Let’s be honest with ourselves: people are prone to religious determinism, simply put, to shamanism. What does this mean?
In short and dry: people interpret phenomena occurring with a certain and observable periodicity as regularity. But what is quite sad, people establish cause-and-effect relations between such regularity of phenomena and their consequences, where the cause is the phenomena and their conditional regularity, and the consequence is any event that follows the happened phenomenon. It is boring, tedious and for egg-headed scientists to understand the causes of phenomena themselves, and scientific knowledge, as we know from numerous surveys in various countries from Myanmar to Canada, is trusted by only 40% of the population on average (although nobody refuses iPhones, electric cars and fridges: apparently all this was produced and invented by divine Providence).
The famous statement “Correlation is not causation”, which means that the observed regularity is not the cause of future events in itself, should be remembered by many market “respected” and very popular analysts, whose fundamental knowledge of macroeconomics and social processes leaves much to be desired. It is very convenient to track seasonality, trends and other events that are repeated in one way or another, and then issue forecasts based on them without really looking into the reasons. Such a practice leads to collapse sooner or later, which is generally confirmed by investment statistics. Everything is the same as in life.
This kind of correlation statements includes such nonsense as “gold is a protective asset” or, for example, the statement, which is only partially true, that the market always outperforms the real economy. Based on the latter statement, let’s try to talk about the market outlook.
Throughout the actual eight months of 2023, we have seen the U.S. stock market trend upward. And throughout all this time, the same narrative has been pouring in uninterruptedly from all significant sources: analysts of investment houses, media, influencers like Michael Burry or the now quite marginal and ridiculous Ray Dalio, the essence of which is the same: the bubble is in place, tensions are rising, the market will collapse any day now, dedollarization is gaining momentum, recession is on its way, inflation is killing. Both by themselves and in the context of global macroeconomic processes, the recent statements about the harm of inflation and the inevitability of recession are certainly true, even students can understand this. Nevertheless, the market has grown and continues to grow while such commentators are pouring water in and out of the glass with pleasure and faith in their shamanism.
Claiming without qualification that the market outperforms the economy is amateurish nonsense. The market is an active reaction of agents, consisting of the assessment of events that have already happened and their individual expectations, which are formed under the influence of a mass of subjective and objective factors. For example, households have one conditions and needs, while pension funds have another, mutual funds have another, etc. It is impossible to talk about a single market reaction; such talks demonstrate elementary ignorance and low qualification of such analysts and commentators.
This statement about the market as a leading indicator is based on an absolutely anthropological thesis, true in itself, about expectations: agents act on the basis of assessments of what has happened, expectations of the future and taking into account their interests and available resources. But in this sense, market fluctuations in asset values are an actual illustration of the difference in goals, expectations, and capabilities of tens of thousands of agents. And in order to analyze the market, it is necessary to analyze the sources of these variables as a whole, rather than the patterns of behavior of agents who interpret these variables according to their individuality.
So, the market is up almost 20% in eight months, even though every day during that period was predicted to be the last day before the crash. Moreover, the stock market continues to rise, and talk of its imminent collapse continues to circulate in the public professional space.
Here I will try to outline the main and basic-causal factors that point to an increase in the probability of further growth, without predominantly touching on macroeconomic and socio-political nuances and assessments.
1. Aggregate inflation is declining. Obviously, such a sharp and significant appreciation of credit and money will inevitably reduce economic activity one way or another. I will not touch here on the valuation aspects of this phenomenon and its causes: firstly, I have discussed it many times before, and secondly, it is too important in this context.
Producers shifted their costs to the consumer, reduced investment costs and reduced output. On the way out, production inflation went down, while consumer inflation continued to rise. Now consumer inflation has also taken a southward course, because the difference between the intension to spend in the face of depreciating money and to have something useful that will cost more tomorrow and the rising cost of credit has become too great. Savings are running out and credit is becoming too expensive. The FED can be satisfied with its forced and linear policy: economic activity is really being destroyed, and thus price growth is being slowed down.
2. Inflation braking hints at a braking of rate hikes as well. This does not mean that the FED will not raise them, it means that the FED will reduce the frequency and pace of increases. This is good news for long duration assets: the technology sector, the venture capital market, long government and corporate bonds. The reason is obvious: the discount rate of future income, whose aggregate potential determines value and price, will stop rising, hence the valuation and investment appeal of such assets will improve.
3. Improved estimates of the future value of long duration assets will mean that the largest institutional investors – funds, pension funds, insurance companies – will need to increase allocation to these high-risk assets. That is, the inflow of money into these assets will increase, which will raise their price.
4. In the composition of inflation, 32% is occupied by real estate prices, which are late in decreasing relative to all other components for an obvious reason: real estate is regarded as the last solid asset and shelter from economic difficulties. However, with rising credit rates and a simultaneous inflationary slowdown in other commodities, the willingness and ability to borrow or spend the last of one’s savings is diminishing, and real estate prices will inevitably fall, albeit last, with the usual lag of 6-9 months. This will give impetus to general disinflation going forward.
5. The inversion of the yield curve has resulted in over $5.3 trillion parked in money market funds, having been pulled out of risky and long duration assets. This money is the proverbial “liquidity is the future fuel for stock market growth when the apparent return to Keynesian stimulus by the government is in sight – because the authorities don’t want to do anything else.
Given the current political vector and bidenomics with its hyper-socialism, a repeat of QE is an inevitable event. But investors are not political activists, investors make money to finance businesses in any environment, wherever and whenever they can. Finding and getting the best deal has never been abolished. So $5.3 trillion is what the market will grow on and with which it can keep from extraordinary sell-offs when it sees the difference between the cost of money and investment income widening again in favor of investment.
6. When we are told about the current market bubble (here we want to remember Nobel laureate Eugene Fama, who spoke about the actual absurdity of this term in a market economy, the only question is whether we really exist in a market economy now) they talk about the fact that the top 7 tech giants have provided returns for the S&P500 in 20203, while all other stocks in the index are in a deep …. hole. Ok, let’s take a closer look at this.
Indeed, the top 7 tech giants – cache accumulators, it must be said, which have actually turned into another type of investment institution along with pension funds, insurance companies and hedge funds – grew by an average of 58% in 2023. At the same time, the other 493 companies in the index grew by an average of just 5%. Many analysts present this as market weakness.
However, if we dig deeper, we see that over the past 27 years since 1995, the S&P500 has grown at the expense of its top 10 constituent holdings – the leaders in capitalization – which have been responsible for an average of 32% of the index’s total return. There is nothing dramatic about the distribution of today’s index companies’ contribution to total return. It only suggests that the divergence in returns will shrink sooner rather than later, implying the need for careful search for alpha and more concentrated rotation management in various assets.
7. The analyst consensus says that the current price-to-earnings ratio of all S&P500 companies, i.e. Price-to-Earning, is 19. This is a strong overvaluation of stocks compared to the 10-year average forward P/E of 17 and the five-year average of 18.6.
However, if we take the P/E of the 493 companies following and excluding the top-7 giants, the P/E ratio is 16, far less than the overall forward P/E of the index now and less than the five- and 10-year averages.
Question to consensus analysts: if you talk about market weakness (which, as it seems, is not the whole truth) and point to the growth of yields actually due to the top-7 capitalization giants, why do you not exclude them in your estimates of comparative multiples? Either this is cognitive distortion and fitting facts to belief, in other words, the usual shamanism of “believers” crowding in, or simple manipulation, which is nothing new.
8. The cost of servicing the debt is becoming too high for the U.S. government. The balance of interest of “less money – lower inflation” versus rising interest on liabilities and the inability to finance spending with new issuance is beginning to tilt toward another round of quantitative easing in all its forms – from increasing the balance sheet of the FED by buying new debt to lowering the lending rate and winding down the scale of reverse repurchase agreement (RRP). When I say new issuance, I don’t just mean debt issuance, but obviously money issuance as well, i.e. an actual increase in the money supply, since a significant portion of the debt is being bought back by the FED.
9. Finally, the most important nuance that should not be forgotten: a Keynesian government of leftist discourse is in power, exploiting many of the insane dogmas of Modern Monetary Theory – MMT – and therefore the most leftist since Roosevelt. This government has persistently peddled its greed and expanded government spending and, in general, the government’s mandate to intervene in market economic processes. This did not happen yesterday, and economic agents are now in direct and dense dependence on the will of the state, or more precisely, political rent-seeking entrepreneurs who are relentlessly increasing their power through budgetary control.
The good news for markets is that election cycles have not been canceled, and the rules of Keynesian dirigisme (and in fact MMT doctrine) must inevitably be followed. The government will be forced to preserve voters’ assets and prevent them from depreciating “head-on” by propping up the aggregators – banks, pension funds, insurance companies, ETFs, and so forth. And the government will inject liquidity into the market at the first opportunity. After all, the credit needle and consumption beyond productive capacity, not at a reasonable level of advance (for example, according to Friedman’s rule), but with advancement to extra limits, when it is physically impossible to cover the loan at the growing cost of its servicing, is the main guarantee of the government’s success and the main means of preventing voter dissatisfaction.This policy is another and willful movement of the problem to tomorrow, another transfer of toxins to the next generation. Leverage in everything is the essence of those ultra-Keynesian policies being pursued by the government led by the current Administration.
That is the essence of things. And precisely because of the reasons described above, the markets are growing and, more precisely, investors with different capabilities, valuations and expectations are reacting more or less rationally, relative to their goals and conditions, to the actions of the state.
What should be the appropriate exposure to risky or protective, short or long, liquid or not so liquid assets is certainly an individual decision of any investor, institutional or private. However, the more this decision is based on sound assessments of real cause-and-effect relationships, rather than on assessments of correlations and patterns (on which, in fact, all algorithms are built), the more investors adhering to such an approach will outperform their competitors and, accordingly, earn higher returns. This is why algorithms dramatically lose their effectiveness in an environment where alpha must be mined.
There is no market bubble. There is an economic reality that corresponds to the political discourse, and both components are absolutely homogeneous with respect to each other. Whether or not to use this reality for one’s own purposes is up to each individual, depending on the moral elasticity of each actor.
Investors are not the saviors of the world or fighters for justice. There is no morality in the market. Nor should there be. An investor and asset manager must live in the circumstances offered, with eyes wide open, without fear of being labeled a relativist. It is such investors who have increased the value of their assets this year and do not bemoan bubbles and tomorrow’s armageddon.
After all, Nathan Rothschild’s phrase “Buy when there’s blood in the street, even if it’s your own” is one of the absolute causal and empirical truths for anyone who wants to be successful in business, much less in investing.