Opinion: Equity investors have now come to a cliff in the road – and options are limited
The coronavirus pandemic has been great for investors, but most now realize that the extraordinary performance of the stock market is not based on fundamentals, which ceased to matter some time ago.
Central banks have pushed up asset prices with massive injections of liquidity and zero interest rates. Consumption and corporate profits are supported by large government transfer payments, fiscal stimulus and industry support.
Will it last? The consensus is that most assets are overvalued. Prices are ultimately the present value of future cash flows. The authorities have manipulated the discount rate, but it is more difficult to change the underlying long-term cash flows, which are driven by the real economy. Low volatility, designed by central banks, also encourages exuberant prices. At some point, staggering government deficits can be brought under control either by cutting spending or increasing taxes. These policies can also lead to inflation, requiring tighter monetary policy and higher rates.
Currently high stock prices put investors at risk of a sudden correction, when the game of musical chairs comes to an unexpected end. Since almost all of the gains have been made in price rather than income (dividends, interest, etc.), vulnerability is exacerbated. The unstable structure of the financial system – high leverage, shadow banks, illiquidity, unresolved links, growing tendency to follow investors – means that any problem can trigger a major adjustment.
Investor options are limited. One could believe in the permanence of a “new normal”. Investments in risky assets are then justified on the basis that the authorities must guarantee high and rising asset prices, mainly because the alternative is too horrible to consider. This assumes that political options remain unlimited indefinitely.
Or investors can build on the momentum, essentially Keynes’ so-called beauty pageant investment theory, which anticipated today’s âmemesâ actions. A successful investment requires investors to select the faces that are most popular among all the judges, rather than those they may personally find the most attractive. The difficulty is knowing the mind of the judge and knowing when to sell before the music stops.
Third, investors can park their money in cash. This means accepting exceptionally low returns perhaps for an extended period and, worse yet, missing out on additional gains.
An alternative is to reposition defensively in assets or businesses with reliable income streams operating in critical industries or selling commodities. These traditional âwidows and orphansâ investments are more difficult to find today. âSafeâ government bonds now offer little income but high risk. The prices of stocks and real estate are strongly correlated, reflecting the behavior of investors as well as the common reliance on leverage. More liquid, higher quality assets frequently come under selling pressure when leveraged investors need to raise funds. Today, just as a rising tide lifts all boats, a falling tide leaves everyone stranded.
Fourth, investors may seek to profit from higher inflation, turning to stocks that benefit from higher prices. But the impact on stock prices will depend on earnings inflation (that is, higher prices for finished goods) or cost inflation, including wage increases. If the latter is the case, the earnings compression can negatively affect stock valuations. Combined with higher rates, this can negatively affect inventory. Another alternative is inflation-indexed securities, such as Inflation-Protected Treasury Securities (TIPS) TIP,
Fifth, investors might go âoff trackâ, believing that existing policies are unsustainable and that the economic system is irreparably broken. This favors cryptocurrencies, precious metals or collectibles – non-traditional assets whose supply is naturally constrained. The state’s ability to confiscate, tax and regulate, as well as the use of courts to enforce rights, complicate this quest for freedom.
The ultra-rich and some wealthy individuals have already left the network by entering private markets. Concerned about manipulated and gamified markets, they are now focusing on companies and unlisted real assets as well as private debt, sacrificing liquidity and transparency for better economy, confidentiality and control. Unfortunately, these options are limited for ordinary people – a different form of inequality.
Investors are therefore faced with Hobson’s illusory choice, where only one thing is actually offered. They can lose by betting against price increases or as prices continue to rise.
Policymakers, meanwhile, continue to compound decades of mistakes. They must now continue to take on debt and keep rates low in order to keep asset prices high. Public deficits are essential for maintaining economic activity. Kicking the box is the only way to make sure reckoning day is postponed – NIMTO (not during my tenure). This forces investors to go further up the risk curve to generate returns.
Maybe today’s investors should stick to comedian Will Rogers’ famous investment advice: âDon’t gamble; take all your savings and buy good stocks and hold them until they go up, then sell them. If it doesn’t go up, don’t buy it.
Satyajit Das is a former banker. He is the author of âA Banquet of Consequences – Reloaded: How we got into this mess we’re in and why we need to act nowâ (Viking 2021).
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