2023-01-05

Where are we with equities

For me, equity prices are dependent on so many factors, it’s hard to know what is driving them over any given timescale. With forex, there are a variety of simple models, such as covered interest rate parity, which help one think about why a currency should go up and down against another. With equities, the factors are almost uncountable. Matt Levine has come up with a theory that the value of a stock is a function of how connected the company that issued it is to Elon Musk (seriously: check this out!). So when briefing.com says that the stock market went up (or down) because non-farm payrolls were a few percent different to analysts’ expectations, well, let’s say I’m not convinced.

The problem with equities is that they carry a bundle of rights. Rights to a dividend stream, but also rights to vote on certain decisions a company might take. This makes an equity fundamentally different to a bond, even though ‘equity’ on a balance sheet is right there, alongside liabilities, balancing the assets of that company, and so seems to be very bond-like. The ‘Fed Model’ of equity prices simply compares the earnings yield on a stock with the redemption yield on a Treasury bond, and if the gap is larger, or smaller than usual, the equity (or really the whole equity market) is under- or over-valued. This puts the voting rights at zero, which is where a lot of retail investors would put them. But when J D Rockerfeller separated the dividend stream from the voting rights in the ‘trusts’ he created, he certainly didn’t see things that way. By careful exercise of these voting rights of companies that he did not own (well, did not received dividends from), he cornered the market in oil transportation, making himself the Elon Musk of his day.

In the 1950s and before, holding equities as an asset against the liabilities of pension funds was regarded as dangerously radical. George Henry Ross Goobey is known as the “father of the cult of equity” for persuading the trustees of the Imperial Tobacco Pension Fund to allocate 100% of its investments to equities. The world has never looked back, and even when (supposedly) funds exactly match their cashflow liabilities with risk-free bonds, in fact they repo the bonds and punt the cash on equities, as we discovered when Kwasi Kwateng’s ‘mini-budget’ blew up the UK gilts market.

With all these complications, one would have thought that to understand the state of the economy, one should look at ‘simpler’ assets like FX or bonds, or commodities. But Stan Druckenmiller argues otherwise. His point is that central banks are buying trillions of fixed-income assets (in the Fed’s case, maybe $9 T). The consequence of this is industrial scale price manipulation. Nobody makes a living trading JGBs these days: the Bank of Japan basically is the market, so their price bears no relationship to the state of the Japanese economy. Really, much the same goes for treasury bonds and gilts. It’s funny how the financial industry, and big business, is generally vehemently against price controls on anything they sell, but seems anxious to retain them at all costs on money, something they buy (borrow), but this post is about equity.

Nowadays, equities are the ‘default investment asset,’ still, pace bitcoin. They are, though, at the centre of the world’s most epic bubbles: John Law’s schemes for the Bank of France, and the South Sea Bubble, to the point where governments simply banned companies from issuing shares for a very long time, until they relented to facilitate the funding of railways in Victorian times.

For me, I equities are a bit scary, but as a retail investor, I feel I actually might have some edge looking at nano-cap entities which simply have too small a float for any professional investor to get involved. It’s not easy, though. Small cap stocks can be buffeted by forces way beyond their control.