Theory versus reality – Can any theory explain the current action of financial markets?

Jul 31, 2020

Welcome to Finance and Fury, the Furious Friday edition.

Today – want to look at market theory versus reality – because a lot of market theory doesn’t hold up – so are the markets truly changing? Is this just a short term divergence prior to markets going back to match traditional investment theory?

1. Or are markets transitioning to an entirely new systemic paradigm – If so - Metrics of the past will not be able to predict how markets behave according to expectations
2. In this episode – have a look at some theories of market changing – later in probably another episode - want to focus on something else I haven’t covered – Want to look at an alternative view – such as looking at social dynamics shifting in society –
   1. Summary Strauss–Howe generational theory – similar to the K Wave theory – but apply this to markets next episode

To start – let’s look at Theories versus reality – essentially, what should happen versus what is happening

1. Most existing theories of economics and the financial system cannot match successfully with current conditions –
   1. Technically – in the short term they haven’t be able to for a while – but over the long term they could at least have some validity to them
   2. Buying companies undervalued and holding them long term – Value investing used to do well – was the bedrock of a lot of investment strategies – however now it has been significantly underperforming
   3. The strategy of following metrics and long-term data on corporate earnings, Treasury yields versus dividend yield strongly suggest a fundamental break with the past is in progress
2. Current theories – on PE, things like CAPM – don’t hold up –
   1. "Fundamentalist Theory" – based around that the action in the Financial System’s and markets is reflected by something fundamental
      1. That "something" is defined by an economic performance or metrics
      2. e. there is low interest rate – there should be higher inflation and be seeing real GDP growth and lowering employment

• corporate profits are low and P/E ratios are high – so the markets shouldn’t be charging ahead

1. The market should be lower based around fundamentals – but they aren’t – so what are some theories on why this is

3. If markets are changing - past economic and financial system models, analytical tools and metrics will have to be entirely reconsidered and reconstructed
   1. That is the issue with a lot of the theory – for instance what I learn at Uni – gets adopted decades after the real-world changes occur
   2. How theories based on evidence work – need to have the evidence there to have it be applicable to a scenario – so theories are lagging – which can be an issue
   3. Following most economic or finance theory from today was based around fundamentals in the 80s or before –
4. Over the past few months – all of the market and economic events associated with the COVID-19
   1. analysts have struggled to match the action in the Economy with that of the Financial System
   2. Existing disparities have been amplified through maldistribution in the financial system - dramatically exacerbated the financial indices but at the same time – increased disparities in the population around the world
      1. Those invested have high net wealth while those that weren’t haven’t seen this rise
   3. In no quarter is there found any real explanation for the utter failure of all existent theories to anticipate or explain our current experience.
   4. I’ll admit that I am annoyed by this – what should be happening in markets isn’t – makes it hard to predict anything – especially when market performance is being buoyed by Central banks as the last line of resort – creates an insider’s club
   5. As the general public – we are the last to know and insiders in the market have already had a chance to react –
      1. Look at the group of 30, or the club of Rome – where key central banking figures sit at the same table as the heads of the largest investment banks in the world as well as politicians
      2. They have private meetings – would have to be naive to believe that something every now and then doesn’t get mentioned as to what policy will be taken

• Its not like there people are friends beforehand – they are selected for these groups based around what they bring to the table

5. At the moment – there seems like there is a Secular or Systemic Shift occurring – and if so - this creates a situation where prior investment theory can become obsolete – as the inputs that drive markets change – still based around supply and demand – but the factors that affect both change - implications would be so far-reaching and so all-encompassing for the share market
   1. But this isn’t the first time this has occurred – theories do change rather often due to the inputs to the financial system altering
   2. that it is probably similar to the shift occasioned by the Age of Enlightenment, the Scientific Revolution, the American Revolution and (later) the Industrial Revolution – markets were different – inputs were different – things evolve – cover more on this next FF ep
6. Interesting thing at the moment - irrespective of viewpoint on economics – left versus right – each in their market analysts and what theories say should occur doesn’t hold true – both schools are trying to figure out why the emergent reality does not conform to their models
7. Theories change - Let’s examine the current existing views on the mismatch between the economic crisis and the action in the financial system – go through two
8. The Disconnect Theory – works based on the Austrian economic view point that has been around since Nixon first disconnected the dollar from the gold standard
   1. basically states that action in the Financial System is so far out of sync with the metrics of what are generally perceived to be “The Fundamentals” of the economy – that eventually a disparity will have to collapse in on itself
   2. Essentially markets aren’t tethered to any fundamentals anymore as there is nothing real in fundamental terms tying markets to them
      1. Imagine that somehow you could change gravity – normally if you jump from a 20 story building – you can guess what the outcome would be based around the reality – but now assume that you can control your mass and gravitational field where you can float – the assumed result is not the actual outcome
   3. When money is almost free and can be created out of thin air with no immediate consequences – you are floating and the outcome isn’t what is normally predictable or observable in reality – the reality that economic theory predicts anyway
   4. If money is backed by something – such as gold or if you have a limited demand for your money – you have a problem by flooding the market –
   5. But that is not what the Fed faces – a lot of Central banks also don’t face this – as through swaps the Fed can create demand for other currencies – like the AUD
      1. Therefore – under current conditions you can flood the market to create a new reality and makes a situation where theories no longer fit in
   6. The “Fed Theory” is an extension of the neo-Keynesian POV in “Don’t Fight the Fed” – this theory abandons any pretence of analysis and advocates to ignore the real world-view – where you don’t bother to make any sense of it at all…cuz Fed is the driving factor – whilst lobotomized in a way and requires no though process to invest – there is evidence that this is what is occurring in markets
      1. The fed has made a pledge to support markets and to provide low interest rates – which helps to fuel low borrowing costs for large companies indebted – and to boost the valuations of these companies
      2. Regardless of their promises to keep interest rates low – they may be preparing to pull the plug on the markets without notice – can be done quietly and with little notice to the average person - the Fed balance sheet has begun shrinking over the past month -
         1. Fed balance sheet peaked in June 2020 - It is not coincidence that the S&P 500 peaked around that date.
         2. Much of the prior contractions were due to the Fed reducing its currency swaps or lowering their balance sheet
      3. However – over the past few weeks the Fed actually drained liquidity from the system – but this is a fraction
         4. $4.17 trillion in Feb to $7.17 trillion by June – $3 Trillion in almost as many month – Now in July - $6.95 trillion– withdrawal of around $200 billion over the past month – market may depend then on which direction this continues on –
            1. Put this into perspective – back in June 2008 - $895 billion – increase by just under 8 times in size over 12 years – annualised growth rate of around 18% p.a. – and that money has to go somewhere –
            2. Back in Feb – balance of $4.17 trillion – from 2008 to 2020 – saw a growth in monetary base by around 13.6% p.a. – very close to the US share index growth over that time – then the index is dropping by 40% -
            3. To get the index back up after a 40% loss – need 67% increased return – from March to May – bottom to top – any guess what the balance sheet by the fed increased by? 69%
         5. Where has a lot of this money been going? - The Federal Reserve established the Secondary Market Corporate Credit Facility (SMCCF) on March 23, 2020 – Talked about this – this is the SPVs created with the Treasury to support credit to companies by providing liquidity to the market for outstanding corporate bonds.
            1. The SMCCF purchase corporate bonds in the secondary market – already issues – need to be by investment grade U.S. companies or certain U.S. companies that were investment grade as of March 22, 2020 – so large companies
            2. Also = purchasing U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. corporate bonds. The SMCCF's purchases of corporate bonds will create a portfolio that tracks a broad, diversified market index of U.S. corporate bonds. The Treasury, using funds appropriated to the ESF through the CARES Act, will make an equity investment in an SPV established by the Federal Reserve for the SMCCF and the Primary Market Corporate Credit Facility.

• Since the SMCCF’s launch - the market has regained the lost value –the purchases have slowed in the pace though - purchases from about $300 million per day to a bit under $200 million a day

1. Catch 22 – as if market conditions continue to improve - the Fed purchases could slow further, potentially reaching very low levels or stopping entirely – but this could create a situation where markets then drop massively as the safety net is gone –
   1. If the decline in the US balance sheet continues - This is a dig downside for stocks – depends on by how much is pulled form markets
2. Also - the head of the NY Fed’s Markets Group - man who in charge of doing the actual buying involved in the Fed’s QE programs - made a speech said that they would consider reducing its QE programs soon if market conditions improve
   1. So the Fed is literally warning us that if the markets continue to rally, the Fed is going to “pull the plug” on QE and support – but at the same time they may be ready to jump back in – just after another 30% decline
3. Given all of this and how markets are now responding to the Fed – it seems like fundamental theory has been put on pause – would come back if fed stops interventions – but too early to tell if they will – unlikely

3. Self interest will rule the day – people within the Central banking community have collectively billions invested in markets – so they will keep the values high – until they don’t
4. Next week – Look at the systemic shifts – based around societal theories – look at if the current period is a transition to a fundamentally new underlying economics – look at the Strauss/Howe "Fourth Turning" generational shift perspective

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