Are Investors Delusional…Or Exploiting The Delusion Of Others?

Authored by Bill Blain via MorningPorridge.com,

“Customers don’t expect you to be perfect, but they do expect you to fix it when it goes wrong..”

Markets are roiled by lockdowns and approaching holidays. Already the guessing season has begun – with predictions running all the way from Gloomy to Dire. Central Banks will be anxious to be seen to be doing the right thing – which probably means more of the same. And investors? Delusional or exploiting the delusion of others.  

Rather than a Bang, it feels likely 2021 is going to end on a phuttering wheeze… New lockdowns across Europe, and one-off lock-ups in China, to address outbreaks are a reminder Covid isn’t over. The global economy may be getting used to the virus, but when folk start coughing…. markets take notice. In the UK the numbers remain significant, but it looks extremely unlikely Government will try to close the economy – which may be the smart thing to do… I guess we will find out.

As Coronavirus adds to the general air of misery, Morgan Stanley and others are warning it’s going to be a tough market, more boom and bust and greater volatility. No Sh*t Sherlock awards to them all. There are an increasing number of Market Big Dogs warnings about “red lights”, “bubble valuations”, and reversal indications – all of which is exactly what you’d expect at this time of year.

Come the end of November and the US Thanksgiving holiday this week marks the beginning of the Guessing Season – when analysts and strategists around the globe present their best stabs-in-the-dark on what might just happen next year. Every year I say something sage and wise along the lines of Stocks Markets might go up while Bond yields could rise, but maybe not.

The one strategic outlook I really look forward to is Saxo Bank’s Outrageous Predictions… it’s a must read. Sadly, none of their predictions for 2021 came to pass. Germany did not bail out France. Amazon did not buy Cyprus. Blockchain is still a solution looking for the problem it might be able to solve, and we didn’t crack nuclear fusion to give us all unlimited energy..

Back on Planet Now, consumer confidence is crashing in the face of 6% plus inflation and the threat of higher interest rates. Corporates are complaining about soaring labour costs, rising input prices and warning about difficulties to come. Yet, the market is still trading at levels any previous generation would dismiss as insane. Is that a surprise…?

Not really.

Central banks got us here, but will they get us out? We’re watching to hear who will be given the reins at the Fed; a dove or a dove? And in Europe the FT reports the spat between departing Bundesbanker Jens Weidmann and the ECB: “Given the considerable uncertainty about the inflation outlook, monetary policy should not commit to its current very expansionary stance for too long”, says the last Bond Vigilante. It’s unlikely to change the ECB’s perspective.

How central banks respond to the current market will be critical – but let’s face it; turkeys don’t vote for Christmas or Thanksgiving, and Central Bankers are going to take the heat. They will be measured and fail to deliver shocks. If you are looking for the Central Banks to be dramatic – you are watching the wrong channel.

Everyone is waking up to the inflation threat – and trying to second guess just how transitory it may be. Prices rose because of supply chain breakdowns – which will correct given time. But upward pressure on prices is easy – downward pressure will be sticky even after these supply chain issues are cured. The result is the current round of wage inflation – if tractor makers get a hike in one state, you can bet everyone else will demand similar. Inflation may be triggered by a “transitory”, but it builds momentum fast – which is where the central banks are going to struggle with their overuse of the T word.

Which neatly brings us to the question – when are Central Banks going to do the right thing to normalise rates? Many fools argue rates should have risen earlier to address inflation, but doing so would simply have created an economic downturn just as the globe was coming out of lockdown. In normal markets rising and falling interest rates could be used to moderate demand and supply – but not once the genie is out the bottle.

The big issue facing investors today is relative pricing. Stocks look massively over-priced. But relative to negative bond yields, they show much greater relative value. Predicting a crash because stocks are overvalued misses the point.. they need to be overvalued to something..

In the past I always said: “In Bonds There is Truth”. But there isn’t any truth anymore. Bond prices are distorted and set artificially low.. And that simply encapsulates why stocks are so high – relative to mispriced bonds.

So when is the great crash going to come.. if at all?

This is a very different world. While the global market is simply a voting machine – weighing up everyone’s vote to arrive at the market price, it’s a question of who owns the votes.

This is an educated guess; but I reckon the top 10 largest institutional investors on the planet control around $33 trillion AUM. The total volume of liquid bonds is around $120 trillion, while global stocks have a total market cap around $107 trillion. Therefore – the 10 largest voters on the market control around 14.5% of the total financial asset float. That’s a lot of control.

They have a problem. They are so big they can’t generate alpha returns from markets where they are the market. They probably also suffer from groupthink – I doubt market fundamentals on key issues like central bank behaviour, rates, the dollar and risk are perceived that differently at Blackrock or UBS? Their scale also gives them a block vote on prices – owning 15% of the global stock market is more than enough to keep nudging it in the right direction, and using their bulk to push hard when required. Global risk now resides with these names – not the banks.

I’m not saying they rig the market in their favour – but it’s clear they are likely to move in parallel directions in terms of the strategic direction of prices. Does that mean you should be reading all their research? Probably.

At the tactical level – is it the actions of the 70% institutional market, or the 30% of volume controlled by retail investors that spins the prices of meme-stocks and cryptos? Probably. These moves in stocks like Rivian are aberrations, but smart traders will play them, trading on the crowd sentiment.

As we’re all aware, much of the activity just doesn’t make sense. While Rivian was worth billions despite an abject lack of sales, at the end of the spectrum we saw a major Big Tech corporate name’s stock crash last week. Its crime? It missed earnings forecasts by a couple of percentage points, and its stock tumbled 11% overnight. Wow! That tells us market confidence in the company has cratered, with a pretty damning outlook on the key issues like the firm’s future profitability, its ability to sustain earnings, management quality and competitive threat environment.

The firm in question is Alibaba. It is my worst performing stock pick of 2020, and has cost me dear this year. Earnings came in at $31.1, but earning forecasts were $32.1 bln! $30 bln… that’s what Tesla might struggle to make over a couple of decades – but, of course, its “phenomenal earnings-quality” means its’ tiny profits might be a fraction of Alibaba’s, but are worth 4 times Alibaba’s enterprise value. Apparently.

The risks to Alibaba are clear: regulation, censorship, political sensitivities, data privacy, etc. Analysts collectively describe these as “headwinds”. Yet, fundamentally, it’s a great business with a strong established position across the Chinese markets. My guess is the retail/sentiment traders won’t see that – but the big boys will.