Political Economics Prof

Tag: Financial Markets

  • The Stock Market is Up and the Economy is Down: What’s Going On?

    The Stock Market is Up and the Economy is Down: What’s Going On?

    It is a puzzlement why the stock market can go up while the economy is in a virus-caused depression. Much of the economy is in lockdown or closed because of decreased consumer demand. As many of one-third of workers and many small businesses are on federal life-support programs. Profits have disappeared. Large numbers of bankruptcies loom. Given the uncertainty, including recent record numbers of new virus cases, the usual stock evaluation metrics are worthless.

    With the economy tanking, how come the stock market has gone up dramatically?

    And continues to go up.

    THE STOCK MARKET

    Let’s decompose the stock market. When people talk about the stock market going up or down, they usually refer to an index such as the S&P 500 as the measurement. The S&P 500 is a market-value (cap, short for capitalization) weighted index. The ten most valuable companies account for over 20% of the total value of the index.

    There are over 3,000 actively traded stocks. But the 500 companies account for over 80% of the total value of all stocks. They also account for a minuscule percent of the 10-20 million companies in the United States.

    Public companies account for about one-fifth of U.S. employment. Small companies account for about half of private sector employment. Government accounts for about 10% of total employment.

    So, the dominant public companies are not representative of the economy. They are not even a representative sample. They are publicly owned. Even the smallest is much larger than almost all other U.S. companies. They are usually multinationals. And the largest, most dominant companies in market value are technology companies. The six companies with the highest market value are Facebook, Apple, Amazon, and Alphabet (the parent company of Google. Counted twice. Don’t ask.), collectively known as the FANG companies, joined by Microsoft.

    Technology companies account for over 30% of the total value of the S&P 500. Digital or online companies are 13 of the 20 most valuable corporations in America. Nine of them did not exist or were small companies 25 years ago.

    THE VIRUS ECONOMY

    The economy has gone into a depression, the worse since the Great Depression of the 1930s. Damage has been limited because of massive federal income maintenance programs for workers and small business owners.

    The severe downturn, caused by the virus and attempts to control the spread of the virus, has made visible that the economy is divided into two parts. (Yes, I know this is a huge simplification but not as simple-minded as most economic theory.) There is the service sector, the largest employer. Most of the companies are small. Many of the employees are low wage. They work in buildings and meet customers. Services and their employees have been very hard hit by the virus and the depression. At the other end are the technology companies that dominate the digital economy. As a group, they have done well during the depression as consumers and business have used their digital platforms and services as substitutes for physical interaction (aka store shopping, visiting doctors’ offices, online entertainment and commuting to work).

    This split is reflected in the stock market and the indexes. Of the 500 largest companies, 44, mostly tech companies, are up 20 percent or more since the market low of March 23. The big six are up over 60% since the bottom of the market, accounting for more than 40% of the increase in the value of the S&P 500. Tech companies like Nvidia and biotech companies account for much of the rest of the increase.

    Less known is that approximately 160 companies of the 500 are down more than 20%. Although the market average is almost the same as at the beginning of the year, the stock prices of about 350 of the 500 companies are down. They are large and important parts of the older economy.

    TIMING

    The timing of the market moves is surprising. The market hit its high on February 19, a month before the president admitted there might be a problem and weeks before the more aggressive governors announced lockdown rules. While the president was telling the country there wasn’t a problem, investors began unloading stocks.

    In the last week of March, as the president began hinting there might be a problem, the stock market hit bottom. As the number of new virus cases and deaths rapidly increased, and lockdown and quarantine rules were extended, the economy tanked. But the stock market began a rapid recovery, one of the strongest and quickest in history. Even as the virus situation worsened in most of the country, the stock market continued to go up.

    During the strong advance no one, not even corporate management, had any firm idea what corporate sales and profits would be in the future. No one could do the usual financial analysis. Every wealth fund manager, financial analyst and investor I’ve talked to said the market was crazy, irrational, unpredictable (usually preceding by a colorful adjective).

    But the main reason is obvious. The dominant companies in the stock market were part of the digital sector of the economy. Besides the monster tech companies, they were into telemedicine, video conferencing for fun, family and business, video streaming and other online entertainment, e-commerce, cybersecurity, and many other online services. Behind them was a large increase in cloud computing services.  

    The accelerated shift to these companies’ services and products indicated accelerated increases in sales and profits. The macroeconomic averages and totals for the economy looked dismal. But not for these companies.

    The stock market looks ahead. Investors forecast. They anticipate. Today’s news and events have little influence, even short run influence, on stock price movements. Investors have placed bets on their best estimate (known among statisticians as SWAG – statistical wild-ass guesses) of what will happen to corporate sales and profits in the future. As my old econ prof used to say, “You puts down yer money and takes yer chances.” Transitory and political events, no matter how dramatic and urgent, usually have very short run or no influence on stock market prices.

    But not the virus. By mid-March, it was obvious it would have a large and lasting impact on the economy. It was the powerful “exogenous shock” of economics (also known as the “black-swan” or “fat-tail” or “big tsunami” event). 

    The unknown was how big and especially how long. Politicians, especially the president and some Republican governors, argued the virus’ effect would be short-lived and not too deadly or disruptive. They dismissed the proposed attempts to limit economic activity to slow down the spread of the virus. The famous “V-shaped” recovery. It seemed that many investors agreed. As the market rose rapidly, new investors flocked to the market. Average daily volume so far this year is up over 60% compared to average daily volume in 2019. Much of the internet chatter sounded awfully familiar to me – it was the same as in histories of the 1929 stock market crash.

    But the market hasn’t collapse (yet). The big difference is the massive income maintenance federal aid programs, along with the Fed’s massive money creation and its underwriting of virtually the entire debt market. Already about 40 million  American workers (25% of the labor force) have received some form of federal aid. The main program has been unemployment benefits. The maximum benefit has been raised by $600/per week and eligibility standards have been loosened. About two-thirds of the workers who have been on unemployment received benefits as high or higher than their pre-virus income.

    Investors are betting that worsening virus news will have little effect on the economic recovery, that federal income maintenance programs will go on as long as needed (or at least to the November elections), that the Fed will keep the Fed funds rate near zero and finance the massive government deficits, and that demand for online and digital services will continue to increase.

    Result? Sometime in late 2020 or early 2021, total earnings would be expected to return to 2019 levels. The S&P 500’s price/earnings ratio (P/E ratio) of this forecast has already returned to the high 2019 levels. 

    New medical protocols are reducing the death rate. Sometime in the near future an effective vaccine will be announced. All of the stock market will go up. Given how crazy this market has been, I suggest waiting a week and then start cashing in some of your winnings.

    THE STOCK MARKET IN 1933

    Something similar happened in 1933. At the depths of the Great Depression, with the entire banking system near total collapse, the stock market started to recover. The main reason seems to have been that investors were encouraged by the optimism and vigorous pursuit of new laws and policies by the incoming president, Franklin Roosevelt. In that year, the stock market went up an amazing 66.7%.

    SUMMARY

    Investors, as investors, are not directly concerned about Covid-19. They are concerned about the economic consequences of the virus, both short term and long term, especially to public companies. 

    The dominant dynamic is that most of the economy’s industries and companies are experiencing accelerated movement to the digital economy. Face-to-face transactions are expensive. Check-out personnel and cashiers are disappearing in supermarkets, Target and McDonald’s. Retail stores will function more like local distribution warehouses. Think about classrooms and doctors’ offices. And, in the future, a shrinking labor force will probably push up the low wage part of the labor market. Digital interaction will continue to be less expensive and more effective.

    The stock market – don’t look at the averages. Look at the winners and the losers. The stock market is up because it is dominated by digital and technology companies. Changes in relative stock prices indicate which economic sectors and companies will innovate and and grow their sales and profits faster than the overall economy.

    One way to think about the stock market (big public companies) is that it is made up of past winners (past innovators), current innovators, and potentially successful (profitable and growing) future innovators. The market mostly invests in future growth based on innovation. It punishes “legacy” companies, in old industries with growth determined by the growth in total income, that stop innovating.

    In short, investors are buying companies that are benefiting from the economic consequences of the virus and attempts to limit its spread. These same companies will continue to benefit after the virus is contained. Since these companies dominate the market and the averages, the market is going up. And, increasingly, these are the companies that will drive economic growth and will dominate the economy in the future.

    For a discussion of some of the economic and governmental budgetary changes caused by the virus, see my After the Virus.   

  • Explaining Derivatives – An Analogy

    Explaining Derivatives – An Analogy


    You go around to farmers with cows. You buy all the cows and pay the farmers a small fee to milk the cows and sell the milk. You pay for the cows with ass(et)-backed securities called MBSs (Milked Bovine Securities) that you tell investors are udderly safe. But some of the cows don’t give enough milk (cow flow problems) or give no milk at all. You take some of the asset-backed securities, say they’re backed by the subprime cows, and use them as collateral to sell another set of securities called CMOs (Cow Milk Obligations). Then you buy CDSs (Cow Dried-up Swaps) from AIG (Angus Insurance Company) to insure the CMOs when the cows stopped giving milk. If you work it right, you collect more on the CDSs than you pay out to retire the CMOs. The money you get from selling the dead cows go to pay the CLOs (cow leather obligations).

    You could also sell CDOs (cow dung obligations) that depend on how much cow dung is produced. This is a typical Wall Street product – turning shit into gold.

    ====================================================================

    You might be interested in

    Introduction to the Stock Market Crash of 1929 and the Beginning of the Great Depression


    for an introduction to the ultimate bull market that turned into cow dung.

    For a list of all pages and posts, see Guide to Posts.

  • You, Your Brain and Credit Cards


    A basic assumption in economics and business finance is that individuals are rational in the sense that they compare the cost and benefits of a decision. Generally, this means comparing the cost of investing or consuming today to the expected benefits in the future. Cost is usually the price of the product or investment; expected benefits are harder to figure. The rule is simple; if the expected benefits are greater than the cost, buy it. If not, don’t.

    Even if the cost is spread out into the future – a car paid for with a cash down payment and a car loan – it is relatively easy in theory to discount future costs along with expected benefits back to “present value” (today’s dollars) and do the comparison.

    One question that economics and finance doesn’t ask is: Does how you make a purchase or investment affect the buying decision? Does it matter if you pay cash or use a credit card? Theoretically, the answer is no. But recent neuroscience research indicates that the answer is yes. Whether or not you buy something may be influenced by how you pay for it.

    Paying with plastic fundamentally changes the way we spend money, altering the calculus of our financial decisions. When you buy something with cash, the purchase involves an actual loss… Credit cards, however, make the transaction abstract, so that you don’t really feel the downside of spending money. Brain-imaging experiments suggest that paying with credit cards actually reduces activity in the insula, a brain region associated with negative feelings. As George Loewenstein, a neuroeconomist at Carnegie Mellon, says, “The nature of credit cards ensures that your brain is anesthetized against the pain of payment.” Spending money doesn’t feel bad, so you spend more money. Jonah Lehrer, How We Decide, p.86.

    In another experiment, a group (MIT students) was asked to bid for Boston Celtics tickets. Half the group was told they would pay with cash, the other half with a credit card. The average credit card bid was twice as high as the average cash bid. (Drazen Prelec and Duncan Simester, “Always Leave Home Without It,” Marketing Letters, 12 (2001), 5-12.)

    This example is one of many experiments that indicate our brain tends to highly value immediate gain or pleasure and has difficulty computing future cost. The brain is not very good at “discounting” the future or understanding abstract concepts like interest rates on credit balances. The price we pay for impulsive purchases is an interest rate on credit cards that would make a loan shark blush.

    This type of behavior is reinforced by other types of “irrational” behavior that leads to bad decision making. The limits to human rationality is a major reason why managers find it difficult to make strategic decision involving future events. (See a summary of the brilliant work on the limits of “rational” decision-making by Nobel Prize-winning Daniel Kahneman, Thinking Fast and Slow.)



    ==================================================



    Go back to the List of Posts by Topic.


  • Financial Markets 101 and the Current Financial Crisis


    I’ve been asked to define some financial terms and comment on the current financial crisis and coming recession.

    -Financial institution (is it any bank or stock broker?)

    -Investment bank ( I never understood why Goldman Sachs was considered a kind of bank)

    -Systemic risk

    -Counter party risk

    -Mortgage backed securities vs. mortgages (does a mortgage become a security when it’s bunched up with a lot of other mortgages so a person can invest in the whole bunch?)

    -Hedgefund

    -Relationship between hedge funds, short selling and credit default swaps.

    Financial Institution – any company that deals in finance – money, credit, stocks, insurance. It could be a bank, stockbroker, insurance company, hedge fund, credit card company, mutual fund company, etc. Even half of GE is a financial company.

    Investment bank. In 1934, the U.S. government passed a law dividing banks into commercial banks and investment banks. That law has since been repealed so there is a lot of overlap now. Big commercial banks usually have investment bank subsidiaries. Some of the big hedge funds are evolving into investment banks.

    So, what is an investment bank? Unlike a commercial bank or savings bank, an investment could not take in private deposits (think checking accounts). Until the revolution in banking that began in the 1970s, investment banks mostly did underwriting (floated new stock and bonds of big companies), arranged financing for mergers and acquisitions, dealt in government bonds, sometimes investing their own money. But with the explosion of new kinds of financial instruments and markets, especially derivatives, investment banks greatly expanded their business, both as brokers (bringing buyer and seller together for a fee) and dealers (taking a position with their own or borrowed money). They also entered into complicated relationships with hedge funds and private equity funds.

    Goldman Sachs was always an investment bank. Like a lot of old-line investment banks, they also had ties with banks in Europe. So advising foreign banks on U.S. investments and handling their investments was a part of their business.

    Systemic risk. The big change in financial markets in the last 35 years (beginning in 1973) has been the pricing of risk, starting with the Black-Scholes equation that priced options. New financial instruments (products) were invented to let individuals and companies either hedge against risk (similar to buying an insurance policy) or speculate (take on risk hoping to make a big profit). There is nothing new about this – it’s just the huge size and sophistication of the markets that’s new. Now, any one company can hedge against risk or lots of types of risk (changes in the value of foreign currencies, changes in interest rates, changes in the price of raw materials, even changes in the weather). But there is a big question of whether or not this reduces the overall risk in the global economy. No one knows. This overall risk is called systemic risk, or the risk in the entire financial system.

    My personal feeling is that systemic risk is much higher because of the complexity and interconnections of financial markets. Which gets us to counterparties.

    Counterparty. Generally, it just means someone on the other side of a financial contract. So, if you have a mortgage, you and your bank are counterparties. But the term usually has a more limited meaning to describe the two parties to a private contract involving some type of derivative. The main risk is that the counterparty won’t be able to pay up if it owes you money in the future. So you really have to trust the other party, which is why most counterparty contracts were between the biggest and most secure financial institutions. Until recently, when companies like hedge funds became major players in these markets. So, counterparty risk mostly means the risk of the other guy not being able to pay up during or at the end of the contract.

    Mortgage-back securities vs. mortgages. Generally, yes. Banks generate mortgages. They then sell some of them to companies like investment banks or Fannie Mae. Then the income from the mortgages (the monthly mortgage payments) of a bunch of them are sold as a bundle to other investors. How? But creating (selling) a mortgage-backed security. Think of a mortage-backed security as nothing more than a bond backed by the cash flow of the bunch of mortgages. That’s the easy part. Then the mortgage-backed securities can be sliced and diced into lots of pieces, sometimes called collateralized mortgage obligations (CMOs) or “tranches”. There were typically six tranches. The lowest one, the one with the highest risk, was so risky the issuers of the CMOs (often investment banks) kept it. These were the parts of mortgage-backed securities that were called “toxic waste.” Investors could pick which combination of risk and return they want.

    That’s the easy part. The “toxic waste” tranches were then bundled and sliced up again. Incredibly, the “best” of these “toxic waste” securities were often rate AAA. True alchemy – buffalo chips had been turned into gold.

    But wait! There’s more! The buyer of a CMO or some other security might enter into a contract to hedge some of the risk. The counterparty might enter into a second contract on the other side to offset its position in the first contract. Some other institution that bought a mortgage-backed security or a CMO might decide to arbitrage the difference between changes in interest rates on mortgages and interest rates on some other debt instrument, typically U.S. Treasuries. And on and on it goes.

    Since most of this activity is done in private, unregulated markets with no reporting of positions, no one really knows the whole picture. Most of this is done with borrowed money – leverage. Systemic risk again. We are now seeing what happens when everyone tries to “deleverage,” a large part of which is no longer knowing which counterparty to trust, unwinding positions and paying back loans. Result – markets freeze up, no one wants to lend or take a position, assets like mortgage-backed securities can’t be sold and so no one knows what their market price is. Uncertainty and lack of liquidity (inability to sell an asset) are the worst things that can happen to financial markets. This is what’s happening right now and why the only lender or investor left in many countries is governments. Very ironic.

    Hedge fund. Basically, any unregulated investment company that can do whatever it wants. There are about 7,000 or so in the U.S. They pursue many different strategies. They control about $2 trillion (less this month) and are often highly leveraged, meaning they borrow a large multiple of their capital. So most of them pursue high-risk strategies that make them a lot of money (high return) most of the time. But in a downturn, they lose lots of money and many go out of business.

    I’m going to fudge a little on your last question because it covers a lot ground.

    Short selling. This means a bet that something, usually a stock price, is going to go down in price. If it happens, the short seller makes money. One way to do this is to use put options. Anyone can do this, not just hedge funds.

    Credit default swaps. These are like insurance policies. This started out as a rather conservative way to insure against a counterparty or some other financial institution going bankrupt. For example, say you owned bonds issued by Lehman Brothers and started to get worried about Lehman’s solvency. You might buy, for a fee, a credit default swap. If Lehman goes bankrupt, some of their bonds might only be worth 9% of their face value. The seller of the credit default swap then has to pay you some or all of the difference, depending on how the swap was written. This actually happened this week. What’s funny about this example is that Lehman Brothers was a major writer of credit default swaps.

    But, as usual, some smart guys saw these as a way to speculate. Leaving aside the details (rather messy), more and more credit default swaps became a bet on the probability a company would go bankrupt.

    AIG was a big seller of credit default swaps. It looked like a safe way to earn the equivalent of insurance premiums. Until this fall. It’s like what happens to an insurance company when a large hurricane like Katrina hits. The probability is low but when it happens, the losses are huge. In this case, so big it brought down the company.

    Recommended reading. Taleb, Fooled by Randomness. A rather philosophical musing about the role of risk in finance and life. Written by a former derivatives trader.

    FINANCIAL CRISIS

    I always thought, and said so many times in class over the years, the Alan Greenspan and the Fed were mostly smoke and mirrors. For twenty years, everything broke right for the economy. The Fed did more harm than good but basically nothing much until after 9/11. Then, to set negative real interest rates for three years as a massive subsidy to the banks, see the housing bubble coming as early as 2004 (I found an old article), and do nothing about it because of “ideology” is moral cowardice or stupidity (take your choice). Also, the whole question of deregulating parts of the financial market is mostly a non-issue. Huge parts are private and/or unregulated anyway (hedge funds, private-equity firms, investment banks) and even the regulated part has figured out how to get around the rules (SIVs, something right out of Enron). AIG was one of the most highly regulated firms in finance. Also, I don’t think anyone thought through the systemic risk of the proliferation and rapid growth of layers of derivatives financed by debt.



    Most investment advice doesn’t work in a big market downturn. Especially “diversify.” Everything goes down. Past patterns that are the basis of arbitrage break down (hello LTCM). And the risks are far higher than the models indicate, as Taleb argues.



    There is also a long-run problem. The Dow and S&P are back to where they were in 1996. So if you had put money into your 401K every month for the last 13 years, you would have had a negative rate of return. My back of the envelop guess is that the total real return on stock index funds in this period -after inflation and fees – has been about a negative 50-60%. No wonder investors put their money into houses.



    There’s some really scary stuff out there already. If the auto industry and their suppliers go bankrupt, they could dump their entire pension expenses on the U.S. government. Could be higher than $20 billion a year. The huge California pension fund (Calpers) has been very aggressive in the past and earned above average rates of return, So far this year they’re down $40 billion and that’s without taking a markdown on their big investments with hedge funds and private equity funds. (What the hell are pension funds doing investing billions in hedge funds?) I would guess that most public pension funds are now underfunded, certainly true in New Jersey.



    So we go into this recession with a $1 trillion budget deficit, a $600 billion trade deficit, one million foreclosures, five million mortgages underwater, and a financial system that can’t even price debt instruments. At some point, foreign savings will stop financing all of this. Already, around the world, a lot of capital is “coming home,” causing problems in Eastern Europe and other emerging economies’ financial markets. 



    I hope I’m wrong but I think this recession is going to be really nasty.