what I think stock prices are signaling

A simple, but very useful, way of looking at financial markets–particularly those in the US–is that:

–they quickly incorporate new information into prices, and

–at any given time they accurately reflect (or discount) consensus expectations about the future.

discounting the future

For bond market professionals, a breed I’m happily ignorant about, it seems to me the future is at most a few weeks away. For the stock market, where I actually do know something, the what counts as discountable depends on circumstances. In a bullish phase, which we’ve been in for about 18 months, especially so after voters booted Trump out of office, the future can mean as far ahead as three years. In a bearish phase, when things don’t look so good, the future can be as little as six months.

the consensus doesn’t mean everyone

Academic finance theory is based on the nonsensical proposition that everyone is in the same financial position, has the same risk tolerances and has identical information. The reality, I think, is that new information only gradually, sometimes even very slowly, filters into markets (meaning affects stock and bond prices). I think it’s possible to take the temperature of markets, and sense their near-term direction, by figuring out what new things they are beginning to digest.

what’s percolating in now

It’s interest rates, which is an enormous factor.

Everyone knows that when you buy, say, a 10-year government bond (it’s actually called a note–don’t ask why), you expect to get: protection against inflation; a return that’s somewhat higher than that (i.e., a real return), to compensate for tying your money up for so long; and your money back when the bond matures.

If we assume the trend rate of inflation is 2%, then the interest payment on the 10-year should be, in concept anyway, 2.5% or so, and certainly more than 2%. The actual yield as I’m writing this is 1.55%, up from 1.28% a couple of weeks ago–and from 1.19% in early August, when fears about the delta variant/anti-vax pressure from red state politicians were the highest.

Why are rates so far below where they “should” be? Partly market fears about covid, but mostly because the government has been keeping rates extra low to dampen the negative effects of the fragile economy of 2018 – present.

Anyway, the Fed has been signaling that it intends to start the process of removing extra stimulus soon–and, in fact, more quickly than both it and the consensus had thought a month or so ago. The first step in the process, which has been clear for a long time, will be to gradually remove the downward pressure it is exerting on the long bond. Next, in the middle of next year (?), it will begin to raise short-term interest rates. Two ultimate goals: to restore positive real yields, and to do so in a way that allows inflation to stabilize at 2%+.

stock market implications

Rising rates affect stocks in two negative ways:

–they cause PE multiples to contract, as fixed income becomes a more attractive alternative (my stress would be on more rather than attractive, because I can’t feel my heart pounding at the prospect of 2.5%/year), and

–even the mild headwind this will create will likely cause stock investors to shorten their investment horizon from being willing to pay for earnings, say, three years in the future, to maybe 24 months.

There is a counteracting positive: presumably the reason the Fed is picking up its stimulus removal pace is that it detects the economy has a greater head of steam than the consensus realizes. Therefore, for at least some companies, earnings will likely be surprisingly high.

Finding these winners will require at least some stock-by-stock security analysis work. The market’s immediate reaction has been what it usually does in these situations–to sell off any stock with a high PE based on current earnings. Worst hit have been names like ZM, down by 23% in a market off by around 4%, which are perceived as pandemic/stay-at-home beneficiaries. Interestingly, in contrast, another s-a-t stock, ETSY, is lower by only a tad more than the market.

At some point, however–I’d make a guess, but I’m always too optimistic in situations like this–Wall Street will shift away from this baby-and-bath-water strategy and look past the damage to PEs to find stocks with superior earnings prospects. I think it will be very interesting to see whether Wall Street or Reddit will drive the rebound. I’m genuinely unsure which it will be. One indicator may be the relative performance of the ARK funds, whose all-bat-no-glove strategy contrasts sharply with traditional money managers’ some-glove-no-bat approach.

signal vs. noise on Wall Street


In 1991(?) I encountered a political analyst just hired by Prudential Securities. At that time he was writing that neither major political party had particular relevance for most Americans any more. The Democrats, he said, had a cultural agenda but no economic one. The Republicans didn’t believe in much of anything, but were moving toward an unholy alliance with the religious right that the party would come to regret. Clients found his work interesting but irrelevant. Just noise.

In 2021, we have Heather Cox Richardson, who teaches 19th-century American history at my alma mater, Boston College, describing today’s Republicans as the 19th-century southern pro-slavery Confederacy redux, intent on stripping voting rights from minority groups. Congress seems incapable of addressing aging physical infrastructure, high-cost health care or a weakening education system. And, of course, there’s the Trump-led, Republican-abetted attempt at violent overthrow overthrow of the government elected last November. Kind of like a bad science fiction novel. Stock market implications, if any? …the main potential issue I see is capital flight. I think this is regarded as too far-fetched to be on the front-burner for Wall Street, or at the very least too controversial to be put in print.

On a more mundane level is the continuing misuse of the concept of inflation in the financial press. Inflation isn’t about a one-time increase in the price level. It’s about the situation where prices continue to rise, year after year, often at an accelerating rate. This induces changes in consumer attitudes and behavior. People, and corporations, begin to anticipate continuing future price rises and deteriorating value of the currency and other fixed-income-like assets they hold. They change purchasing behavior, hoarding and buying physical assets they think will retain value rather than holding currency.

Think Russia or Venezuela as extreme examples. The US suffered a mild version of this in the late 1970s. The reality is that we’re closer today to the opposite (and worse) situation–deflation.

Signal tomorrow

Lehman and the financial crisis

It started innocently. Around the turn of the century Congress decided to make home ownership accessible to more Americans, on the idea that owning a home made families happier, more prosperous and more law-abiding. It put Alan Greenspan in charge of supervising more liberal bank mortgage lending but–he later said in Congressional testimony–told him not to look too hard at what was going on.

Banks of all stripes had long since learned that although they might want to hold some mortgage loans on their books the real money would be made by fees from processing loans that would be put into large packages and sold to institutional investors. So they amped up their efforts when they got Washington’s encouragement. Trouble started when the banks exhausted the most creditworthy mortgage applicants. In order to keep the fee income rolling in, the mortgage industry did the following (my analysis/perception of what happened):

–banks lowered their credit standards and began to focus on apparently lucrative “sub-prime” borrowers

–lenders began to take mortgage applications with little credit information on them/independent mortgage brokers began to be, shall we say, less vigilant in putting down accurate information about the borrower on applications

–banks split large packages of mortgages into tranches according to perceived risk levels, using academic theory to argue this magically made all the tranches less risky

–as the quality of these packages deteriorated, issuers successfully pressured credit rating agencies to override their normal assessment protocols and issue over-optimistic ratings

–the financial press reported that toward the end, banks were using bait-and-switch tactics to resell mortgages to institutional clients, showing them one list of mortgage security contents before sale but delivering instead an inferior set. I have no direct knowledge of this. It is the case, though, that at some point these transactions, even involving a US seller and US buyer, began to be executed in London rather than in New York. My, cynical, take is this demonstrates that the banks knew clearly that what they were doing violated the law in the US but was apparently permissible under the “regulation lite” regime in the UK

–in mid-2007, seriously overborrowed consumers began to fall behind on their loan payments and to default. By early 2008, it was clear that despite having laid off much of their exposure to the ultimate dumb money in world banking, Continental European heavyweights, the overall US banking system was in tatters and needed to be bailed out by Washington

–press reports from 2008 show that Washington decided it couldn’t simply bail everyone out and pretend that nothing bad had happened. So it chose Lehman, an avid participant in sub-prime mortgage trading, but not a firm crucial to the US financial system as a whole, and allowed it to fail.

How does this differ from Evergrande in China? We’ll see as the facts about Evergrande come out. As things stand now, Evergrande appears to me to be one company pushing the boundaries of the Party patronage system. Its calculation was that no matter how high its financial leverage might be, the mayors and bank presidents who arranged its loans would continue to provide it with more money. Its mistake, I think, was to make itself so much of an outlier and to borrow large amounts from the individuals who bought its condos. This last likely violated unwritten rules of conduct and made it more of a social threat.

The sub-prime mortgage crisis in the US, in contrast, is, to my mind, not a case of one reckless company, but rather of large-scale, systematic fraud.

shifting gears

Late last year and earlier in 2021 I began to shift my portfolio away from stay-at-home beneficiaries to companies that would benefit from reopening. The stocks I reduced or sold completely were generally the right ones; the ones I bought, however, didn’t do me much good.

I’ve noticed in the past few days that this latter group has begun to perk up. I think this change is for real. How so?

–for one thing, although anti-vaccine propaganda will likely continue, and the human toll from political posturing will likely continue to be high, it’s probably not going to get any worse (as a human being, I hope; as an investor, I’m betting)–the Fed now thinks the economy is strong enough that it can begin to lessen the downward pressure it has been putting on the long end of the bond market and that short rates will begin to rise art a somewhat faster clip than it imagined a few months ago

–temporary Federal stimulus aimed at offsetting some of the pandemic’s economic damage to incomes, has already begun to shrink. Absent action from Congress, it will continue to do so. As/when this tightening of policy begins to affect financial markets, rates may begin to rise–and because of this, PE ratios will start to contract a bit. That’s a bad thing for financial markets. At the same time, however, equity investor interest will begin to rotate away from “story” stocks, where profits are an aspirational goal, toward more conceptually mundane economic-cycle-sensitive ones. That’s because the latter group will begin to show rising sales and earnings–some of them will doubtless be surprisingly good (I’m tempted to write “shockingly,” because that’s the way I think things will play out, but I think that’s too emotion-laden).

In any event, this shift is how I read recent price action.

Evergrande vs. Lehman and Long Term Capital Management (LTCM)

Evergrande hysteria seems to have been a one-day wonder on Wall Street, as investors began to look deeper than over-the-top media coverage to realize that, while a big deal for China, it’s really only a worry for the rest of the world to the extent they’re Evergrande creditors.

The comparisons being made with Lehman and LTCM were headline-grabbing (which I guess was the intent) but way off the mark. I thought I’d write a brief recap of my take on both of these.

LTCM is easier. The important thing to realize is that while there’s tons of liquidity in the trading of the Treasury bonds that are selected to be the constituents of T-bond derivatives (called “on the run”), there isn’t in very similar bonds that aren’t (called “off the run”). Because of this, off the run bonds trade at slightly higher yields than virtually identical ones that are lucky enough to be on the run. For years, investors of all stripes–banks, brokerage houses, wealthy individuals–have shorted on the run bonds, used the money to buy nearly identical off the run ones and held to maturity. Under normal circumstances, this was like picking up $100 bills on the street.

In 1994, a famous Salomon Brother bond trader decided to execute this bread-and-butter strategy on an heroic scale. He founded LTCM, put a couple of Nobel Prize-winning financial academics on the board to enhance the brand, and raised a ton of capital.

Investors more than tripled their money in the first three years. Then came the implosion of the Russian economy in 1998, which triggered a flight to safety–meaning on the run bonds went up in price while off the run went down. Suddenly, LTCM, which was reported to be borrowing as much as 25x it’s equity, was bankrupt.

The “crisis” wasn’t about rich people losing money. It was about how to sell tons of highly illiquid securities that LTCM had (incredibly recklessly, in my view) bought, with nary a peep–that I heard anyway–from its eminent directors. The Fed cobbled together a consortium of banks to hold them and gradually sell them off.

Lehman tomorrow.