Basics of Financial Investing – Part 11

Clearly the performance of the stock and bond markets is related to the state of the economy. This article explores the various aspects of the relationships. First, we examine the role of recessions and large economic slowdowns, and their impacts on stock and bond prices are examined. Then the impact of the Fed and its influence on interest rates is explored, followed by a concept called ‘‘flight to quality.’’ The chapter ends with a discussion of corners and cartels. All of these subjects constitute background material for an understanding of the economic impact of market cycles.

Perhaps an understanding of the level and direction of economic activity can help one with timing issues. The stock market (which is driven by fundamentals such as sales, profits, and growth) and the economy (which has a very large impact on a firm’s fundamentals) do tend to move in sympathy with each other. The stock market is believed to lead the economy by about six months. That is, the market tries to anticipate where the economy will be about six months into the future and then attempts to price stocks accordingly. When the stock market falls significantly, that drop may well signal that the market expects (correctly or otherwise) that the economy is in for some tough times. The market’s expectations may or may not be accurate. As Paul Samuelson (Nobel Prize– winning economist) once said: ‘‘The market has forecast nine out of the past five recessions.’’ The stock market’s economic crystal ball is often a bit cloudy. Nonetheless, the stock market does generally try to anticipate what is about to happen to the economy. While it is not always correct, often enough it is.

Recessions And Economic Slowdowns Of Lesser Magnitude

One interesting phenomenon involves the stock market’s behavior during recessions. A typical recession lasts a bit more than a year; thirteen months is about average. The stock market tries to look ahead by about six months. So when the market expects that a recession is coming, it will generally start to decline while the economy is still expanding. Then it will begin to rise early in the life of a recession while the economy is still declining. On the other hand, the stock market generally does not react positively when the economy turns up. This tendency for the stock market to rise when the economy is still declining and not rise when the economy does begin to expand seems paradoxical.

But the investor should not be surprised. The stock market is focusing on the future rather than on the present. The above discussion suggests that about six months into a recession could be an attractive time to invest in stocks. Within a few months the market will begin to anticipate an economic upturn and start to rise. Similarly, about six months before a recession begins may be an attractive time to sell. Unfortunately, predicting a recession six months in advance of its start is very difficult, to say the least. Still, if you watch the Fed and the economic statistics that the Fed watches, you may be able to develop some expectations for the economy’s future.

The Fed, Interest Rates And Stock Prices

Stock prices tend to move inversely with interest rates. That is, falling interest rates tend to cause stock prices to rise, and increasing interest rates usually depress stock prices. The Fed is likely to take steps designed to cause interest rates to rise (decline) when it sees a need to slow down (stimulate) the economy.

Falling interest rates tend to enhance stock values in several ways. Declining rates result in lower financing costs for companies that borrow. Low interest rates facilitate consumers’ financing of large purchases such as houses and automobiles. Declining interest rates increase disposable income by reducing the portion of time payments that must be used to cover the interest charges. All of these influences tend to stimulate economic activity and thereby corporate profits and revenue growth. In addition, declining interest rates in the marketplace correspond to declining rates for discounting the projected income stream of stocks (dividends). Stimulating the economy by reducing interest rates tends to increase profitability. Similarly, lowering the rate at which the income stream is discounted tends to enhance investment values. Thus, most of the time stock prices will rise when interest rates fall. Rising interest rates tend to have the opposite effect on the economy and stock market. That is, rising interest rates tend to depress the economy and generally lead to falling stock prices.

The Fed’s influence on interest rates provides it with a great deal of power to affect the level and direction of economic activity. Using its so-called open market operations tool, the Fed can inject funds (reserves) into or withdraw funds from the banking system, thereby increasing or reducing the supply of loanable funds. As the supply of loanable funds varies, so does its price (the interest rate). The Fed’s strongest influence is at the short end of the market. That short end is where it implements its open market operations by buying and selling Treasury bills. The Fed generally does not buy, sell, or hold longer-term governments (or any other long-term security for that matter).

Note, however, that stock market participants closely monitor current and anticipated interest rate movements. The stock market also seeks to anticipate Fed actions. By the time the Fed has acted to reduce or increase interest rates, the stock market’s reaction has generally already occurred. Any attempt to take advantage of the relationship between the stock market and interest rates is likely to require anticipating what the Fed will do. Even that strategy may not succeed, as the market is also trying to guess the Fed’s next move.

Flight To Quality

Normally stock and bond prices move up and down together for the reasons discussed above. Declining (rising) interest rates have a positive (negative) impact on both stock and bond prices. Sometimes, however, interest rates will decline and stock prices will fail to rise (and may even decline). To understand how the two markets (stock and bond) can move in opposite directions, we need to explore what factors in addition to interest rates determine stock prices. Stock prices can be viewed as being determined by three factors (recall the dividend discount model that we discussed earlier):

  • The current level of dividends and earnings
  • The expected rate of growth of dividends and earnings
  • The rate at which expected future dividends and earning are discounted (market interest rates and risks)

If everything else (current levels and expected growth rates of dividends and earnings) stays the same, a decline in the rate at which dividends and earnings are discounted will cause a stock’s market value to rise. That discount rate is strongly influenced by the level of market interest rates. Note, however, that the discount rate employed to determine the present value of the stock’s expected income stream is composed of two factors: the market rate on risk-free assets and a risk premium applied to risky assets like stocks.

The first of these two factors, the risk-free rate, is approximately equal to the rate on governments, a market interest rate. Governments are viewed as being essentially risk-free. The appropriate risk premium is another matter. In particular, this risk premium is not constant over time. Nervousness on the part of market participants may, on occasion, lead to an increase in the premium demanded by the market in exchange for accepting risk (flight to quality). This action could cause the discount rate on stocks to rise even as market interest rates on governments are falling. Thus in a flight to quality environment, stock prices tend to decline even when the interest rates on risk-free government bonds do not rise.

In addition, growth expectations may sometimes cause bond and stock prices to move in opposite directions. If the stock market’s growth expectations become more pessimistic, a decline in interest rates may not result in higher stock prices. That is, the (negative) impact of declining growth expectations may dominate the (positive) impact of the interest rate fall. Indeed, a weakening economy may lead to both a decline in interest rates (bond prices rise) and a decline in growth expectations (stock prices fall).

Corners And Cartels

Very few, if any, individual investors will ever try to corner a market or be invited to join a cartel. Such activities are largely illegal in the United States (Sherman Antitrust Act of 1890). Moreover, few individual investors have sufficient resources even to think about trying to gain control of a market.

Still, investors may on occasion find themselves involved in a market in which an attempted corner or cartel is under way. Accordingly, investors are likely to benefit from an understanding of what happens in a market that is subject to an effort to corner or cartelize.

A corner is an attempt to control (and generally to raise or at least stabilize) the market price of some type of asset by acquiring ownership of a very large part of the available supply. In the early 1980s, what was then the very wealthy Hunt family of Texas (the deceased father of the clan, H. L. Hunt, had made his fortune in oil) tried to corner the market first in soybeans (to a limited extent) and then in silver (to a much larger extent). They did so by acquiring large positions in the contracts traded on the Chicago futures market. At first, they were able to squeeze the market by the very act of accumulating their large positions. The world supply of silver was huge but the available supply of deliverable grade silver located in the designated Chicago warehouses was much smaller. Only silver refined to .999, and in the form of ingots stamped by a select list of refiners (e.g., Engelhard), is certified for delivery to satisfy a futures contract. By purchasing the contracts and then, upon their expiration, taking delivery of the silver ingots, the Hunt brothers— Bunker, Herbert, and Lamar (their sister was wise enough to stay out of the maneuver)—created an artificial shortage of the metal, or at least of that part of the market (certified ingots) that the futures market relied upon. As a result, the price of silver shot up from around $3 an ounce to over $50 an ounce. On paper, at least, the Hunts, who now owned a lot of silver, were fabulously wealthy. They could not, however, prevent additional silver from coming into the marketplace, particularly the futures market where they traded. And, of course, they were the principal large buyers. To whom were they going to sell?

Turning silver coinage, silverware, jewelry, and unrefined silver ore into the appropriately sized, refined, and stamped silver ingots needed to satisfy delivery on a futures contract required only enough time to refine and certify the metal. As time passed, more silver was turned into deliverable-grade ingots. Time, however, soon began to run out on the Hunts’ effort to corner the silver market. They could maintain silver’s high market price only by buying more and more of the metal. At first they used the collateral value of their silver holdings to finance additional borrowings. The resulting funds were used to buy more silver futures contracts. This pyramiding strategy worked well when the metal’s price was rising, but not once it topped out. As the market price of silver declined, the collateral value supporting their loans began to erode. Soon thereafter, their collateral became insufficient to support their debts. Eventually the Hunts ran out of money and credit to buy any more silver or even to cover the loans on the silver that they had purchased. Their lenders reacted by calling in the loans. These calls forced silver sales, which in turn pushed the price down. A second problem faced by the Hunts was (ultimately successful) lawsuits by those who claimed to have been damaged by the Hunts’ alleged market manipulation. When the dust settled, the Hunt brothers had gone from being billionaires to bankrupt, and the price of silver was back to about where it had started.

OPEC (Organization of Petroleum Exporting Countries) is an example of a cartel. It has at various times had some success in raising the price of crude oil. In the early 1970s, OPEC was able to take the price of crude oil first from under $3 to $12 and then to over $30 a barrel. It did so by persuading its members, especially Saudi Arabia, to restrict the supply. OPEC, however, could not forever maintain the high price level that it was able initially to achieve. Among its problems:

First, non-OPEC members increased their production, spurred on by the high market price OPEC had established. OPEC tried, with limited success, to persuade the non-OPEC oil exporters (e.g., Russia, Mexico, Norway) to cooperate by limiting their own production.

Second, users of crude oil both became more energy-efficient and shifted to other cheaper sources of energy (e.g., coal), thereby reducing their oil usage. That is a natural reaction to a price rise. The longer the time the market has to adjust to the higher prices, the greater the amount that buyers will conserve and shift to substitutes.

Third, OPEC members could not agree to limit production sufficiently and very generally failed to adhere to the limits that they did impose upon themselves. Cheating was rampant. Non-OPEC oil exporters were even less inclined to limit their production.

In other words, OPEC was, in the long run, unable to control either supply or demand for crude oil. Thus, the market price initially tended to fall back to the market clearing level. When the price of crude oil later rose, it did so because of a true scarcity, not because OPEC controlled either supply or demand. Other examples of cartels in coffee, sugar, bauxite, and so forth have had a similar experience.

The vast majority of corners and cartels eventually fail. Market forces almost always overwhelm the best efforts of those who would try to maintain an artificially high price. The market clearing price is one that allows everyone who wants to buy at that level to purchase what they want from everyone who wants to sell at that market clearing level. At the market clearing price, the quantity supplied equals the quantity demanded. As the price is pushed above the market clearing level, would-be buyers begin to disappear while the amount offered for sale increases. A gap emerges between the amount that market participants want to offer for sale (quantity supplied) and the amount willing purchasers are prepared to purchase (quantity demanded).

To raise the price above the market clearing level, supply must be restricted. The higher the price is pushed, the more supply must be restricted. One who manages a corner or cartel can do so by purchasing the excess or restricting the production that is under his or her control. Either approach is costly for the cartel members. Moreover, the higher the price, the more incentive outsiders (nonmembers of the cartel) have to sell into the artificially high-priced market. As time passes, the buyers find alternatives, and the non-cartel group sellers offer greater and greater amounts for sale. Thus an ever-increasing excess supply needs to be removed from the market in order to maintain the artificially high price level.

You may on occasion suspect that a corner or cartel group is attempting to manipulate the market. If so, you can expect that the effort to produce an artificially high price will eventually collapse of its own weight. Does this mean you should bet against the market manipulator? Not on your life! What you don’t know is how long the effort to manipulate the market will continue and how high the price will be raised before it collapses. Suppose that during the Hunt corner attempt you had concluded that at $20 an ounce, silver was very much overpriced. You could have sold silver futures contracts short at $20. The market would eventually have proven you correct. If you had had the resources and patience to hold on long enough, your position would have shown a profit. Silver’s price did eventually fall back to below $5 an ounce. But along the way, you would have seen the market prices soar (to $50 an ounce) far above the level that obtained when you established your short position. Unless you had very substantial backup resources, your short position would have been liquidated when you could not meet the ever-rising margin calls. Even if you had been able to maintain your position, you would have had a lot to worry about as the price was rising against you and your short position.

For most investors, the best strategy for dealing with a corner or cartel is to stay out of the way. On occasion you may be on the favorable side of an effort by a corner or cartel to bid up the price. When that happens, you should take your profits (don’t get greedy) and then move on. If you are on the wrong side and the market manipulation hurts you, you may want to hang on, but only if you have the staying power and the exposure is not too great. Otherwise, you should get out of the way and wait for the dust to settle.

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