Capital markets 101
All the basics of how and why investment work
Welcome to this Spring Break edition of Contention. Don’t worry, we’ll be back with the latest dissident business news next week.
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Contention takes brevity seriously -- it means respecting your time as a reader. But that also means it can be hard for us to find the space to explain how and why the basic mechanisms of the financial system work. We’re on break this week, so we’re going to dispense with brevity and lay it all out.
We promise it will not be a habit -- think of this as an evergreen encyclopedia for our growing community.
How capital works
First things first: capital animates more or less every financial and economic institution in the world today. Capital is money that can turn itself into more money.
How does that work? On the most basic level, capital buys things that it then re-sells at a higher price. Not all of these processes are created equal. Speculation, for example, means buying things without any intention of adding any value to them and then selling higher because of new demand. This is a zero-sum process for capital as a whole, however, as money just moves from one pocket to another.
Real investment means that the total stock of capital grows itself by purchasing materials, tools, facilities, and labor power, combining them to make new, more valuable products. The dead materials can’t add any new value to themselves, but human genius and effort can -- capital grows by pouring labor power into material inputs.
At the heart of the process is a sort of arbitrage -- the act of buying and selling the same asset under different conditions, at different prices, pocketing the spread. Here’s an awesome example using pizza. In general, capital buys the use value of labor power (the value it adds to the dead materials) but only has to pay for its exchange value (the price workers are willing to sell at, wages).
This means that all things being equal, businesses want to wring as much productivity -- output per unit of labor time -- as they can out of workers while paying them as little as possible. Political pressures make major wage suppression difficult at home, so U.S. capital accomplishes most of its valorization in so-called emerging markets.
Important fact: the investors who own the capital are usually not the entrepreneurs actually making it grow -- buying materials and hiring workers to create value-added products. Capital markets exist to allocate investment dollars to the businesses that need them to recreate and develop our economic system.
Investors allocate capital in these markets in order to maximize returns, the level of growth they expect from the investment. Returns are then a function of profits, the difference between outlays (expenditures) and revenue (total sales) for a business. Profits are also called earnings, and because earnings are the final outcome of revenue minus all expenses, you’ll see revenue referred to as the “top line” number for a business and earnings as the “bottom line.”
How debt works
Investors deliver their capital to businesses in two basic ways: debt and equity.
Debt is the more important of the two, even though the stock markets -- i.e. equity markets -- get more attention. This is because while there are many businesses that never sell any of their equity, virtually every business incurs debt at one point or another. How markets are pricing debt has consequences for enterprises -- and workforces -- large and small.
Why does every business need debt sooner or later? Because debt is the process of pulling future money into the present, and almost every business has some moment when its expenses and income arrive at different times. Debt allows the business to spend tomorrow’s money today.
Lenders, also called creditors, earn return on their capital outlay by charging interest. Two primary factors determine how much interest they charge:
Risk: the less certain the repayment, the higher the interest rate.
Inflation: prices tend to rise over time, and creditors want to ensure that their money will have the same purchasing power when they get it back.
There are two main vehicles for debt: loans and bonds. Most of us have taken out loans -- in fact, most of us are still paying on some of them. Bonds are a form of security, or a tradeable legal claim on some piece of property. Governments and larger businesses sell bonds at a certain price and at a specific interest rate, also called a “coupon” or the bond’s yield. They agree to pay that yield on a regular basis until the bond reaches maturity, at which point they repay the principal. Bondholders can sell their bonds to others above or below “par” or the face value of the note.
You may have seen us say that bond prices move inversely to their interest rates. Here’s why:
If you bought a bond at a specific price and rate, but yields overall went up afterwards, nobody would pay you face value for the bond -- they could just buy a new one and get a better rate. You would have to lower the price to find a buyer: rates went up, prices went down.
If, however, yields dropped after you bought the bond, the higher rate you’re getting paid would be a great deal for other investors. You could sell it above face value because of that increased demand: rates went down, prices went up.
It works the other way too. If bonds are in demand, issuers can get away with paying less interest and still attract buyers. If nobody wants bonds, issuers need to offer more interest to entice them. This phenomenon is extremely important for understanding market moves.
With the exception of high-yield or “junk” bonds issued to businesses with risky credit, bonds are considered the safest type of investment, especially U.S. Treasury bonds, considered the ultimate risk-free asset. If economic fortunes are looking rough, investors will flee to the safety of bonds. This means higher demand, higher prices, and lower interest rates. This is how rates reflect predictions for lower growth.
When business is booming, investors move out of bonds and into stocks, reducing bond demand and raising interest rates. Again, this then mirrors market expectations for the growth to come.
This has another important implication for markets: the concept of present value. This concept can be confusing, but remember that debt is all about bringing future money into the present.
If I want to have $100 a year from now and interest rates are 5% a year, I need to have a little more than $95 today.
If rates are 10%, on the other hand, I’d only need $90.91 to have $100 in a year.
Next year’s $100 is worth $95 today in the low rate environment, but only $90 in the higher rate situation.
So higher interest rates mean that today’s money will be worth more in the future, therefore its present value is lower. Lower interest rates mean that present value is higher.
How the Fed works
All of this adds up to significant power for the most important lenders of all: central banks. The Federal Reserve or Fed is the U.S. central bank, and it has three main levers of power over lending:
It sets the federal funds rate at which banks lend to each other, the floor for all interest rates in the economy overall.
It can buy or sell Treasury bonds to create bond demand (raising prices, dropping rates), or to increase supply (dropping prices, raising rates). Since 2008, the Fed has also bought mortgage-backed securities, taking mortgage risk off lender books, allowing them to charge lower interest rates. During the coronavirus crisis, it also bought private debt for the first time ever.
It regulates banks and can increase or decrease their reserve requirements and leverage ratios -- the risk they can take on -- in order to stimulate or suppress lending.
Congress has given the Fed a dual mandate: encouraging full employment and ensuring price stability. All of those emergency actions were in the pursuit of price stability when liquidity crises threatened to seize up markets. “Liquidity” is another way of saying money, and since buyers are the ones bringing money to a transaction, liquidity crises just mean that everyone is selling and no one is buying. The Fed stepped in to buy things, keeping markets operating.
These policies have extended after the initial emergencies, holding down interest rates and adding trillions of dollars in securities to the Fed’s balance sheet, further suppressing interest rates and propping up present value.
How stocks work
This brings us to the other main class of capital investments: equity. Equity investors use capital to buy partial ownership of businesses, and this ownership then entitles the investors to a portion of future profits.
There are a number of ways to sell equity -- venture capital, for example, comes in at the early stages of a business and provides needed investment in return for substantial chunks of the company.
Stocks are the most common and important form of equity investment. Companies can designate a portion of their equity to put on the market, break it up into shares, and sell that ownership to anyone who wants to buy it. They only raise capital when they issue the stock, with the first-ever issue known as an initial public offering (IPO).
Lately, a different method of going public has exploded in popularity: special-purpose acquisition companies (SPACs) or “blank check” companies. A group of investors takes a company with no operations public, uses the stock sale to raise capital to buy a private company, and then completes a reverse merger to bring that company public without the need for an expensive, rigorous IPO.
Issuing stock after a company has gone public is tricky, because doing so means that the total supply of shares -- the stock’s float -- grows, dividing the total value of stock (its market capitalization) into smaller parts. This equity dilution does not make investors happy.
Equity is all about claiming future profits, which is why the stock market is forward-looking, and a company’s valuation goes up and down with its expected future performance. This is where interest rates and present value become very important: higher interest rates mean lower present value, and so stocks should be generally priced lower. Lower rates, on the other hand, should mean better stock prices. This is why Fed interest rate suppression has led to the biggest bull market in history.
But not all businesses are the same. A company’s price-to-earnings or P/E ratio divides its share price by its current earnings (profits) per share. The higher the ratio, the more of the company’s value is coming from future earnings. Companies with especially high P/E ratios are often called growth stocks, and they tend to be companies reliant upon big innovations -- Tesla, Nvidia, Apple. Their profits may be lower today because they are pouring their money back into research and high-tech equipment to win big tomorrow. Higher interest rates can disproportionately impact their stock price.
Companies with lower P/E ratios are usually termed value stocks, because their stocks tend to reflect current or near-term performance. Utility companies, energy companies, and financial institutions are all less affected by higher interest rates, and may even benefit from them.
Equity investors collect their share of company profits in one of three ways:
The company re-invests in its main business operations: more property and output by definition means a more valuable company and a higher stock price.
The company issues a dividend, a cash payout to shareholders.
The company buys back investors’ stock, delivering cash in return for equity and concentrating the company’s value in fewer shares, the opposite of dilution.
Companies report their earnings and other detailed information for investors every quarter. These reports tend to bunch up in the middle of the fiscal quarter, called “earnings season.”
There are about 3,500 publicly traded companies in the United States alone, but when people refer to the “stock market” they usually mean one of the major indexes of stocks. The indexes try to convey information about the market as a whole. The three most important:
The Dow Jones Industrial Average -- a price-weighted average of 30 large companies selected to represent the industrial economy as a whole.
The S&P 500 -- a capitalization-weighted average of 500 large companies selected to represent the stock market as a whole.
The Nasdaq -- a capitalization-weighted average of most of the stocks traded on the Nasdaq stock exchange, the trading floor where shares are bought and sold. At 50 years old, Nasdaq is younger than the New York Stock Exchange and it has a higher concentration of younger companies, exposing it to more tech enterprises.
Capital investors have also invented ways of hedging their investments, betting on the opposite side of their main play to stem any losses. These hedges can be lucrative investments in their own right. The most important hedges are stock derivatives or options.
Let’s skip over all the derivatives for bonds, commodities, currencies, and other investments for now. Stock options are the most important -- they allow investors to bet on the future price of a stock.
A call option gives the investor the right to buy or “call” on the stock in the future at the present price, betting that the price will go up.
A put option allows the investor to later sell or “put” the stock on the market at the present price, betting that it will go down.
Concentrated options buying -- especially of call options -- helped fuel parabolic price rises for meme stocks earlier this year.
One final piece to the interplay between debt and equity and the Fed’s role in the economy: large institutional investors like pension funds, endowments, and insurance companies must produce yield to meet their obligations. When interest rates are high, they will allocate a larger proportion of their capital to bonds.
When rates are low, the only way to secure any returns at all is to take greater risk, allocating more money to stocks. Those Fed interventions have pushed interest rates much lower than they would have been without its extraordinary action. Many believe that this has underpriced risk, leading to new rounds of speculation.
Why things aren’t working
This is a good place to wrap up for now, with one final point: internal capital allocation in firms always tends to invest in more productivity, which means more expensive technology. But remember that it is labor power that allows capital to grow, not the dead materials. Each individual firm can gain a temporary productivity advantage, but in the system as a whole capital is increasingly misallocated, creating secular -- i.e. long-term, beyond any specific business cycle -- downward pressures on profit rates.
This too contributes to a scramble for yield, outsized risk, and further misallocation of resources. State intervention becomes increasingly necessary, and in a capital-driven system the apex conjunction of state and capital drives that role: central banks.
We are somewhere in the midst of that accelerating cycle. Understanding some of the basic landmarks in its development can help us stay oriented. We hope this Spring Break edition of Contention has made that easier for you.
Disclaimer
Our only investment advice: Keep it short.
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