How Can Stock Market Asset Prices Fall?

For the stock market to drop in value, something else has to be in greater demand. In the realm of paper assets, the only competition for equity is debt or debt-money, and the non-paper competition is commodities and real-estate. Let's look at each one, except real-estate, which should be clear without saying in the spring of 2010 is a non-starter.

It's been clear for about three years now that money does not flee to hard assets when paper assets are in jeopardy. Those hard assets experience a sell off, too, as money flees in a crisis for the stability of U.S. dollars. This should be expected for some of the reasons we pointed out in November. So if the stock market has a significant sell off, don’t expect a commodity price spike. Whether one thinks it should or shouldn't is irrelevant. That fact is it hasn't done so for the last three years. If you think it should, then take the sell-off as a chance to take a position at steep discounts. We address the fallacy of the counter-argument for deflation at the end.

We are then left with the realm of paper-assets: debt-money (currency) or debt instruments. Debt instruments can get very complicated because there are many types with a variety of risk and valuation models. However, we can simplify that into a few commonalities: short term and long term, corporate and government. There is another debt instrument that doesn't quite fit that simplification: debt derivatives. Of the collateralized debt types, they essential represent the same fundamentals as bonds, except risks are slightly lower as default risk is diversified among autonomous entities. The other common derivatives can be grouped as options, futures, or credit default swaps. Virtually all of those by definition are relativity short-term bets.

If one is worried about equity valuations (the theme of this writing) corporate bonds would be of interest to some as bonds receive the first-fruits of cash flows and stand ahead of stock in bankruptcy (government usurpation notwithstanding). But if equity prices are at risk, corporate default risks rise, too, so prudent investors won't flee to corporate bonds in a crisis. We find ourselves left with short and long government debt, or debt derivatives, competing with equity for capital investment.

Let's take debt derivatives now, particularly the CDS type. The only intelligent reason to sell equity for CDS is a credit crisis. This is in fact exactly what we saw in February. As the credit crisis that precipitated the change subsides, money flows back out of short term CDS instruments and back into longer term assets. While we don't have access to CDS price charts, we can certainly see the equity markets didn't stay low for long, which is consistent in fact and in theory with crisis of the past. So CDS competition is necessarily sudden or short lived, especially as CDS contracts are temporal by nature.

The next type of debt instruments we look at are short term parking places: short-term government bonds, and short-term derivatives other than CDS. All are havens for capital in times of uncertainly. All are temporary parking places where one then reallocates into something of greater risk with more reward potential as the precipitating event subsides. The certainty of that movement is assured by monetary low-interest rate policies of central banks. No serious money manager can sit on ROI assets below 2% for long unless in fact the world experiences price deflation of all asset classes across the board. The Austrian theory of inflation arising as a consequence of money creation suggests in this season of 2010 that is an absurd expectation. The arguments to the contrary are addressed below.

Like real-estate, it should go without saying that holding long term government bonds in an era of Keynesian expansion with extremely low interest rates as one of the most high risk (to asset price) low-yield investments of capital. Just as rolling short term bond holdings into short term bond holdings for an extended period is only sensible in an era of broad-based systemic price deflation, holding fixed rate long bonds when currencies are threatened by increasing debt, and interest rates have no where to go but up, is asking for capital loss.

Finally, the last paper asset vying for attention of investor and speculator capital is currency. In a crisis, even after all the liquidity measures and deficit spending in the U.S., the U.S. dollar is still the target of those fleeing for safety. Again, we aren't concerned about whether that is a long term good bet, but simply recognize it as the status quo. If indeed one believes such moves are unwise in the long run, take it as an opportunity to buy more reliable dollar based assets at a discount if it should transpire. But keep in mind, when this flight to safety takes place, money that isn't secured in currency derivatives will be parked in government bonds of the currency of choice, and we’ve demonstrated those arguments only have temporary extremely short value propositions. So the fundamentals of holding "cash" (pseudonym for currency), is really just another name for a bond position, and hence currency moves will follow the fundamentals of bond investments. Since bonds of all substantive nations are basically in the same boat, we don’t expect significant changes in currency price ratios as much as we’ll see in equity positions, and of course foreigners’ demands for equities ultimately translates into foreigners’ bias for currency price ratios. We covered that topic to some degree in our September piece titled "Where is the Next Bubble?"

Given the choices money managers have in allocating capital, there appears to be only one reason to expect any kind of significant decline in equity prices in the near term, and that's a flight to safety. Just as the financial crisis of the past faded into history, there's every reason to believe this one will play out the same. We pointed out some of those reasons in November under the title "Contagion: Been There, Done That"

In that piece we also point out how the latter sub-crisis had less effect than the instigating crisis. We've seen this take place recently with Greece's crisis, where there was some quick and noticeable reaction to flee to dollars and push down equities and commodities, but it was short lived and of little significance. Many have tried to build the case that "this time it's different" and pull some data out of a hat that appears different. Typically what we find is that they simply were unaware of similar data that did appear last time, or they miss the similarity of essence and difference only in nomenclature of the old and new data.

So we are left with the only variable that could explain a protracted equity bear market - positive or negative inflation. Positive inflation usually gets improperly discounted by the established world view in one of two ways -- they pick a measure of money that hasn't grown well and then conclude we'll see tame inflation or deflation, or they pick a secondary influencing factor (velocity is popular these days) and argue that it will overcome the creation of money. We've provided some links on the velocity argument back in July '09 and revealed how money supply and velocity can take some interesting forms. It is our belief that the contradictions between the Austrian school theory that inflation is a monetary phenomena, and the new school that it is a velocity issue, is simply missing the point that the Austrian school theory carries with it an inferred premise that the time between the money hitting the street and the prices showing up at retail are delayed by several months to a few years. In order for monetary inflation to not eventually show up in price inflation (either consumer or capital asset price increases), one has to permanently and systemically keep the velocity low. For nations whose people have consumer goods in abundance, inflation most likely appears in financial asset prices. For nations whose people have a higher portion of earnings going toward basic goods and services, inflation most likely appears in consumer goods.

One could achieve low monetary velocity with an economic collapse, but no substantial and influential market participant in the global economy is working toward that goal. Every policy choice and operation is designed to get people to dump their cash for something that will provide a return. All policies are designed (intentionally or accidentally) to make holding cash a losing proposition. It's the essence of both kinds of capitalism; traditional theoretical capitalism and corrupted modern capitalism. The former objective is to use one's financial capital to produce value in goods and services to reap a return on investment. The latter objective is to use one's financial capital to make other people's money work for you. The latter is the fundamental basis of the debt-money system used by every nation on earth: leverage. With every segment of every population save a few fringe radical thinkers working toward the same objective (i.e. maximum return on investment) something global and earth shaking will have to occur to put everyone off their agenda. We aren't suggesting that can't happen, just that the most likely expectation is that it won't happen until this next round of business cycle expansion pops sometime in the teens of the 21st century.

For the stock market to drop in value, something else has to be in greater demand. At this juncture in 2010 it goes without saying that real-estate and long bonds are non-starters. Other hard assets have proven themselves unattractive as replacements (albeit good co-equals) for equities. Being left with nothing other than short-term non-performing parking places and short term quick gains made attractive by temporary sudden shocks, there simply isn’t any real long-term asset class competition to distract the global investment community from demanding more equity positions. The prudent scholar, historian, and investor should be prepared for another cyclical equity bull market in the coming few years.