Repeat after me, the markets are not the economy

Markets Print for 28 May 2020 · by Jeff Zananiri

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  • We are witnessing one of the largest divergences between the financial markets and the real economy, in history.
  • Tech has seen a particularly outsized recovery, partly fueled by historically loose monetary policy and the widespread adoption of passive flows into market cap weighted index funds.
  • Understanding the divergence exists is paramount to understanding what potentially comes next; populist and socialist movements and inching closer to the end of the wealth creation cycle, and the beginning of a wealth distribution one.

Divergence Everywhere

We are living in a financial environment some compare to The Twighlight Zone (a popular show from the 1950s, where life was almost normal except for some glaring bizarre unexplainable phenomenon).

Today’s life is hardly normal on many levels. At first glance, perhaps the most unexplainable are the current equities prices, which has led to the dreaded question from friends and family: “Why is the equity market up, despite all the economic uncertainty we know we’re facing today?”

Embedded in that question is the faulty assumption that the market needs to reflect economic reality. Well, it doesn’t always work that way. As we’ve written in the Macro Print, central bank liquidity and financial alchemy (“buybacks” will be covered in the Editorial Print), and not the economy, have been the main driver of the equity market for a while now:

“If, in 2008, you had asked most economists what they thought would be the end result of this money printing, they would have said “inflation”. They were partially right, though mainly wrong. Goods and wage inflation remained benign, but asset prices such as the S&P500 index in the US soared, disconnecting from corporate and economic fundamentals.” – The Lykeion Macro Print – May 2020

This means that, as long as there is excess liquidity in the market through central bank support,  markets can continue on an upward trend, despite the grim forecasts you might have for the economy. Again, in the current episode of the Twilight Zone, the financial markets are not the economy and vice versa, and what we’re seeing right now is a growing divergence amongst the two of them. Could we end up living in a world in which we have price deflation and continued asset inflation? Could we live in a world where the stock market continues to trend towards all-time highs, whilst we have an economic depression and unemployment levels last seen in the Great Depression?

Tech’s Herd Immunity

The clearest indicator of how the market is incrementally diverging from the economy must be the performance of the NASDAQ, the tech and biotech index that is usually seen as the benchmark for the high growth companies of the tech and digital revolution. The index is up year-to-date, despite the millions of jobs lost on the back of the COVID crisis.

The price action of the NASDAQ is mainly being driven by the strength of companies like Microsoft, Apple, Amazon, Facebook and Alphabet, which together comprise almost 40% of the index.

These companies have resisted the current virus-driven economic headwind given the omnipresence of their footprint and the increasingly diversified nature of their businesses, their deep access to capital markets and the amount of cash they have in their balance sheets, which gives them optionality to support their share price with buybacks and increased dividend payouts (which increases the demand for their shares, helping support prices). If we look at Apple, for example, it currently has more than $192 billion in cash to support its share repurchase and dividend payout program, which, for reference, in 2019 amounted to an extraordinary $81 billion (more than the GDP of Panama, and they make damn good coffee). They have been vocal about how they will be repurchasing their stock amid the pandemic, and this has been incredibly important in supporting prices.

Among all those companies, there is perhaps no bigger poster child stock for the “COVID Winners” category than Amazon. Jeff Bezos’ creation has been killing its brick and mortar retail competitors for years, and the forced shutdown driven by the virus only accelerated that reality. The S&P Department Stores Index is down 60% YTD in 2020, in stark contrast with Amazon, which is hitting all-time highs.

Whilst a big part of the outperformance of these tech companies has been driven by the strength of their balance sheets and the quality of their operations in a period of high global uncertainty, some aspects that have helped support their prices are of a more technical nature. The most important one, and a topic we urge our readers to spend some time on (we’ll cover it in depth in future prints), is Mike Green’s thesis on the distortions of the current market structure derived from the rise of passive investment.

“The behavior we are seeing in public markets is not a signal of collective decision making, “the wisdom of crowds” or the Efficient Market Hypothesis at work. Instead, it’s an indication of a market that has been twisted into a shadow of its former self by two forces – passive investing and synthetic attempts to generate yield by systematically selling volatility.”

“Over the past 25 years, we have experienced unprecedented growth in passive investing. Most Americans and market participants are unaware that this has become the primary mechanism by which investments occur.  Regulatory changes, heavily influenced by the lobbying activities of Vanguard and Blackrock, have led to an inexorable flow of capital towards passive investing. Today, more than 100% of gross flows into the stock market are passive (meaning discretionary managers are facing gross redemptions) and nearly 85 cents of every incremental retirement dollar now flow into a target date fund. Roughly half of all 401Ks hold a target date fund as their sole security.”

If you want to understand how the market works nowadays, you need to understand passive investments. And when you understand passive investment, you get a sense of why large companies (such as tech) are poised to become larger and larger.

In simple terms, as new funds enter the equity market through passive strategies, typically in the form of ETFs, the custodians (i.e. Blackrock, Vanguard, etc.) use those funds to indiscriminately buy equities following the market-cap weight of a company in a certain index like the S&P 500, the Dow Jones or, of course, the NASDAQ. This means that, if I were to invest $100,000 to buy an ETF that tracks the performance of the NASDAQ, I would end up buying almost $40,000 worth of Microsoft, Apple, Amazon, Facebook and Alphabet given they constitute almost 40% of the index.

Given that “more than 100% of gross flows into the stock market are passive”, all new money that comes into the market disproportionately flows into these large tech companies, given that they comprise disproportionately larger percentages of those index funds. This ensures that there is a constant stream of demand for those large companies independently of changes in economic conditions (such as those prevalent today) or underlying fundamentals, which ends up driving the price of their stock higher, increasing their weight in the index and leading to an even larger percentage of new funds being allocated to them. And although this is a simplified sequence of the process, can you see the self-reinforcing cycle that ends up leading to higher prices of Microsoft, Apple, Amazon, Facebook and Alphabet?

We would caution our readers not to interpret the narrative for NASDAQ companies as a benchmark for the price action across the market. Most individual stocks did not bounce back like the above-mentioned names, and entire industries across the globe are still significantly down year-to-date. That is probably the way it should be given how much the world has changed in these past few months. The problem though is that tech companies are becoming so large that their strength and performance is “optically” eclipsing the weakness in other markets or industries, from the airlines to the European Banks, to emerging market economies such as Brazil.

What is the consequence of the divergence between financial markets and the real economy?

One of the things that ends up at risk given sustained and increasingly divergent financial markets and the economy is, broadly speaking, good old fashioned, red-blooded capitalism.

According to a report published by Americans for Tax Fairness and the Institute for Policy Studies’ Program for Inequality:

“Between March 18—the rough start date of the pandemic shutdown, when most federal and state economic restrictions were in place—and May 19, the total net worth of the 600-plus U.S. billionaires jumped by $434 billion or 15%, based on the group’s analysis of Forbes data. The billionaires’ worth rose from $2.948 trillion to $3.382 trillion. The top five U.S. billionaires—Jeff Bezos, Bill Gates, Mark Zuckerberg, Warren Buffett and Larry Ellison—saw their wealth grow by a total of $75.5 billion, or 19%.”

This means that whilst 38 million Americans lost their jobs, Jeff Bezos increased his net worth by 30% to almost $150 billion (GDP of Ukraine, and they make damn good Vodka). The impact of this global pandemic is so starkly different among different social classes that it ends up fueling populist and socialist movements. Capital ownership is being rewarded, whilst the middle-class is suffering the consequences of the economic squeeze.

And whilst we don’t know how this will end, we surely believe that it is important to keep in mind that, as the financial markets continue to diverge from the economy for both fundamental and technical reasons, it ends up having not just a financial impact, as well as a social one. As the research house 13D has long argued for, we might be at the end the wealth creation cycle and at the beginning of a wealth distribution one. (We’re not advocating this should be the case, just pointing out this may be the new set of facts we will now live with.)

Retail Investment 

The divergence between the financial markets and the economic reality of many people losing their jobs and thus 1) having more time in their hands and 2) looking for alternative streams of income, has led to a stellar increase in retail investment.

As Jason Goepfert posted on Twitter, TD Ameritrade and E*Trade daily average revenue trades (i.e. trades that generated revenue for the broker) increased 300% from 1 million to 4 million in the last couple of months. According to Investopedia, Robinhood tripled its trading volume in March of 2020 compared to March of 2019, while Fidelity clients logged in 56% more frequently in March 2020 than in March 2019.

There is a narrative in the retail market, and especially on social media, that the “dip” we just went through was and still is a marvelous buying opportunity. Surely, in the short term, that has materialized profits for some new joiners in the financial market. The problem is that many of these new retail investors do not understand the point in time in which they are investing. They also do not understand the structure of the markets, the products they invest in of the drivers of the investments they’ve made, and this all leads to an increased probability of loss of capital for those same retail investors.

Case in point is what recently happened with the largest oil ETF, United States Oil (USO), which saw assets under management (AUM) increase from $1.2 billion in 2019 to $3.9 billion on May 8 2020 as many retail investors were trying to “buy the dip” in oil prices. As highlighted by an Oxford Energy report, “According to, which tracks the number of users holding each asset on online trading platform Robinhood, the record 220,905 user accounts were holding USO fund on 28 April 2020, up from only 8,000 two months earlier”. What the retail investors did not understand is the need that ETFs like USO have to roll the future contracts that they own in order to give its holders exposure to oil, and that is very costly in the long run. Additionally, the hidden costs of rolling the future contracts are the main reason why, since inception, the ETF has lost more than 90% of its value, and one of the reason why, instead of higher oil prices, retail investors ended up with negative oil prices for the first time ever.

Retail investors, besides being typically less experienced, are frequently known to make mistakes which sometimes force the SEC to take action to protect them from themselves. Just this year, amid the pandemic-driven remote work schedules and the explosion of demand for Zoom Video Communications’ services, investors ended up pouring money into a defunct China-based company also named Zoom (Technologies instead of Video Communications), leading the alter-ego stock price to rise by +1,800% until the SEC was forced to step in. As Chartr highlighted back in April of this year, “Similar looking tickers have misled other investors in the past. When Twitter (TWTR) went public in 2013, investors bought Tweeter Home Entertainment (TWTRQ) which on one day increased by 1,500%. And in 2017 when Snapchat (SNAP) went public, the stock price of Snap Iterative soared 164%.”.

On the opposite side of the spectrum lie many of the most experienced investors around, who are calling out this market for being a terrible risk versus return investment opportunity. Stan Druckenmiller stated during a webcast held by The Economic Club of New York that the risk versus return ratio for equities is the worst he’s seen in his career (and that dude has been making returns in the market since before Diego was born). Warren Buffet, who started 2020 with $128 billion in cash, could have been expected to shop around during the most recent market weakness, but instead  has been pairing down or fully exiting positions, even at a large loss (he fully exited all of his U.S. Airline holdings (see the May 2020 Editorial Print) and sold large stakes in financial institutions such as Goldman Sachs).

Again, the divergence between professional investors and retail investors almost mimics the financial market’s divergence from the economy, and although it is not our role to define which one is right, we tend to think investors with a track record and decades of experience make a stronger argument than Fortnite players who got bored of buying new “skins”, especially when valuations are, again, at record levels.

What Peaked Jeff’s Interest this Month?

GOLD: We can see asset inflation, or at least the anticipation of it, showing up in the love for Gold. In 2008, when the FED ballooned their balance sheet from under $1 trillion to over $3 trillion in the immediate aftermath of the Great Financial Crisis, gold also broke out of a multi-year range and then tripled. This time the central bank action is worldwide and much larger with gold still hovering around the highs made in the years after the original QE rounds. This gold move could just be getting started.

GOLD MINERS: The S&P 500 Gold Miners Index is the top sub-sector up 46% in 2020. This GDX (Gold Mining ETF) to SPX comp chart shows that the Gold mining index hasn’t participated with the last leg of the S&P bull in the second half of the 2010s. Though Gold is back near all-time highs, the Mining companies still have a long way to go to get back to 2011 levels.

EUROPEAN BANKS: The Euro banks have been the poster child for negative interest rate pain. Could they be perhaps a sneak peek for what awaits for other places like the U.S., where negative rates are being championed as a good thing? Europe lifted its short-selling ban in mid-May so we’ll see how that works out in terms of price action. One particular bank stock in Europe that faces a true crisis right now is Banco Santander, Spain’s largest bank. Spain and Italy have been two of the countries most affected by COVID. We’re looking at a bank that has lost 80% of its market cap value in the last 5 years, and a stock price that hasn’t seen current levels since the early 1990s. This isn’t just about recession or depression, this chart tells a story of systematic collapse.


Take a Step Back

The purpose of the Markets Print is to help our audience contextualize the movements we’ve been seeing in the markets. The challenge (but also the fun) is that the markets have infinite stories to tell, but we need to be selective about what we write about each month. For our launch edition, we wanted to really distill how the economy and financial markets are moving in different directions and try to give you some perspective on why. But the financial markets are full of interesting stories, from the corporate credit bubble, to the U.S. dollar debate and its potential impact across the world, to the oil or gold commodities market.

We’ll timely write about them all and continue to cover the themes across our publications. All you have to do is make sure you tag along for the ride.

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