re: Discussion of Fed Liquidity’s Impact on Equity Markets

Isn't it ironic this was three tweets below the one you linked?

:crickets:

That's what I thought...

my frnd. our team listens to green religiously. investing in the upside down. very great to listen

So, my biggest takeaway from the Mike Green podcast is that we are in a time (which may only be temporary) wherein traditional fundamental analysis has completely broken down. If you look at a standard business school finance curriculum, or even the CFA curriculum for that matter, you can toss many of the primary theories out the window for the time being. Modern Portfolio Theory, Efficient Markets Hypothesis, CAPM, Black-Scholes - these bedrock principles of finance are more or less meaningless at the moment (in terms of explaining price movements), yet they still influence everything from how we price options, to how we incentivize employees, to how we understand, measure and attempt to mitigate risk, to how we construct portfolios, etc. The Fed has created such distortions in the market that a new toolset is required, and that toolset flies in the face of accepted financial orthodoxy. That's really what prompted my creation of this thread. And, so I think, it's at the heart of what Mike Green is saying, which has prompted him to develop these new tools. That said, you can't help but hear in his voice a desire to return to the days of old, when markets functioned as means for interested buyers and sellers to transact at a price they each found fair, as opposed to the passive flows, algos and Fed distortions currently dominating the market.

You hear this same refrain from Druck. This guy went 30 years without a down year, 120 quarters with only 5 down quarters, and produced 30% compounded returns over that timeframe and was literally telling you before the most recent COVID-induced round of QE that he no longer recognized the markets. Can you imagine what he must think now? While he's always been more macro vs. micro and a bit more technical vs. fundamental, those methods of analysis have broken down just the same. You'll hear him complain about the lack of price signals, about interest rates being artificially low, about the mission creep at the Fed, about the ridiculous amount of new money being injected into the system, etc. It's no wonder passive vs. active flows have increased so much. When artificial causes produce scenarios in which demand grossly outstrips supply, discretion doesn't matter anymore. To use a timely analogy, when a global epidemic causes a fundamental shift in the demand curve for masks, there aren't going to be a lot of people reading consumer reviews before they buy anymore. Likewise, when the financial system is awash with free money, and the Fed has basically forced people further out on the risk curve, fundamental value goes out the window until such time as supply and demand find equilibrium.

That, in my view, is the main reason we see such a disconnect between stocks and the economy right now. Sure, the markets are forward-looking. But that forward outlook is a hell of a lot more uncertain now than before COVID, yet stocks are nearly at identical levels. The Fed's indirect support of equities has thus caused the true risk of stocks to be grossly understated by masking their true volatility and compressing (and on an inflation-adjusted basis, just about eliminating) the yield associated with competing asset classes.

On top of that, just as we are artificially masking the riskiness of stocks, you have many economists coming around to the view that the traditional models we've been using for decades actually understate risk. What we saw in March is an event that, according to the assumed normally-distributed, bell curve-shaped risk models that are the foundation for everything from CAPM to Black-Sholes, was never supposed to happen. Very convincing theories are being put forward that show price movements are not normally distributed. In reality, there's a lot more excess kurtosis than previously assumed, resulting in many more insignificant movements, but also fatter tails with many more disruptive movements than the traditional bell shape. And, yet, precisely as we are understanding that equities are riskier than previously assumed, the Fed is doing everything in its power to drive a greater proportion of capital directly towards them. This can't end well. And I found it fascinating that Mike thinks if and when the "end" comes, it will be when the 10-year strikes zero.

If you haven't read the below, I suggest you check it out. See the intro to Chapter 1 for a good preview:

LINK

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This can't end well. And I found it fascinating that Mike thinks if and when the "end" comes, it will be when the 10-year strikes zero.

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Awesome post, you get it.

Just wanted to say that if the bond market forces the Fed to zero interest rates, there would be no incentive to hold our Treasuries. That COULD cause the daisy chain to unwind. I think draconian tax policies could also pull forward liquidations of retirement assets. There's other regulatory issues like the forced liquidation of retirement accounts once you pass away and gift the assets. Mike Green has models that are showing a daisy chain unwinding of BlackRock and Vanguard have the indexes prices at $0 Since Congress is Congress and lobbyist and big law are doing their thing, they aren't regulated and don't have reserves to unwind themselves.

Essentially the value of most of those accounts doesn't matter until they need to sell. The nominal value can go up but there's not enough buyers to replace the sellers 1 for 1. He claims there have only been a handful of days when those two asset aggregators have had net outlfows since 1999. Can you name anything that grown from $4T in value to $14T in less than 10 years? It's a bubble in of itself.

His take on ESG is so awesome as well. Essentially Wall Street has priced their products so low they need a new marketing tool so they can jack fees since competition in passive is so high.

It's getting so bad that even the Federal Reserve recognizes the issue. I bet they understand this and are prepared to buy boomer stocks so Millenials aren't buying depreciating assets.

Boston Fed

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The past couple of decades have seen a significant shift in assets from active to passive investment strategies. We examine the potential effects of this shift on financial stability through four different channels: (1) effects on investment funds’ liquidity transformation and redemption risks; (2) passive strategies that amplify market volatility; (3) increases in asset-management industry concentration; and (4) the effects on valuations, volatility, and comovement of assets that are included in indexes. Overall, the shift from active to passive investment strategies appears to be increasing some types of risk while diminishing others: The shift has probably reduced liquidity transformation risks, although some passive strategies amplify market volatility, and passive-fund growth is increasing asset-management industry concentration. We find mixed evidence that passive investing is contributing to the comovement of assets. Finally, we use our framework to assess how financial stability risks are likely to evolve if the shift to passive investing continues, noting that some of the repercussions of passive investing ultimately may slow its growth.

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Interesting read, thanks for the posts

What does this mean for the average person? That I should stop putting money into Vanguard funds each month? Drastically change my asset allocation away from equities? Buy land?

It all sounds scary but not sure how to take it.

Pair trading feels appropriate for the times, assuming you can get a good borrow rate on the short side of the trade. I’m also in a European carbon ETN, whose underlying the government wants to go as high as possible to drive FFs out of the generation market. The fund is pretty illiquid, but uncorrelated. The EUA market is chewing through a post-Brexit glut at the moment, as UK firms had to dump their positions. I expect steadily higher prices as that situation resolves. And it’s nice to invest in something the government is literally cheerleading to go higher

Also, good read below on liquidity and an old article featuring Druck from the 1980s. You’ll find his words very relevant to today:

Stanley Druckenmiller on Liquidity, Macro, Margins