Two things that I’ve been thinking about:
- I have a new podcast that I’m enjoying: “Hard Pass”. It’s short and sharp, and one of the most recent episodes is called Amateur Night at the Exchange. In it, Barry Ritholz talks about the craziness of the market: and mainly, how people are paying almost double what they used to for the dividends of low-growth utility stocks. He calls it one of the stupidest plays on the market.
- In addition to that, in the last 24 hours (at the time of writing), the US stock market soared to a new all-time high. Which a lot of people are describing as ‘madness’. Because: Brexit, low global growth prospects, Trump, etc.
I guess what we need to do first here is define what ‘sanity’ is, because madness/stupidity is the deviation from it.
Here is the traditional thinking:
- Investing is full of risk.
- The more risk there is, the less willing I am to make the investment.
- So in order for me to give you the investing money if you’re a bigger risk, you’ll need to pay more for it.
- That is: as the level of risk goes up, so does return that the asset must generate in order to be funded by investor money.
And in this environment, there is a lot of risk #Brexit #lowglobalgrowthprospects #Trump. So you’d expect there to be a lot of return required, right?
Only, that doesn’t seem to be the case at all. In fact, the opposite is happening. The level of risk is what it is, but asset prices appear to be rising.
Sidebar: The Relationship Between Returns and Asset Prices
Just a reminder: there is an inverse relationship between returns and asset prices. I realise that sounds a little back to front, but it’s because the world is a little back to front:
- When we go to a bank, we put our $100 into our savings account, and we expect to earn our 0.2% interest (that’s 20 cents a year), or whatever.
- So in our daily lives, the asset price is fixed at $100, and the annual payout of 0.2% or whatever depends on the amount of money that we put in.
- But in the big world out there, we flip that around. The payout tends to be more constant (eg. this bond has a coupon rate that pays out $5 per year; or this share pays out dividends of 10 cents every quarter), and the asset price adjusts around that to determine what the ‘return’ is.
- It would be like going to the bank to invest your money, and being told “Yes sir, that’s great news. We have this savings account here that earns you 20 cents per year – how much are you willing to put in to earn that?” And because you’ve shopped around, you know that most people are willing to put $100 into the savings account to earn that, so you offer to ‘buy’ that 20 cents of payout each year for a hundred bucks, and the banker agrees, and ta dah! – you’re earning an effective 0.2% return on your savings.
- What that means is: if you’re willing to pay more for that payout (eg. $200), then the effective return goes down (same eg. down to 0.1%, because you’d be earning 20 cents in return for your $200 loan to the bank). And vice versa.
- That is: the higher the asset price, the lower the return.
Back to the world’s craziness
So what we’re seeing in the world: the perceived level of risk is going up, but asset prices are also going up, and therefore returns are falling. Bizarrely enough.
Some possible implications:
- The level of global risk is actually going down, and we’re just too dumb to see it (but the markets are seeing it); or
- The world is crazy (!!); or
- The traditional risk-return relationship has been thrown off balance in the last few years, possibly indefinitely.
Option 1 seems unrealistic, and Option 2 does seem like a pretty logical conclusion. But my bet is sitting with Option 3 (and it’s something that I’ve spoken about before).
Basically, my guess is that we’ve seriously underestimated the impact of Quantitative Easing on global investment markets.
The QE Fallout
At its core, the impact of QE was as follows:
- It drove up the prices of bonds, forcing investors to go outside of the bond markets in the hunt for yield;
- So investors went to the stock markets and bought up equity. They also went elsewhere, but the most remarkable thing during the QE period was the rapid rise of share prices.
If you ask me, that particular rise in share prices had nothing to do with an expectation of future growth, or renewed faith in the consumption capabilities of the middle class, or a massive reduction in global risk. Rather, it was a function of liquidity in the markets, and that ‘hunt for yield’*.
*I mean, no one really can say that for sure. But I don’t think too many people would disagree with that understanding of those market movements.
Now when you have money hunting for yield, then it hunts it down. It bids up asset prices and drives down yields (or returns – they’re effectively the same thing here). And I want to point out that this was intended: this disruption of the risk-reward relationship was what QE was meant to do. It was meant to make it ‘cheap’ for companies to raise capital, because the holders of capital would not be demanding especially high returns for their money. Instead, they’d be prepared to settle for lower returns.
Crucially, there was meant to be a next step in this process. If the ‘cost’ of risk was low, then entrepreneurs and businesses should have been more willing to take on risk. They should have been willing to hire people and expand and so on. QE was trying to create the private sector alternative to the Keynesian expansionary fiscal policies that the world’s governments were trying to avoid.
Only, that next step was never really taken. Which shouldn’t really be that surprising. After all, the private sector won’t generally take risks with cheap capital if the underlying business environment seems anaemic, especially if there’s no reasonable expectation of a quick turnaround. I mean, you don’t invest in a chicken farm when you live in a world of vegans, no matter how good a rate you can get on the loan. It just doesn’t make sense. The risk is just too high relative to the potential return, ironically enough.
So now we sit in a world of artificially-inflated asset prices – still waiting for that to translate into better jobs and wages for the middle class (once companies seize the moment to raise cheap capital, expand and hire the middle class). But it hasn’t happened yet.
And to be honest, I’m not sure if it’s even reasonable to expect that it will. Fundamentally, the investors that have been forced to hunt for yield now have two options:
- They could be the activist investors who encourage even more risk-taking in an already-risky global environment; or
- They could settle for lower, safer, returns on their money – especially as they’re low on alternatives.
And I think that’s generally where investors are in this. They’d rather accept lower returns in existing assets by bidding up their prices, then ask their asset managers to hunt for higher yields in more risky ventures and expansions.
So to go back to the initial question about the world’s craziness, I have two potential answers:
- Yes, it is; or
- Quantative Easing has actually re-based the entire risk-return spectrum.
Or “C – all of the above”. Because when has the world ever been anything but crazy?
Just a thought.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.