THERE has been so much bad news lately that the only good news, if you believe it, lies in the stock market. Simply put, despite all the trade war and political bad news, the US stock markets hover around historical highs. And Asian stock markets are still guided by sentiment in Wall Street.
Is that market optimism justified?
From its trough on March 9, 2009 to last peak on April 23, 2019, the S&P500 Index rose 334%, so everyone who invested in US stocks have done well. How justified is this?
One investor who has done incredibly well is Berkshire Hathaway, the investment company led by legendary investor Warren Buffett and his partner Charlie Munger. Their famous annual newsletter just came out and I recommend that any serious investor read it very carefully for its nuggets of wisdom.
First, as a qualified accountant and former securities regulators, I agree with Buffett that generally accepted accounting principles (GAAP) has added “wild and capricious swings in our bottom line.”
Second, Berkshire is a value investor, focused totally on operating earnings of companies that are ably managed in “businesses that possess favourable and durable economic characteristics”. They succeed because they focus on the forest rather than the trees, transforming from a company that manages listed shares to one whose major value resides in operating businesses. Because they believe that under GAAP, their book value is understated relative to their current value, Berkshire will be “a major repurchase of its shares” when prices are “below our estimate of intrinsic value”.
Let’s take a broad “forest-not-trees” look at the stock market, mainly in the US, but also relevant here in Asia.
First, stock markets are getting more and more concentrated, meaning the largest stocks dominate in terms trading volume, liquidity and asset holding. Most institutional trading concentrates in the index stocks, either directly or indirectly through the ETF (exchange traded funds of indices). If your stock gets out of the index, its price will suffer and liquidity will decline. For example, the number of listed stocks in the US have halved since its peak in 1996 to around 3, 600 today.
Because of onerous regulations and transparency requirements, many good firms have delisted and moved to private markets and even public trading moved to “dark pools”, where no one knows what is happening.
Second, stock indices are designed to go up rather than go down, because the stocks that do not perform are eliminated and replaced by performing stocks. The more conservative indices, like the Nikkei-225, reflect better the performance of Japanese companies because they do not like to kick bad performing stocks out. So the Nikkei-225 index is today still at 21,000 level, just over half its peak in December 1989. In contrast, the S&P500 is 8.4 times higher.
Third, stock markets are now driven by momentum play more than valuation. The fundamental reason is that with the availability of Big Data, quantitative trading (Quants) and very low trading costs have enabled Artificial Intelligence (AI) or robot trading to detect any market anomaly (not just in stock markets, but also currency, interest rate, commodity and derivative markets), so that buying and selling of a stock can be machine driven for algorithms that no retail investor or regulator can understand. Quant trading now accounts for half the volume in major stock markets. This explains to me why markets shocked by bad news (such as US-China trade war) recover quite fast, because the market trades on news arbitrage rather than fundamentals.
Fourth, how do you value stocks when the interest rates have been driven to historically low levels (even negative in some cases) by central banks and the shares are subject to huge buy-backs? The theory of investment is that the market is highly liquid, efficient and you are trading against thousands of small investors who cannot individually influence the price.
Between 2007 to 2018, share buybacks amounted to over US$5 trillion for S&P500 companies. In 2018, share buybacks totaled US$806bil, and including dividends, exceeded the companies’ investments in fixed equipment. It is almost impossible to answer whether companies buying back their own shares make the companies healthy in the long run. But analyst Ed Yardeni, who is a supporter of buybacks, argue “S&P 500 companies are mostly buying back their shares to offset the dilution of their shares resulting from compensation paid in the form of stocks that vest over time, not just for top executives but also for many other employees.” Exactly, companies buyback shares to help the CEO’s option bonuses!
Furthermore, the “buy” side of stock market is now increasingly the large quant funds, long-term institutional investors like pension and life insurance funds, but also sovereign wealth funds and central banks. For example, few people are aware that the Bank of Japan “bought just over 6 trillion yen (US$55bil) of ETFs in line with its target for 2018 and now holds close to 80% of outstanding Japanese ETF equity assets. Total purchases to date represent around 5% of the country’s total market capitalisation. The bank also owns close to half of all outstanding Japanese government bonds (FT.com).”
The current stock market levels are all basically supported by central bank quantitative easing (QE), because the top five central banks increased their balance sheet by US$13.4 trillion since 2007, without which real interest rates would not have declined to historically low levels. As Yardeni points out, the S&P500 index closely mirrors the balance sheets of Fed, European Central Bank and Bank of Japan. Without QE, stock markets would not be where they are.
Finally, all investors are locked-in – damned if they invest, and damned if they don’t. Given so much liquidity, and everything is expensive, where else can they put their liquidity?
In short, the forest looks healthy, because of lots of liquidity provided by central banks, which are printed at zero marginal costs.
We are witnessing climate change in terms of rising temperatures in global conflict. When liquidity dries up, wait for the markets to bomb. But maybe the central banks will bail us out again. That is why markets are so complacent.
Who worries about boiling frogs?
Tan Sri Andrew Sheng writes on global issues from an Asian perspective.