No really, why are stocks still rising?
The world is on fire, so why are markets so chill?
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A reader sent us a brief, important request this week: “would like to see more on why markets are up when the world is on fire.”
This is, in many ways, the theme of almost every edition of Contention, and we’ve pulled it apart a number of times:
Dire economic straits can be good for big business as workers are less likely to press for higher wages, and competition goes bankrupt.
Investment prices are all about expectations, and the big losses businesses keep reporting aren’t as bad as predicted.
Those forecasts aren’t rational, and investors are arbitrarily assuming the worst can’t happen.
Central bank action is swelling asset prices -- not like a bubble, but like a tumor.
But let’s elaborate the reasons for this disconnect yet again, because new explanations emerge all the time. Multiple phenomena are causing this contradiction, all part of the same basic force: state manipulation of markets to protect concentrated wealth.
First, let’s be clear: “markets” are not up in every sense. The major indexes are up: the S&P 500 and Nasdaq are already back at record levels and the Dow is not far off its all-time-high. But this is a reflection of the exceptional performance of very few components in each index, not broad-based gains. As of last week:
Half of the stocks that make up the S&P 500 are down for the year still, only 4% of its components are driving all the record gains.
The digital oligopoly -- Facebook, Apple, Amazon, Alphabet, and Microsoft -- are up 37% this year, but without them the S&P 500 is down 6%.
Fully 64% of S&P 500 components are underperforming the index, and they’re missing it by an average of 22%.
All-country stock performance minus the S&P 500 has done nothing this year.
This international perspective highlights another crucial, largely unreported aspect of the alleged stock rally: pricing the S&P 500 in euros instead of dollars wipes out all of its record performance.
The bull run is closely associated with the devaluation of the dollar, because inflated liquidity is being blasted directly at equity markets.
Remember: stock prices reflect discounted future cash flows. Cash flow means income left over after expenses, so if investors have reason to believe that income will increase or expenses decrease in the future, stock prices move up. Monopoly pricing power means higher income, suppressed wages mean lower expenses, so large-scale bankruptcies and unemployment can actually benefit large firms.
Earnings expectation beats have moved stock prices upwards, but only 1% of that outperformance has come from increased income. The rest has come from cutting expenses, i.e. the very layoffs and cancelled purchases that make the rest of the economy miserable.
Because forecasts around cash flows aren’t certain, prices take into account a risk factor closely associated with interest rates. The larger the risk, the bigger the discount for the future cash flows, and the lower the stock price goes.
The Federal Reserve has taken emergency action this year to suppress interest rates. It dropped the rate it charges banks to near-zero levels, but more importantly it bought up trillions of dollars in bonds -- including corporate bonds for the first time.
Bond prices and their interest rates move inversely to one another, so this single-payer bond market bids up prices and sets a ceiling for rates. This squeezes investment out of safe assets, and makes riskier investments -- like stocks -- artificially more secure-looking.
The implicit -- sometimes explicit -- assumption is that the Fed won’t let markets crash for long. We now have central planning for capital, so why wouldn’t you buy?
But if the cost cuts that drove earnings beats in the last quarter have now hit bone, if failed fiscal stimulus means a big drop in aggregate demand, or if accelerating political chaos raises volatility too much and markets do drop, what can the Fed do? Their only card left may be to intentionally depreciate the dollar in even more aggressive ways.
That is to say, the most likely outcomes of our present condition are that things keep burning like they are or the people that started the blaze will throw gasoline on it. Either way Contention will be here to sound the alarm.
Our only investment advice: Don’t watch the RNC either.
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Photo credit: Pxfuel