Markets Have Their Reasons

The markets have to behave in certain ways because of what they are and how humans behave. For instance, deflation might be scary, it might be a reason to sell, BUT it also triggers changes in where capital goes to try to protect itself to mitigate the damage. That eventually creates neglect where even if deflation never turns around there is opportunity and if it does turn around there is greater opportunity so once capital gets cornered into safety, it has to eventually move... some opportunity requires some more creativity than others. For instance, when oil is trading below a certain level (assuming you were managing ridiculous amounts of money) you could take over all companies trading below book value, either sell futures to lock in the value of the book that includes oil prices so if they go down you are hedged and can lock in the value until it resolved, or buy futures plus one company you intend to hold, liquidate the companies entirely except for the one and by doing so reduce the production of oil, have the value returned to shareholders, take physical delivery of the oil and force the price up and then convince a country to build up its national oil reserve so you could sell them the oil or halt production and use the oil you took delivery of to provide the demand... and if you take over a lot of energy companies you can certainly gain control over pricing by massively reducing production and then using up the supply. There are many people who would just hold onto a company with declining book value betting on a turnaround that never develops or betting on liquidation from the others that never happens, and it may even be break even, too small or profit or even negative profit at current oil prices to do so, but the act of doing this with several can actually reduce the increase of supply so that demand is greater than supply and eventually prices must stabilize and then go up. This process could work with many types of companies. If there are 50 ships and 20 shiploads of goods, you can buy out and liquidate, or acquire and shelf and stop creating competition that makes pricing and maintenance unprofitable.

The point is, capital has reasons to do things and this creates new conditions that lead to the next. A market will always act in a way that creates movement.

Capital might believe that there is a vicious cycle where politicians have mandated European a pension funds own 80% bonds and the ECB and fed will continue to ease if things ever get worse, and banks will be more reluctant to lend proportional to the fed’s change in rates as the fed tries to stimulate... so as the fed and central banks lower rates, the spread between borrowers and savers grow, liquidity declines and stocks go up on minimal volume and a risk of a sharp decline when the market gets spooked creates a no bid situation and the fed continues to stimulate by lowering rates, trying QE and doing whatever else. Then they see banks no longer willing to lend to banks at the low overnight rates fed is trying to enforce. So when rates have to go higher and higher and still no one lends, the fed steps in and continues to try to control markets. This process forces them to lower interest rates and stimulate more based on their logic, but since banks aren’t really lending that much more and it drives prices of stocks higher where fewer people are willing to participate, this creates volatility risk that moves people into bonds in anticipation that the central banks will always support it. In addition, people looking at the trend of lower and lower rates and talk of “negative rates” don’t really want to borrow if they think they will make more money by waiting in 6 months and seeing if the rates go down or they may wait if the fed cuts by half a percent and the actual rates haven’t gone down by an equal or greater amount. At any rate this cycle can’t necessarily continue forever as interest rates in Europe are already negative. While traditional models have been abandoned by parking money in bonds and waiting for fed to drive up the price and down the yield because that’s what accommodative policy does, this has created risk parody that isn’t proportional as you would expect.

Normally it might look like this: (image from Howard Marx The Most Important Thing)



But as rates offer lower and lower yield, other assets get more and more attractive by comparison and they have been neglected with the decline of global liquidity.

Ironically, it’s deflation due to China totally halting their economy to fight the corona virus that may actually cause stocks to go up if it eventually breaks the European economy. If we deflate further, that inflicts more pain on the economy and those who currently have experienced significant austerity like Germany may revolt at some point or they will have to steal even more from pension funds which could also cause riots, or they will have to steal from all bond holders or people with money. Brexit likely will not be the last country to leave and for them to turn to a marxist approach would only cause additional deflation that would break their economy even more. it may take a final breaking of the european economy to send money out, and the safest place in theory is still US bonds.

However, S&P stocks now yield close to twice as much and additional deflation would push that number above 2. So if you have to park your money do you keep it in something where you can only ever get under 1% tying it up for 10 years and if the government goes bankrupt you get nothing with risks of them forcing you to take a “haircut” (robbing from bond holders) or do you put it in something where you have legal rights to access book value in worse case scenario plus earnings in excess of dividends, plus potential for growth and potential to benefit from price appreciation due to movement of capital into stocks?

So deflation exacerbates the opportunity and may actually trigger the move. Markets always have their reasons, even if they are nuanced and tricky...

Let’s take for instance why value may invert. When credit is in excess, money is moving around and particularly when capital is heavily concentrated into that part of the world and tourism is high and money is coming in, a companies earnings will be inflated, so even if P/E is reasonable, it could still be overpriced. When markets sell off because of an event and/or credit crunch, the earnings are an unknown.

And yet if money has totally moved out, credit has totally deflated, Business activity and trade have halted earnings can be minimal or negative so any price wouldn’t seem justified and yet it might be the best time to buy and there may be the most value out there if earnings revert to historical levels.

Using Shiller PE can help somewhat as the average of the last 10 years of earnings might have some significance but its not always representative of a cycle average and even so, there isn’t any particular level of Shiller PE that you can definitely say is too high and will signal a bottom or too low.

What would the appropriate Shiller PE be if costs of goods approaches zero and excess capital available for the investment class only rises over time? More excess money equals more money to invest and that means higher valuations. There are only so many ways you can spend money in a great economy, investing should be a growing percentage over time and Shiller PE must rise.

The market can be complex, and it may even drive itself to and from extremes from one to the other, but it always has its reasons. I say this because it’s useful to understand things like how deflation would make materials and oil and such even cheaper and at some point an activist buying up multiple companies to reduce production and pricing competition might accelerate the turnaround or else companies can go bankrupt and are forced to liquidate or have their assets sold in bankruptcy courts.

It may seem at the time like when bankruptcies force assets to be sold for pennies on the dollar that it would also put equities lower and debt to equity higher and force others into action and additional bankruptcies. But eventually the gravity that pulled it downward pulls it around and back up. The decreased production and decreases amount of assets in the industry influences prices to go up.

So a real estate company may have vacancies and depressed earnings at depressed prices, when the normalized rent yields when the property isn’t vacant is very high relative to price at the same time its book value goes negative and it is at the highest risk of bankruptcy. The relationship between value and price over time can only be understood when you understand how it can be very counterintuitive most of the time and when you can also find an edge the market doesn’t recognize or can’t capitalize off of or else it wouldn’t be there to trade.

Markets have their reasons.