What's up with Stonks is a biweekly report that delves into the complex and often confusing world of the stonk market. Community Manager Verneri Pulkkinen helps you navigate the troubled waters of market movements and macroeconomic phenomena. Stay tuned for the hottest investment scene news, moderate amount of stock populism and understandable information about the stock market.
In this post, I’ll talk about how the stock market can go down in a bear market due to dwindling liquidity, even if the real economy is still standing on its own feet. Cash is king, even if inflation is eroding its purchasing power.
This week will see a significant batch of interest rate decisions all over the world. In Sweden, the Riksbank started the week with a bang: full 100 basis points interest rate hike. The whip is waving in Sweden's bubbling housing market. On Wednesday, the Fed is expected to raise its funds rate by another 75 basis points, or 0.75% in layman's terms.
The real interest rate, measured by the US 10-year inflation-protected bond rate, has already risen to 1% in the US. The last time interest rates were at a similar level was only for a short period in 2018, until the economy and stock market started to melt. In practice, similar levels were seen in the financial crisis more than 10 years ago. If interest rates remain sustainably higher, the so-called TINA, or “there is no alternative” to equities, can be kissed goodbye.
Liquidity bear market
The present value of stocks is their future cash flows. That’s a safe starting point for any intelligent investment discussion. The present value of cash flows is driven by the return on invested capital and the growth the company achieves with its investments.
The present value is of course also affected by interest rates which affect the cost of capital. One euro today is worth more than one euro tomorrow. If you could get a secure 5% return from a safe bank account, not even an expected return of 10% on risky shares would necessarily be enough.
The state of the economy affects the financial performance of companies. Of course, the long-term investor looks beyond the cycle, but the human temptation to indulge in cycle guesswork ties investors' thinking to the short term.
It’s often thought that stock price movements always reflect changes in the economic and business environment.
In real life, the price of a stock is determined daily by supply and demand on the stock exchange. Kindly note that I'm talking about price and not value, which are two different things. Less demand pushes the stock down.
Investor Lyall Taylor speculates in a Twitter thread that the current bear market may well be more about dwindling liquidity than a weakening economy.
Let me highlight a few points he makes that I think are good.
The European economy is being hit hard by the energy crisis, but the locomotive of the world economy, the US, is still doing reasonably well. Consumption is up and unemployment is low. Interest rates are rising, but the ratio of interest expenses to consumption is quite reasonable. At least for the time being, the tighter financial conditions aren’t reflected in loan repayments, and the level of outstanding debt is reasonably low.
A full-blown recession is by no means a certain scenario. Stocks, especially smaller companies, have still taken a beating. The Russell 2000 small company index is down almost 30%, while small companies on Nasdaq Helsinki are down just under 40% from their peak.
Lyall points out that in an inflationary environment the real value of savings, i.e., the change in value taking inflation into account, falls. An investor's real return can approach 0% and they still must pay taxes on their nominal gains. At the same time, the cost of investment is inflating. I went through this dynamic a while ago in a previous post.
In the longer term, this leads to a situation where capital becomes a scarce commodity. Many of us younger investors, or well, all investors of the last 30 years, are used to a situation where capital is plentiful and interest rates are on a downward trend. If the current inflationary storm continues, capital will be rapidly destroyed and becomes a scarcity commodity again. In this graph US CPI y/y change % is depicted; inflation storms are quite rate after all.
If capital is scarce, there will be fewer buyers for stocks and returns must be higher than previously required. In turn, this puts downward pressure on share prices, even if earnings remain unchanged, or even increase. I often use the 1970s as an example. Back then, the nominal earnings of listed companies tripled in an inflationary environment, but at the same time the stock market stagnated for 10 years. This could be called a liquidity bear market.
Last summer, I joked about how especially small listed companies would take a hit when pandemic period savings were diverted to terrace beers rather than shares when restrictions were lifted. In the first year of the pandemic, we saw a huge burst of liquidity in the stock market, which shot stocks through the roof.
Instead of rejoicing on the terrace, the extra money - if there is any left - goes to electricity bills. In this graph, you can see an estimate of the growth in household energy expenditure in different European countries. In practice, electricity bills everywhere are increasing by a few percentage points in relation to the size of the economy. That expenditure is out of some other form of consumption.
Tightening liquidity pushes the stock market off the ledge, and the so-called real economy doesn't even have to take a bad hit at the same time.
There’s yet another thing that’s awkward for equities. The inflation problem can be dealt with by tightening financial conditions, which the central bank has the power to do. Another public sector measure is to cut public spending. Public spending is someone else's income, so the public sector would no longer stimulate the economy. Central banks from the Fed to the ECB are indeed tightening financial conditions, the Fed with a red face and the ECB with a slightly lower intensity, but public consumption in the US or Europe shows no signs of slowing down. On the contrary, for example, households are subsidized with high electricity bills in Europe.
That leaves the central bank with no choice but to try to maximize the inflation-limiting pain in the one area where it can have an impact, namely financial conditions. This means more interest rate hikes. A collapse of the stock market would be good news for the central bank, because it would make people feel less wealthy and spend less. This phenomenon is often referred to as “the wealth effect”. Financial conditions indexes are collapsing, but not enough to fold inflation:
For the ordinary stock saver, the situation is twofold. As capital becomes scarcer, cash is king, even if inflation erodes its real value and purchasing power. Interesting excessive reactions can occur, especially in small companies, where the share price isn’t so much driven by fundamentals as by the general flight of investors from the stock market and the need to raise a pile of money for the electricity bill, if I may over-exaggerate a bit.
The fall in stock valuations will feel bad in your portfolio. However, when looking years ahead, it’s an opportunity to buy well-performing companies at a reasonable or even at an attractive price. For the net sellers of shares, the situation is of course worse, because you can only get rid of shares at ever-lowering prices.
For net buyers, as long as their personal finances remain in order, the situation is much more delicious.
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