the mix of interests and actors in the financial world will be different, just as it was after the 2008 crisis.

That means we as investors need to think very carefully not just about the countries and sectors we invest in (at decent prices), but to focus on the sort of companies, especially in terms of sustainability and governance. And I would add another letter to the ESG acronym – T – ESGT, for environment, sustainability, governance and tax paying.

All the borrowing we are now seeing will potentially go into asset prices if governments don’t change their tactics on taxation. I think this time they they will expect a payback from business for preserving the daily heroin fix of consumption. And they may even be supplying the ‘methadone’ of public spending as a substitute.

It probably goes too far to say that capitalism is going into rehab but it will need to moderate its habits.

Play dead?

20th March 2020 by Mark Potter Leave a Comment

I am probably being very cheeky criticising the august members of the Bank of England Monetary Policy Committee, but I am not alone.

Their recent actions strike me as being like an attempt to fight a grizzly bear with your camping cutlery tool set.

In the current situation, which is scary but if handled well might be very temporary, it would be better to either adopt immense confidence or play dead and do nothing.

As it is they are just going to get a bent knife and a more hostile threat.

Monday mashup – Desperate measures?

16th March 2020 by Mark Potter Leave a Comment

This morning a coalition of central banks in the most influential countries in financial market terms has announced a huge package of liquidity support and lower interest rates, yet markets have opened with sharp falls.

This is for much the same reason as when I wrote my blog entitled ‘Fed mis-step?’. The dramatic scale of the assistance package prompts market participants to think that the situation is utterly desperate.

I think the news will remain bad for a while, but they say that it is always darkest before dawn.

On the other hand, at times like this where there is overwhelming systemic risk, fixed income assets start to lose value rather than offer their usual diversification characteristics, because no-one wants to buy anything. That creates a liquidity crisis, which is rather like throwing a tool bag of spanners into the global financial system. So the authorities have to try and avoid that and their actions today are consistent with that threat.

My current assessment, which of course evolves as the world reacts to the potential progress of the virus, is that equity valuations will keep falling until there is evidence that the drastic preventative measures have worked.

That means that share valuations will likely be the most ‘over-sold’ they have been in my lifetime at some point and if the virus recedes, investors with cash will need to act quickly to pick up bargains.

It has to be remembered that it is the potential threat of a massive pandemic that is driving negative sentiment – the actual number of cases is very small relative to population and the number of deaths is minuscule as a proportion of populations – at the moment. So if the illness caused by the virus is more or less contained within the resources available, which will vary from place to place, the eventual relief will be massive.

Of course, this virus may be the start of a long term fundamental change in human activity. Consumerism has become the opium of the people, succeeding religion in Marx’s aphorism and capitalism is now about 70% driven by consumption. If that falls away permanently, a recession would be truly structural and last a long time.

Such major structural changes are in fact normal – think of how the world differs from that of the Victorian era, the interwar years or even the 1960’s. The current cycle of economic restructuring and resource sharing began in the 1980s in my judgement.

One could propose that global financial systems are in the end always regulated by social or human issues and that the returns to capital had been lately pushed to out of proportion levels relative to other stakeholders, like ordinary people and the environment. That is not to propose that there is better way of managing economic resources than capitalism – just that the balance of interests has been due for a correction for a while.

Do dead cats bounce?

3rd March 2020 by Mark Potter Leave a Comment

No idea, personally! The phrase ‘dead cat bounce’ can usually be found across the financial pages of assorted media at times like this. I hate the phase because I have a character fault of instantly visualising what words mean without thinking, so it makes me feel rather sad about a cat.

The phrase is getting an airing today because there have been promises from financial institutions, notably the IMF, to pump prime the global economy to avoid a Covid-19 epidemic induced recession. That meant markets jumped up a bit after their heavy losses, so commentators want to know if the issue is fixed (pretty obviously not!) or if this market pick up is just a short term trading behaviour – market players closing short positions, topping up holdings to lower average costs and so on. Or just not being very experienced – there as many duffers amongst investment traders as any other group of humans.

My experience is that one does not get a V shaped recovery from a set back caused by genuine, seriously threating negative events until the worst of the news and the consequent impact is more or less understood. Generally markets will move to well ‘oversold’ values (losses that are more than really justified) first and we are not in that situation yet.

Furthermore, any remedial action needs to be seen as powerful and long term.

I think neither of those two criteria are met: we really don’t know that the virus can be contained and will die out, nor have central banks got much scope to cut interest rates, buy bonds and so on. They have done all that already – the economic antibiotic/anti-viral of choice is not now so effective.

Governments have also spent their ‘rainy day’ reserve money on tax cuts and politician led (ie get me re-elected) spending in many developed economies, not least the USA and UK.

My view is that things will get much worse before they get better, but I never claim to be a prophet (I am too optimistic to be Jeremiah or Cassandra). I am looking at history and assessing probability.

If I am wrong no one will be upset as they see their portfolios revalue back up – me included.

However, if you rush out and buy stocks or funds now and I am right, and I do think history is on my side, you will be disappointed. You would lose out twice – on the devaluation of your holdings and because you have no money or less money to buy much cheaper holdings later.

In summary my personal view is that this is merely a sinking market grabbing a plank that can’t carry its weight and the risk of drowning has not gone away. Time will tell, as ever!

As anticipated…

13th December 2019 by Mark Potter Leave a Comment

Britain Backs Boris (except is was actually England). More likely Can’t Countenance Corbyn.

I personally don’t like surprises, being a planner, but was never going to get NotHarry drawn as Scrooge!

It matters not very much why the Tories have their majority for investors, because the key consequence is the probability of getting an actual Brexit is now that much greater. What that means in the long run is for us to ponder.

The Pound has climbed in value, which will devalue those parts of our portfolios in other currencies, as least for a short while. Fortunately there is good news on the US/China trade talks to compensate. European markets also seem pleased with the prospects of clarity on Brexit.

To balance that, the real UK domestic stock market (ie outside of the FTSE 100) has shot up early today, again as I expected, benefiting holding in UK smaller companies funds and probably value funds too.

We now need to think about what happens over the next 12 months. The first step in breaking the deadlock in British politics and what was oppressing the British economy is now past. What comes next could be quite different to what the electorate is expecting. I will put on my thinking hat.